Prof.

Lalith Samarakoon: As US interest rates

rise, no space for Sri Lanka to wait and see
March 16, 2015
Two contrasting developments associated with USA and EU
Two contrasting developments are now taking place in the global monetary
arrangements. On one side, US Federal Reserve, known as the Fed, which
had introduced an unconventional monetary stimulus called quantitative
easing or QE from around end-2008 is planning to gradually withdraw it
from June 2015. On the other side, European Central Bank or ECB, in
desperation of the failure to arrest slow economic growth and rising
unemployment, has introduced QE in the Euro area.
These two regions account for nearly a half of
the global output and are well connected to
each other as well as to the rest of the world
through trade, finance and exchange rate
arrangements. Hence, the rest of the world
cannot just sit and watch what is happening in
an important part of the global economy.
It specifically applies to Sri Lanka which has
been a side beneficiary of the Feds QE by
attracting high interest seeking US investments
into its government securities market. This is
the view expressed by the Sri Lankan born
academic, Lalith Samarakoon, presently
Financial Economist and Professor of Finance at the University of St. Thomas
in USA through email correspondence with this writer as well as the
conversation he had with him on the Facebook.
Samarakoon in the late 1990s and early 2000s supported the Central Bank
to train its fund managers attached to the Employees Provident Fund in its
modernisation phase.
QE differs from Open Market Operations

Under QE, the Fed started to pump money into the US economy by buying
securities from the market in specified quantities. This differs from the
normal monetary policy adopted by a central bank known as Open Market
Operations or OMO wherein it would buy and sell securities to regulate the
excess liquidity in the market. QE, in contrast, is one-way and supplies
funds to the market on a permanent basis through a pre-announced
program of buying securities.
The result of such a program is twofold: it increases the prices of securities
lowering interest rates and pumps new money into the system increasing
the countrys monetary base the quantum of seed money available to
commercial banks for lending to people by creating multiple deposits and
credit. The lowered interest rates and multiple level of credit created in the
economy are expected to increase the total demand called aggregate
demand inducing producers to produce more. In the process, output and
employment are expected to move up taking the economy out of economic
recession.
US has attained QE targets technically
Both these technical objectives have been realised by the US Fed. Its
monetary base which stood at $ 875 billion in August 2008 rose sharply to $
4139 billion by the end of January 2015. The benchmark 10 year US
Treasury securities rates fell from 4.76% as at January 2007 to 1.91% by
January 2012. An unintended consequence of the interest rate decline in
the US market was the flight of US savings out of the country in search of
better interest return elsewhere.
Sri Lanka which had faced a chronic balance of payments problem and
depletion of foreign reserves quickly capitalised on these low interest rates
and allowed foreigners to invest in government Treasury bills and Treasury
bonds which had offered substantially higher rates than those prevailing in
US markets.
Accordingly, foreign funds flew into Sri Lanka and, by end February 2015, a
total of $ 3.5 billion had been invested by foreigners in government
securities. According to an announcement made by US Ambassador to Sri
Lanka in February 2013, a bulk of these investments had been of US origin.
(available at: http://www.sundaytimes.lk/130210/columns/iran-styleeconomic-crisis-cwealth-summit-in-balance-32552.html). The total of such
foreign funds in the government securities market amounted to nearly a

half of the countrys foreign reserves of $ 7.2 billion as at end-January 2015.

Bernankes justification of QE
The former Chairman of the Fed, Ben
Bernanke, delivering the Josiah
Stamp Memorial Oration at the
London School of Economics in 2009,
explained the rationale behind the
Fed following QE (available at:

http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.ht
m ). According to him, the proximate reason for the financial crisis was the
housing sector bubble that had developed in the US but it was an
unintended consequence of the low interest rate policy pursued by his
predecessor, Alan Greenspan.
When the bubble burst in USA, it soon became a global crisis. The heavy toll
it took in terms of loss of output, employment and wealth throughout the
globe has therefore been substantial. Though the global economy was
expected to recover on its own in due course, the timing and the speed of

recovery were not to the liking of the world community. Therefore, the
governments intervention to accelerate the process was called for.
Bernanke believed, as he explained in the Stamp oration, that the US Fed
still had powerful tools at its disposal to help the US to come out of the
financial crisis and economic downturn.
One mistake leading to another mistake
The underlying assumption of this type of policy intervention by the Fed,
and also by other central banks, is that central banks, or more specifically
the central bank created-money, can boost economic growth.
The reasoning goes as follows: Economic growth comes from the production
of a bigger output and continued production of such a bigger output is
dependent on the consumers ability to buy that output on the one hand
and producers ability to produce more and more output on the other. When
central banks reduce interest rates artificially to low levels, it is believed
that consumers make a hard choice in favour of consumption and producers
in favour of investments. So, central banks seek to kill two birds with one
stone by reducing interest rates. But the reduction of interest rates also
leads to shrink the savings flows since people now get a low rate of return
on their savings.
When the savings flow declines, banks are unable to lend money to
businesses despite the fall in interest rates. To increase the fund-available
for lending, central banks start printing money and supplying to the
financial institutions. It drives the interest rates further down and dries up
savings flows further. Thus, central banks get caught in a vicious trap: They
have to keep on pumping more and more central bank-printed money to
the financial system in order to keep it alive. Thus, one mistake made by a
central bank leads to the making of a series of mistakes.
Unexpected fall in US money multiplier
With this type of money creation, the US would have ended up with an
uncontrollable hyperinflation but it had been saved by an unexpected
market development. Banks which had already been hit once by the crisis
had been cautious about lending and therefore had kept the new money in
the form of excess liquidity temporarily deposited with the Fed.
The result was a drastic reduction in money multiplier the number of
times a given unit of monetary base is increased by a bank in creating
multiple deposits and credit. Thus, the US money multiplier which stood at

5 meaning one dollar created by the Fed will eventually end up as 5

dollars in 2008 fell to a level of less than 1 by end 2013. Thus, for the first
time, the US monetary base has been bigger than its narrow money stock.
It is a blessing in disguise since the Feds QE has not led to monetary
expansion and consequential high inflation.
As a result, the US citizens now experience the historically lowest inflation
which is below 1%. However, it has inflicted the US economy with a number
of macroeconomic ailments: Low inflation, high trade deficit, low economic
growth, high unemployment and pressure on the dollar to fall in the
international markets. Thus, it appears that Bernanke, having tried to solve
one problem, has created so many problems in the US economy.
US has no choice but to give up QE
These ailments take the form of rising interest rates in order to curb
inflationary pressures, ending the current QE since the Fed will not be able
to continue with liquidity pumping at the same rate and a massive shrink of
consumption by US citizens and investment by businesses. It will lead to a
curtailment of the output in USA; it will also have adverse impact on several
other countries which are linked to the US economy and its financial
system.
It has now been the task of Bernankes successor, Janet Yellen, to reverse
the earlier easy money policy pursued by the Fed. According to the latest
reports, the Fed is now seriously considering the tightening the US
monetary policy beginning from June 2015 (available at:
http://www.wsj.com/articles/fed-leans-toward-removing-patient-promise-onrates-1426014812).
In expectation of this move, the 10 year US Treasury securities rate
accelerated from 1.91% in January 2012 to 2.86% by January 2014. It is
therefore likely that the US interest rate structure will move to a higher
plateau within the next six to 12 months.
With a new QE being implemented by the European Central Bank at
present, funds are expected to move from Europe to USA searching for
higher interest rates. As a preliminary for this move, Euro is now falling
against the dollar reaching a level of $ 1.05 per Euro as on 12 March. The
equality between the two major currencies in the world is expected to take
place pretty soon.
Prof. Lalith Samarakoon: Dont just sit and watch the global developments

Samarakoon says that policy makers in Sri Lanka as well as in emerging

markets should take serious note of these developments. Though the
magnitude and duration of US interest rate increases are not known, it is
likely that it would take place in a slow and measured phase. At the same
time, the decline in oil prices has delivered a positive shock to oil importing
emerging economies like Sri Lanka. In that context, according to
Samarakoon, these countries have been driven to an unchartered territory
making it necessary to predict the net impact as early as possible.
Samarakoon has identified some of the net effects: The first to be affected
are the capital markets. Some of the foreign portfolio investments,
particularly the hot money that came to emerging markets and Sri Lanka in
search of higher yields and returns into the government bonds and stock
markets are likely to reverse gradually as investors find acceptable yields in
the US which is a much more stable and liquid market
Further, he says: The cost of dollar-based funding will go up and the policy
makers must factor this in their desire to float more government bonds in
international markets. Definitely, given the drop in Euro and the euro-based
interest rates, the government needs to be proactive to diversify its funding
sources.
What Samarakoon says is that Sri Lanka should not postpone the issue of
the sovereign bonds in the international markets because US interest rates
are to rise after June and EU rates have already fallen. Hence, the proper
policy is to make hay while the sun shines.
Need for having a credible domestic bond market
The global developments have shifted the focus to domestic markets.
Argues Samarakoon: The domestic capital market conditions and investors
will become more important for government financing. The viability and
credibility of domestic bond markets become ever so significant. In that
context, liquidity in the domestic fixed income sector is critical. If the
domestic liquidity also dries up, then there is going to be more upward
pressure on bond yield and general interest rates. The monetary policy will
need to be carefully calibrated so as not to raise the interest rates abruptly
which will have larger and wide-ranging adverse economic ramifications.
Given the current scandal eroding the credibility of the bond market,
Samarakoons assertion that its credibility should be restored should be an

eye-opener for Sri Lankas policy authorities.

The problem does not end here. Capital reversals could also put downward
pressure, according to Samarakoon, on the exchange rate creating a
challenging environment for maintaining a fairly stable exchange rate. Of
course, the benefits of lower oil prices will be partially offset by any
potential currency depreciation. Hence, on a positive side, lower rupee will
benefit exports and to the extent the US economy continues to show
strength and ECBs QE program raises growth in the Euro-zone countries,
Sri Lanka will further benefit from increased demand for its exports.
Samarakoon says that the decline in interest rates in EU area will not
increase hot money flows to Sri Lanka. That is because for investors in EU,
USA with its more liquid and free financial and capital markets will offer
better investment opportunities. Hence, the developments in USA are to
dominate the global scene more strongly in the short to medium term.
Samarakoon: Central Bank should give right signals
In this scenario, how should Sri Lanka design its policies? Samarakoon has
several answers to that question. He says that in the sort-run, the Central
Bank and other policy makers will have to prudently manage and balance
any risks posed by capital flow reversals, downward pressure on the
exchange rate and upward pressure on interest rates. Building a strong
foreign reserve position must be considered a top priority to mitigate the
risks against any negative external shocks. If external financing becomes
too costly and unviable, the domestic money and bond markets should play
a pivotal role in government financing.
But how could that be done? Samarakoon argues that The Central Bank
needs to provide right signals, market guidance and a transparent policy
framework to maintain interest rate stability since higher interest rates
coupled with low growth are to worsen the budget deficits.
In this context, says Samarakoon, Sri Lanka should have a prudent medium
to long term fiscal policy framework that incorporates serious revenue and
expenditure reforms in multiple areas of the economy. Ultimately, fiscal
policy should provide adequate space and flexibility for us to respond to
adverse external and domestic events without destabilising the economy
and social safety network. Such instability will ultimately lead to social and
political unrest, making any meaningful economic reforms more difficult.
Negative economic shock should be properly managed

What is being delivered by USA and EU is a negative economic shock to Sri

Lanka. That shock has to be managed by the countrys Central Bank and
the two line ministries involved in the economy, namely, Policy Planning
and Finance, through a carefully laid down policy package. This can be done
not by increasing lavish expenditure but by prudently managing such
expenditure. This is the biggest challenge presently faced by Sri Lanka.
Swap with RBI is good but support from IMF is better
Sri Lanka now faces the risk of the hot money mobilised by the previous
government flying out of the country without warning. Any sudden
depletion of foreign reserves will bleed the country to an untimely death. It
has been reported that the Central Bank has entered into a swap facility of
$ 1.5 billion with the Reserve Bank of India to cushion its foreign reserves.
This is only a temporary measure and should not be relied on permanently.
A more permanent measure that would require Sri Lanka to implement a
comprehensive economic reform program, as argued by Samarakoon, is a
Balance of Payments support from IMF that is contingent on policy reforms.
Thus, the present negative external shock is the ideal situation for Sri Lanka
to present its case with IMF which is, it appears, under a strange belief that
Sri Lanka does not need BOP support at the moment.
Hence, Sri Lankas policy, according to Samarakoon, should be forwardlooking and proactive. In that background, it has no space for a wait and
see approach.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri
Lanka, can be reached at waw1949@gmail.com); Lalith Samarakoon is
available at lalithsamarakoon@yahoo.com.)