Rupee devaluation on course; prices of fuel, imported items to rise

By Feizal Samath

The Central Bank on Friday finally veered towards IMF calls for a devaluation of the rupee, depreciating the local currency marginally against the US dollar and initiating measures to curb credit growth.
Bankers, however, said these measures were unlikely to dampen imports and ease pressure on the US dollar, unless a bigger rupee devaluation was in place through the daily market operations. The rupee was devalued by 3% in a November budget announcement.

The Central Bank (CB) on Friday raised interest rates by 0.5 % on its reverse and re-purchase rates with banks, a signal for all commercial banks to increase their lending and borrowings by a similar or higher margin. At the same time the CB depreciated the rupee by 20 cents pegging its selling rate per dollar at Rs 114.10 from Rs 113.90 on Thursday.

Both measures are aimed at curbing surging imports, reducing demand for US dollars and thereby reducing a burgeoning trade deficit. The announcement came just after the CB and a visiting IMF review mission concluded a two-week discussion on the US$ 2.6 billion Standby Arrangement (SBA) facility and the fate of the final two tranches totaling US$ 800 million.

On the same day (Friday), the IMF team told reporters that while it appreciated the 3% devaluation announced in November, there was still a need for a more ‘flexible exchange rate policy’ – loosely speaking a bigger devaluation of the rupee.

While the CB appeared to finally move in line with IMF thinking that the rupee is over-valued and hurting exports, bankers and economists were not too optimistic whether these new measures would pull back the overheated economy to a more export-dependent one from one being driven by costly imports.“My own feeling is that import demand will continue to rise and similarly pressure will continue on the Central Bank to utilize its dollar reserves to stop any sharp depreciation of the rupee,” said a senior banker dealing with foreign exchange trading.

The foreign exchange markets swallowed more than US$1 billion from the CB last year, bringing down foreign reserves to US$ 5.9 billion by end December from a healthy US$8 billion in around August 2011.
And that alarming trend continues in 2012 with the CB pumping in US$ 400 million in January and an average US$ 25 million per day in February 1-3 period, forcing the CB to reverse its policy of defending the rupee in view of the import of essential commodities.

“It has been a one-way flow, reserves being sold and not replenished (bought back) through the banking system,” the banker said. Economists said the Ceylon Petroleum Corporation borrows heavily to service fuel imports and increased interest rates would add to fuel costs and further burden the consumer. State banks have also borrowed over US$1 billion dollars on behalf of the government and have to pay back.
“All this borrowing (interest) rates will also go up and passed on the consumer,” one economist said.
CB Governor Ajith Nivard Cabraal said there was no immediate need to draw the remaining US$ 800 million from the IMF facility as it comes at more than double the interest (3.1 % against 1.1% interest for the already-drawn US$ 1.8 billion).

“The SBA technically ends on December 31, 2011. However the review may take a few months before the IMF review team’s report is presented to its board. So there is still time for us to draw this money in the next few months if the need arises. For the moment, there is no need,” Mr Cabraal said.
Referring to his comments to the Sunday Times last week that drawing the balance US$ 800 million meant paying a high 3.1% on the entire SBA facility which drew flak from his most vociferous critic, UNP Parliamentarian Harsha de Silva, Mr Cabraal said this (position) was based on interpretation of the IMF clauses and notes given to him by the CB staff.

“There have been emails with the IMF being exchanged many times over the week to seek clarification on this issue and the interest rate if we take the whole amount. The IMF has now confirmed that the 3.1% is only for the US$ 800 million,” he said. IMF officials in Colombo also confirmed this (See Business Times report).At Friday’s media briefing, IMF review team leader Brian Aitken said the decision to draw the balance tranche had to come from the CB and not the IMF. While welcoming the 3% devaluation, he called for a more flexible exchange rate policy.

The IMF has suspended tranches in previous SBA agreements if targets in the programmes are not maintained. The banker said import demand may come down immediately, but only slightly. That again would be a knee-jerk reaction to the decision and then demand is most likely to rise to normal levels. “This is because we have gone through high interest regimes (20-30 % interest compared to a single digit regime now) and not seen any drastic change in consumption trends,” he said.

He added that the government and the Central Bank need to separately tackle the non-essential sectors like vehicles where imports have been rising sharply.

The rise in vehicle imports has been particularly sharp in the case of motor cars, a costly utility, and a drain on foreign reserves. According to the Department of Motor Traffic, motor car registrations rose 60.14 % to 57,887 in 2011 from 23,072 in 2010, while registrations of three-wheelers rose 39.96 % to 138,436 in 2011 from 83,114 in 2010 and motorcycles by 11.72% to 232,120 in 2011 from 204,811 in 2010.

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