Interview: Arjuna Mahendran
To what extent should one be concerned by Sri Lanka’s current foreign reserve profile?
ARJUNA MAHENDRAN: Sri Lanka’s current reserve number is indeed something many analysts are looking at with a degree of concern. This is really linked with the whole economic model that was in place in the country until the end of 2014. Under this model, the government did the bulk of investing in the economy, meaning that private investors were crowded out, as illustrated by the low numbers for foreign direct investment (FDI). The fact that the government was raising a lot of money in financial markets for infrastructure projects meant that interest rates were high in real terms, and as a result private borrowers were not involved. One of the consequences of this crowding out was that there was a decline in aggregate demand, with real incomes stagnating and in fact declining, as inflation had eroded into nominal incomes.
Since the change in government in 2015, we have made efforts to reorient the economy by getting the government to back off from many of these capital-intensive projects. We felt there was a need to rebalance the economic equation, similar to what China has done over the last three years, where the government has placed less emphasis on public investment and prioritised consumption-driven growth by hiking up public sector wages. This has led to a consumer boom, to the point that we must ensure that we do not end up with the economy overheating. A particular area of concern is the import of motor vehicles, which has exceeded projections. This has led us to impose macro-prudential measures by reducing the loan-to-value ratios.
Generally speaking, the reserve profile reflects that position. Reserves had been run down over the last five years because of the excessive focus on public sector investment, and there were no immediate returns that would help build up the growth of export earnings. FDI was also weak. So our focus now is on boosting the income from foreign earnings, and the principal way we have done this is that we have let the currency float since September 2015. Previously the Sri Lankan rupee was pegged to the US dollar, which made our exporters uncompetitive, as a stable dollar peg was followed by a sudden devaluation every few years. It is better to keep the exchange rate competitive and responsive to market perceptions. Therefore, we hope to maintain our export edge and boost our reserve accumulation. While reserves have been under pressure in 2015 because of the surge in consumer spending, we have still been able to borrow in the markets and establish swap lines with India. In doing so, we have been able to manage reserves without creating panic in the markets.
To what extent is Sri Lanka at present overbanked and in need of consolidation?
MAHENDRAN: I do not think Sri Lanka is currently overbanked. While our financial inclusion ratios are good, there is room to make this better. For instance, the standard measure of financial inclusion is at around 68%, which can be improved. If one looks at the extent to which rural communities have access to credit, it is at only 18%, according to the International Fund for Agricultural Development. This means the banks are not providing an adequate transmission mechanism, not just for monetary policy but also for credit delivery, and that has to be fixed.
For the past two decades or so, the central bank has tended to focus on controlling inflation and ensuring the overall stability of the financial system. However, we should now consider economic development in a broader sense. For example, the banks should do more to address the skewed nature of economic activity in the country, with 45% of GDP being produced in Western Province, despite only having one-ninth of the population. Conversely, the war-affected Northern Province only produces 4% of GDP.
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