Thursday, November 18, 2010

Sri Lanka should channel capital flows to direct investment: rating official

Nov 18, 2010 (LBO) - Sri Lanka can expect higher post-war growth, with lower inflation, higher employment provided deficit spending can be checked and capital inflows channeled to direct investment, a senior rating official said.

"The two key reasons underpinning growth is the return of peace and all that it implies for investor confidence," Roopa Kudva, South Asia head for Standard & Poors', a rating agency, told a forum in Colombo.

"And also the expected economic reforms under the IMF (International Monetary Fund) standby agreement are going to be key factor."

Kudva is also chief executive of CRISIL, an Indian rating agency connected to S&P. She said Sri Lanka's growth this year would exceed 6.5 percent though official projections are near 8.0 percent.

Kudva said Sri Lanka had favourble demographics. Like India, the dependency ratio has fallen in recent years and unemployment was low at around 5.0 percent. This increased the capacity for domestic consumption.

"It clearly underpins the base for strong domestic consumption which will provide a boost for economic growth.

Fiscal Risk

Sri Lanka could get sustainable high growth if large scale private investment comes and government budgeting improves.
Sri Lanka has been deficit spending for years and running a gap in the current account of the budget. Excessive state consumption has dragged national savings levels down.

"The key risk is the fiscal risk, which remains because of Sri Lanka's high levels of debt and high levels of interest payments," Kudva said.

Sri Lanka's national debt is around 80 percent of gross domestic product. Standard & Poor's upgraded Sri Lanka to 'B+' after the country signed a deal with the IMF in 2009.

Sri Lanka however had the prospect of greater economic stability with lower inflation.

"Inflation continues to be a key issue in South Asia. Pakistan particularly badly hit with 15 percent," Kudva said.

Sri Lanka however was the exception, she said, with inflation of a bit over 5.0 percent.

Sri Lanka's central bank had managed to contain inflation so far, though there were fears of quantity easing earlier in the year.

But external flows had built up liquidity in the banking system with higher policy rates than the rest of the world and a stable exchange rate.

Foreign Capital

Though some countries in Asia were contemplating capital controls, Kudva says more sustainable measures to deal with capital inflows were needed.

"For a central bank to balance interest rates exchange rates and inflation is hard," Kudva said.

"The trend that is going to be over next 10 years is strong capital flows coming from the West to the East."

Many Asian central banks that intervene regularly in foreign exchange markets (effectively having pegged exchange rates) find capital inflows a problem.

A central bank that intervenes in forex markets and refuses to float its currency actively loses control of its money supply and can generate high inflation despite having policy rates.

Analysts say only Singapore (modified currency board) and Honk Kong (currency board), which intervenes in the forex market everyday are able to effectively handle capital movements because both countries to not have active policy rates.

Sri Lanka is also having large capital inflows, though the central bank has sterilized them.

Sri Lanka is planning to liberalize forex controls in the upcoming budget.

"In general if policy initiatives encourage foreign direct investment I think it will be useful in the growth context," Kudva said.

"Central banks can certainly focus on short term issues in controlling capital controls in one way or the other. And they have a variety of tools to do that.

"Over the longer term one should expect capital flows to be strong from the West to the East you have to develop long term responses which may not always be policy responses."

To attract investors Sri Lanka had to improve its ease of doing business, Ram Ratings chief economist Yeah Kim Leng said.

According to a World Bank study taxes on profits was averaged 64.7 percent, compared to 39.9 percent in South Asia.

Sri Lanka's has been giving sweeping tax holidays to some companies, pushing up the tax burden to all other firms. The government is planning to phase out tax holidays.

source -

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