Sri Lanka’s shaky economy will get another pummelling as the euro-zone sovereign debt crisis worsens, analysts and industrialists warned last week, while urging policy makers to start steeling the country for it.
But Central Bank Governor Ajith Nivard Cabraal said he did not anticipate a major negative impact. “We don’t need to take any measures right now,” he asserted. “We are watching the situation very closely. We are conducting a review every two weeks or so and if anything is needed we will be ready to step up policy action.”
A combination of actors expressed fears about the euro-zone crisis and its repercussions for Sri Lanka. Fitch Ratings said that, among emerging economies, Sri Lanka’s sovereign rating was at most risk from the fallout.
“Sri Lanka is most at risk due to its high external-funding needs and weak balance sheet,” Bloomberg newswire quoted Andrew Colquhoun, head of Asia-Pacific sovereign ratings at Fitch, as saying. “The same issues also make India and Indonesia vulnerable compared to similarly graded peers.”
Be ready for it
The Institute of Policy Studies, a semi-government think-tank, separately pointed out that Sri Lanka’s manufacturing and tourism sectors are “quite dependent on Europe and as a result could face a severe downturn.” For instance, the apparel industry exports 50 per cent of its products to the EU and over 42 per cent of tourist arrivals in Sri Lanka are from Europe.
“Given that apparels and tourism are two of Sri Lanka’s largest income earners (textiles and garments alone amounts to 39.7 per cent of total exports) it is crucial that stakeholders in the Sri Lankan economy take a very close look at the effects of a possible euro-zone break up and ensure that robust plans are in place to mitigate the ripple effects of such an outcome,” said IPS, which also has the Central Bank governor on its board. “Clearly, other countries have begun to think ahead – Sri Lanka must do the same.”
The euro-zone sovereign debt crisis, classified by the Organization for Economic Cooperation and Development as the world’s worst in 2011, is set to deteriorate this year. The situation was building up since 2009 when it was first realized that Greece could default on its sovereign debt. Since then, there are fears that Portugal, Italy, Ireland and Spain could also default on their public debt.
Led by Germany and France, the European Union has tried to support these countries with bailouts from the European Central Bank and the International Monetary Fund. These measures haven’t been enough. The very existence of the euro is now under threat. If more countries are unable to meet their commitments, the world could be hit with a worse crisis than in 2008.
One of the main challenges Sri Lanka will face is in the area of external debt – how much the government can borrow on the open market and at what rates. When the global financial crisis broke out in 2008 resulting in a liquidity squeeze, sovereign bonds were hard to float and they had to be sold at much higher interest rates until the credit crunch eased. Sri Lanka, which borrows significantly from the open market and needs to roll over some of its sovereign debt this year, might have to go for higher interest rates that we cannot afford.
According to Fitch projections, as quoted by Bloomberg, Sri Lanka’s gross external financing requirements this year equate to 95 per cnet of the country’s reserves. In contrast, Indonesia and India both need outside funds totalling at least 30 per cent of their sovereign reserves.
In a comment left on the IPS Talking Economics blog, an informed observer points to the increased integration of Sri Lanka’s financial market with the global financial system – both through the Government of Sri Lanka borrowing from international capital markets and, increasingly, commercial banks borrowing from abroad. He notes that a lot of this borrowing is tied to LIBOR (London Interbank Offered Rate) or the average interest rate that leading banks in London charge when lending to other banks.
“When Lehmann crashed in 2008, there was a big increase in the LIBOR,” he said. “And even last year, when the euro situation looked bad, the LIBOR almost doubled and has remained at that level. If there is a major credit event in Europe and it causes a sustained increase in risk perception for inter-bank borrowing causing the LIBOR to spike, it could affect repayments on international borrowings that have been made when the LIBOR was at very low levels.”
“A dry up on inter-bank borrowings,” he adds, “could also hurt trade finance, which tends to have a short and sharp impact on global trade.”
Indrajith Coomaraswamy, former director of the Commonwealth Secretariat’s Economic Affairs Division, said there were several channels through which Sri Lanka could get affected. This includes trade and tourism. “The overall impact on risk appetite in capital markets will also have to be considered because these will have implications for decisions made by lenders, international banks that lend money, portfolio investments and foreign direct investment,” he explained.
“There is already now a risk premium attached as a result of the crisis which all countries, including Sri Lanka, will have to pay,” Coomaraswamy continued. “Our capacity to repay may be affected if the euro-zone goes belly up. This is no commentary on the quality of our policies but on the fact that there is much more risk in the global economy which, in turn, means there is a premium attached to money that is being lent.”
So, if the risk appetite of international capital markets comes down because of the euro-zone crisis, it would impact negatively on the global economy which then has implications on the cost of funds for everybody.
But Cabraal said there was no cause for alarm. “The type of money we are raising means we have a clientele spread right across Asia, Europe and the US,” he explained. “Our view is that, even if there is any kind of reduction of investment appetite, it would be fairly well compensated by the appetite that has been enhanced both in Asia and the US. We don’t expect that also to be a problem.”
Asked about the possibility of having to pay higher rates of interest, Cabraal said Sri Lanka’s bonds are trading at “very competitive rates compared with many other countries.” “There, again, we don’t expect it to be a major challenge,” he insisted.
Exports to take a hit?
Garments are our main export to Europe but other products also make their way there. This includes rubber goods and processed fish. It is feared that the capacity of affected countries to buy from Sri Lanka would be less.
“There is no question that there will be an impact on exports as long as the euro-zone crisis exists,” said Dawn Austin, chairperson of the Exporters Association of Sri Lanka. But she felt that it will encourage some exporters to innovate and diversify. “Having lost the GSP Plus, certain industries saw themselves hone their products to reach a higher end,” she recalled. “And I’m talking here of the apparel industry.”
“I think exporters will start looking for other destinations and obviously for other buyers,” she reiterated. “That could compensate in the long run.” The problem, though, is that other export-oriented countries will be doing the same so Sri Lanka “needs to sort itself out and bring down our cost of production.”
Demand has already fallen. “It’s beginning to reflect in the May figures,” Austin said. “But we are talking of exports to the euro-zone. Don’t confuse it with exports in general.” Asked how they would encourage the government to tackle the situation, she said her association and the chambers are getting their budget proposals together. “Those usually form the basis for what the government will be requested to address but nobody had come out with anything specific yet,” she said.
Here, again, Cabraal was optimistic. “We have done several scenario analyses considering different countries in the euro-zone that have dealings with Sri Lanka,” he outlined. “We do not do business with the entirety of the euro-zone. We are actually doing serious work – exports, imports, investments-mostly with the UK, France, Germany and Switzerland. We find that we have very little to do with some of the affected countries. Our main exports go to Germany, UK, somewhat to Denmark and a few others. None of those countries are badly affected.”
The Central Bank’s assessment, therefore, is that if those countries, “do not get into any kind of serious situation, it is unlikely the euro-zone crisis will have a serious impact on the Sri Lankan economy”.
Meanwhile, Coomaraswamy said the euro-zone problem could also reach Sri Lanka through tourism. A large percentage of visitors to Sri Lanka come from Western Europe. If their countries are hit, it is likely that they will not take long haul holidays. Finally, remittances from people in countries such as Italy might reduce.
He expected the next year to be tough. “What could happen is that there will be an economic slowdown, interest are rates high, there is a credit ceiling for banks, investment will be less, so growth will be less,” he assessed. “If that is so, then tax collection will also be less since economic activity will be less. Government revenue will consequently reduce, as will its scope to provide assistance to people.”
This might mean that more sectors will appeal to the government for assistance.