Positive real interest rate should be maintained to control spiralling inflation – Dr. Nishan De Mel


By Rajiesh Seetharam

March 2022 was a significant month for the Sri Lankan economy with the floating of the rupee after following a fixed exchange rate for eleven months. President Gotabaya Rajapaksa also announced his willingness to work with the IMF, after a prolonged period of reluctance to go for an IMF bailout package by CBSL governor and the Government. The recent IMF article IV consultations were released in March which called for renewed efforts on growth-enhancing structural reforms. 

Against these developments, Ceylon Today spoke to Verite Research Executive Director, Dr. Nishan De Mel, who stated that adhoc policy decisions made things worse and stressed the need for positive real interest rate to control inflation and to attract foreign exchange to the country. Excerpts of the interview are as follows:

How do you view the recent floating of the rupee?

A: The rupee had to be floated, but there are other things which should have been done parallel along with it like further hiking interest rates so that it is a positive real interest rate, announcement of debt restructuring programme and suspension of debt repayment on International Sovereign Bonds (ISB) as of now. 

A sudden float of the rupee resulted in at least 45% depreciation of the rupee so far from Rs 203 to around Rs 280, resulting in spiralling inflation.   

Interest rates have to be increased more based on how bad the situation is.  When you run negative real interest rates, you can’t expect people to convert dollars into rupees.

Without doing all these things, letting the rupee loose is not going to help. This is huge mismanagement. You can’t exacerbate the shortage and expect depreciation to solve the problem.

How do you think IMF should be approached? Can reaching out to IMF solve the economic crises?

A: Government lost one-third of its revenue due to late 2019 tax cuts, which resulted in Sri Lankan credit rating being downgraded and we lost access to international capital markets. 

An economy is an ecosystem. We had to reduce foreign borrowings, but it had to be done systematically as a step by step process gradually. When we lost access to international capital markets suddenly, our foreign exchange reserves started to drop drastically. As of end February 2022, reserves stood at USD 2.3 billion, which is hardly enough for month of imports. 

Immediately we need to suspend servicing debt as when we are repaying without the ability to maintain a balance, we are going to have a shortage on foreign exchange. To reduce the speed which the reserves came down, government had to clamp down the availability of dollars available for rest of the economy, and that is the reason for the shortages. As a result we have run out of US dollars to buy our essentials including fuels, gas.

The solution lies in restructuring the debt, and providing a sustainable plan to win back investor- confidence, which may improve our credit ratings and gain re-access to international capital markets.

IMF can help in certain ways. It can give the technical advice. It can also give credibility as creditors may not accept Sri Lanka’s requests and IMF being an independent reputed financial institution can help Sri  Lanka.   IMF can also provide bridge financing to help the country meet the payments for essential items, but IMF cannot do provide bridge financing as long as Sri Lanka is ready to repay its debts. So, though Sri Lanka looks like it is moving in the right path, but it is moving in the wrong sequence. 

What other possible outcomes do you see arising if the economic crises continues?

A: I see three dangerous situations which may arise. Without a proper debt restructuring mechanism, Sri Lanka may end up in a disorderly default. In such a situation, negotiations with creditors may be extremely painful and it may take more time to negotiate a deal compared to an orderly default. 

Inflation is already very high. As a result of sudden depreciation of the rupee, it can lead to extreme inflationary cycle, where it keeps snowballing into wage-price spiral. This needs to be stopped immediately, to bring in stability.

Thirdly, if the current crises continue, SriLanka may fall into a situation where it might need to restructure its domestic debts in addition to the external debts. 

What other measures should be taken to control the economic crises?

A: Measures should be taken to increase investor confidence because when confidence is low, investors would bet against the country’s economy and it would be difficult to attract dollars into the country. Current adhoc appointments of various committees with the appointment of people who created the problems do not bring in confidence. 

“Sri Lanka’s ISB grew from USD 5 billion to USD 15 Billion during  2015 to 2019 when there was a IMF programme.” How do you see this statement on IMF?

A: During 2015-2019, Sri Lanka’s total debt stock increased by 42.8%,and at least 89.8% of that increase was due to the interest cost on accumulated past debt.Also one should take the total external debt into consideration and not only the ISB’s, because there can be different instruments in which a country can hold external debts. 

During that period, certain short term instruments were converted to ISB’s. On the other hand, Sri Lanka enjoyed high growth rates during 2010, 2011 and 2012 during which Sri Lanka was on an IMF programme.

Despite going to the IMF, countries such as Argentina, Pakistan are still struggling with high inflation and debt issues. There is heavy criticism against the IMF too? What are your views?

A: There is no short cut for proper governance of a country. You can’t blame the IMF for everything. Poor governance and finding a scapegoat in the IMF is something politicians generally use. There are countries which have used IMF assistance productively. 

Now in the case of Sri Lanka, our debt to GDP ratio increased by 24% in the last two years to 120%, which could have been controlled in the Budget.

Sri Lanka lost access to international capital markets due to tax cuts in late 2019. The external reserves were going down, because the Government was paying debt even after losing access to international markets. With State revenue dwindling, our interest cost to revenue ratio has increased to 70%, which is one of the highest in the world. Remittances have come down drastically due to mismanagement of the exchange rate. The IMF is not involved in any of these issues. These are all domestic issues which we need to fix. 

What are your views on the recent credit lines offered to Sri Lanka from India and China?

A: Credit lines are a way of hurting the future more to reduce the current pain. All these credit lines have to be re-paid. So credit lines are not the solution, proper sustainable economic policies is the way forward.