US interest rate hike: Sri Lanka has no

alternative but to follow the suit

US interest rate hike is linked to all

other interest rates

Monday, 20 March 2017

The Federal Reserve Bank the central bank of the United States
of America announced last week that its benchmark interest
rate would be increased from 0.75% per annum to 1.0% per
annum. The increase is, according to financial market parlance, is
by 25 basis points and in terms of Sri Lankan standards where the
central bank interest rates are between 7.0% and 8.5%, may be
insignificant. But for Americans, it is an increase of the prevailing
interest rate by 33%. Since the benchmark interest rate is the
rate at which depository institutions with the Federal Reserve
Bank would lend their surplus moneys to others on an overnight
basis without collateral, it is linked to all other interest rates in the
US economy as well as the global rates like the London Interbank
Offered Rate or LIBOR. Hence, an interest rate increase by the
Federal Reserve Bank is a global event rather than a mere local
event.

US interest rates are to double in the year to come

This is the third time the Federal Reserve chose to increase its
interest rate within the last 15 month period, the first being in
December 2015 from 0.25% to 0.50% and the second, some three
months ago from 0.50% to 0.75%. Two more interest rate
increases, possibly in the amount of a quarter percent each, are
expected in June and December this year. If they materialise, the
benchmark Federal Reserve interest rates will go up to 1.5%
indicating a doubling of the interest rates in that country within
one year imposing far-reaching consequences on the rest of the
world as well.

Monetary stimulation to come out of the economic

recession

When the US economy was hit by a major recession following the

financial crisis of 2007/8, the Federal Reserve Bank started to
stimulate the economy by pumping money to the countrys
financial system and reducing interest rates to a near zero level.
 Increasing monetary base while reducing
interest rates

Accordingly, the monetary base money printed by the US

Federal Reserve and supplied to the market rose sharply from $
847 billion in January 2008 to $ 2100 billion in March 2010. This
monetary base explosion continued since then in an
unprecedented manner rising to a peak of $ 4149 billion by
October 2014 and settling around $ 4000 billion since then. On 15
March 2017 on which date the Federal Reserve decided to
increase its benchmark interest rate, the monetary base stood at
$ 3929 billion, still a very high figure compared to its level prior to
the financial crisis (available at:
https://fred.stlouisfed.org/series/BASE). This was an extraordinary
stimulation of the economy by using monetary policy. To reinforce
this strategy, the Federal Reserve benchmark interest rate was
reduced in a number of moves from 5.25% in mid 2007 to 0.25%
in December 2008. It remained at this near zero level till
December 2015 when it was increased to 0.5%; in two
subsequent benchmark interest rate hikes in December 2016 and
March 2017, the rate was increased to its current level of 0.1%
(available at: https://www.thebalance.com/fed-funds-rate-history-
highs-lows-3306135).
Structural growth issues cannot be stimulated by
expansionary monetary policy

The US quarterly real economic growth data since 2009 does not
show that the economy has shown an appreciable recovery in
response to the monetary policy stimulus package introduced by
the Federal Reserve Bank. During 2005/6, before the economy
was hit by the economic recession, the US economy grew in real
terms at an average rate of 3.0% per quarter. During the
recession from 2008 to 2009, the economy contracted on average
by 1.52%. After the introduction of the stimulus package, the
growth was, on average, only at 2.08% per quarter, much below
its pre-recession performance. Hence, the US growth was a
structural issue and without correcting it, attempting to stimulate
the economy through monetary expansion does not appear to
have worked in the US economy. Hence, from around 2015, the
reversal of US monetary policy had been expected and its ripples
had been felt in both the rich and poor countries. The countries
which had specifically been adversely affected had been Sri
Lanka, India, Thailand and Indonesia which had attracted US hot
money into their respective economies by way of investments in
local securities markets in search of better interest yields.

Sri Lanka taking advantage of US capital flight

This was because, along with the monetary stimulus package, the
US interest rates fell sharply. 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-style-economic-
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.

When US interest rates rise, Sri Lanka is a casualty

Hence, if the anticipated interest rate hike in the US economy

would become a reality, Sri Lanka would be one of the casualties
experiencing foreign exchange outflows from the country. This
writer in an article published in March 2015, drew the attention of
the Central Bank to the potential risks faced by a would-be capital
outflow and emphasised on the necessity for tightening monetary
policy to prevent a potential capital outflow (available at:
http://www.ft.lk/2015/03/16/prof-lalith-samarakoon-as-us-interest-
rates-rise-no-space-for-sri-lanka-to-wait-and-see/). This was not
heeded to and the result was a sharp fall in the foreign
investments in government securities over the previous two year
period.

Ben Bernankes use of monetary stimulation to come out

of recession

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 a loose
monetary policy known as quantitative easing or QE to stimulate
the economy (available at:
http://www.federalreserve.gov/newsevents/speech/bernanke2009
0113a.htm). 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
Federal Reserve still had powerful tools at its disposal to help the
US to come out of the financial crisis and economic downturn.

Low interest rates and abundant money to stimulate both

the demand and supply

The underlying assumption of this type of policy intervention by

the Federal Reserve, 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.
Low interest rates also dry out savings

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
funds available for lending, central banks start printing money
and supplying such money to 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.

Though money was made abundant, banks did not lend

that money

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 Federal Reserve. 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.

A blessing in disguise

It is a blessing in disguise since the Federal Reserve Banks

quantitative easing 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
percent. 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. This was the ailment which his
successor, Janet Yellen, inherited when she assumed duties as the
Chairperson of the Federal Reserve Bank in February 2014. She
has now started to reverse the trend by increasing interest rates.

Sri Lankas easing of monetary policy

There has not been consistency in Sri Lankas monetary policy

since early 2015. On the same day as the infamous Treasury bond
issue, namely, 27 February 2015, the Central Bank did away with
the lower interest of 5% it paid to banks and primary dealers if
they had used the Banks standing deposit facility for more than
three times a month. Since commercial banks had been using this
facility liberally in view of the excess liquidity they had had at that
time, the average standing deposit rate had been settled around
5% though the formal rate had been 6.5%. As such the abolition
of the practice of paying a lower interest rate amounted to
increasing the Banks effective standing deposit rate by about
1.5% percentage points. Thus, it was an unintended tightening of
the monetary policy by the Bank.

Giving confusing signals to the market

Then, making a U-turn in its policy, the Bank decided to reduce its
policy interest rates by half a percent in April, 2015 bringing down
its standing deposit rate to 6% and standing lending rate to 7.5%.
Thus, the signal given to the market was that, despite the growing
money and credit levels and potential risk of capital outflows, the
Central Bank would loosen its monetary policy. However, in
December 2015, confusing the market, this loose monetary policy
was somewhat reversed by resorting to an inappropriate
monetary policy measure, namely, the use of the statutory
reserve ratio by increasing it from 6% to 7.5%. Thus, the market
was totally confused about the intention of the Central Bank
whether it was following a tight monetary policy or a loose
monetary policy. Creating such confusions in the minds of those in
the market does not augur well for a central bank which is
expected to give clear directions to the market.

A too short and too late monetary policy tightening

However, in 2016, in two separate moves, the Banks monetary

policy was tightened: In February, by increasing the standing
deposit rate to 6.5% and standing lending rate to 8.0% and in July
further to 7% and 8.5%, respectively. But these measures were
too short and too late. It also prompted the visiting IMF mission to
flag Sri Lanka that its Central Bank should stand ready to tighten
monetary policy if the money and credit levels would begin to
rise. This is exactly what has now happened. The monetary base
is now rising at the rate of 27%, up from 16.5% a year ago. The
growth in broad money supply at the moment remains at a high
level of 18% per annum. The credit to private sector has risen at
an annual rate of 22%; the Central Banks lending to the
government has skyrocketed recording an annual growth rate of
80% per annum. Meanwhile, the investments in government
securities by foreigners have fallen from a peak of $ 3.5 billion in
February 2015 to $ 1.2 billion as at the end of February, 2017.
The freely available foreign reserves have fallen to a record low
level of $ 4.7 billion as at the end of February, 2017 whereas the
countrys debt repayment obligations during the next 12 month
period have increased to $ 4.8 billion. The obvious corollary has
been to exert pressure for the exchange rate to depreciate.
No alternative now, but to increase the policy rates

Given this scenario, Sri Lanka cannot remain oblivious to the US

monetary policy tightening. If Sri Lanka does not follow suit, the
remaining foreign investments in government securities by
foreigners amounting to $ 1.2 billion might also fly out of the
country. That would be fatal to the Sri Lankas exchange rate.

Thus, at the moment, Sri Lanka has not been left with an
alternative, but to tighten monetary policy by way of an increase
in Central Banks policy interest rates.

(W.A Wijewardena, a former Deputy Governor of the

Central Bank of Sri Lanka, can be reached at
waw1949@gmail.com.)
Posted by Thavam