ECONOMYNEXT – Sri Lanka’s actions, including currency floating and taxes on imported items, will help stabilize the economy amid global turmoil, Central Bank Governor Nivard Cabraal said as the rupee was falling in a free-floating exercise.

The rupee closed at 255/265 against the US dollar on March 10, having opened at 240/260 as the currency headed towards a free float. The curb market rate and the interbank spot market have become unified.

There was still no active trading in the spot market.

Sri Lanka faces high oil prices and the central bank has depleted its reserves.

Cabral tightened the policy rate by 100 basis points to 7.50, allowed the market rate to rise, and also called for fuel price hikes as oil prices soared in a bubble triggered by the Federal Reserve, made worse by Russia’s invasion of Ukraine.

This week, the government announced that it was putting in place controls on certain imports.

“On our advice, the government appears to be responding positively and that would help steer the economy towards calmer waters at a time of unprecedented global challenges,” Cabraal said March 10.

“By performing these functions, we would be able to increase the policy space to take a more sustainable approach.”

Cabraal called for higher taxes on 700 imported items, which will increase tax revenue.

However, authorities have also granted licenses to many items which critics say lead to corruption as they have done in the past and increase distortions in the economy.

Leading economist WA Wijewardena said the float was a step in the right direction, but policy rates need to be raised to help the rupiah and also calm inflation.

“We need to raise rates to contain rising inflation in the country,” Wijewardene said.

“But it has a positive effect on the exchange rate. One of the reasons for the very high demand for imports is the cash available. Strong aggregate demand stimulates imports.

The central bank, as an adviser to the government, has also called for higher taxes and a pause in non-emergency investment spending, which will immediately put a damper on imports.

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The slowdown in government investment financed by domestic borrowing will reduce the deficit and reduce aggregate demand, leaving more foreign exchange inflows for items like fuel.

In 2021, imports of capital goods, including building materials, jumped to $4.46 billion from Rs 3.5 billion a year earlier, while imports of fuels rose to 3, $7 billion versus $2.5 billion.

The central bank also called for higher fuel and electricity prices. Oil prices, which have bubbled up due to the Federal Reserve’s money printing (Powell Bubble), have reached levels not seen since the Greenspan-Bernanke bubble that collapsed in 2008.

Rising energy prices shift purchasing power toward oil and reduce non-oil consumption, allowing total imports to remain the same.

If oil is subsidized by credit, this will drive up interest rates and if the policy rate of 7.5% is applied, money will be printed to account for the subsidies, which will put additional pressure on the rupee.

There are calls to raise rates to help the rupiah and also eliminate arbitrage opportunities between overnight rates and the yield on 3-month bills. (Colombo/March 11, 2022)