By Arujuna Sivananthan –

Dr. Arujuna Sivananthan

A bubble in economics refers to a period in which a product or asset is traded in high volumes at prices that are at significant variance with its intrinsic value. History is replete with examples including the Dutch Tulip Mania from 1634 to 1637, the French Mississippi Bubble in 1719-20 and the South Sea Bubble in the Great Britain in 1720.
In an article in the Journal of Monetary Economics, Ricardo J. Caballero and Arvind Krishnamurthy suggest that emerging market economies provide ideal conditions for financial bubbles and that they come at a cost. Undeveloped and weakly regulated financial markets can lead to investors undervaluing risk premia for protracted periods causing bubbles. Bursting bubbles expose economies to capital flow reversals, prolonged periods of asset price deflation and other welfare reducing outcomes.  Caballero and Krishnamurthy also suggest a set of policies to mitigate bubble risk including prudential banking regulation and the undertaking of structural reforms to develop public debt markets and property rights.
In its December 2011 Macro-Prudential Risk Monitor, rating agency Fitch moved Sri Lanka’s banking system to the high-risk  ‘3’ category “due to strong real credit and asset price growth stemming in part from the strong growth of imports” asserting that “Historical experience suggests financial systems in this category are at risk of instability”. Moody’s in rating the proposed Bank of Ceylon’s foreign currency obligation makes the following observation of the sector i.e. “deposit growth has not been able to keep pace with its credit growth”. Sri Lanka’s state owned banks in particular have bloated their balance sheets using money markets rather than deposits and have set aside less capital against these new assets than in previous years; most of which were generated by lending to the government and loss making state owned enterprises.
Sri Lanka’s zealous adherence to a soft-peg of the rupee with sterilised interventions since mid 2010 also fuelled excess credit growth. The Central Bank continues to print rupees to keep interest rates low and alleviate the drying up of liquidity in money markets caused by import demand for foreign exchange.
Unfortunately, excessive credit growth plays a critical role in fomenting asset price bubbles. Former president of the European Central Bank Jean-Claude Trichet in a lecture at the Monetary Authority of Singapore observes that “deviations of the credit-to-income ratio in excess of the 4 percentage point threshold alone as a warning signal would have even predicted 79% of financial crises”. In Sri Lanka’s case, credit-to-income growth, despite remedial steps by its policy makers, remains well in excess of 4 percent.
Evidence of Sri Lanka’s bursting asset price bubble is apparent in all markets. The benchmark Milanka stock index is down approximately 30 percent from its highs in 2011. However, its performance measured in US dollars over the same period is worse –it is almost 43 percent lower. Sri Lanka’s economy grew by an impressive 8 plus percent last year. However in dollars terms it has contracted. In April 2012, Sri Lanka’s economy is 10 percent smaller than it was in January 2011. Foreign investors and expatriates lured by Sri Lanka’s high yielding rupee bonds and deposit accounts have suffered too. A depreciating rupee has not only eroded any interest income earned but resulted in them suffering capital losses. Also, anecdotal evidence is suggestive of Colombo’s property market remaining depressed.
Caballero and Krishnamurthy also demonstrate that secure property rights are crucial to sustaining long-term foreign direct investment. However, in Sri Lanka’s case, the Asian Development bank in its 2012 Asian Development Outlook publication states that “Investor confidence is a key factor in attracting investment and this requires a predictable policy environment as articulated and reinforced through the legal, regulatory, and institutional framework. Thus the lack of such an environment for the private sector is a major obstacle to private sector development”.
Sri Lanka’s policy makers have taken some tentative steps to alleviate the financial stresses it confronts. However, whether they shall be adequate to deal with prevailing headwinds not just on the domestic front but in a global economy mired by uncertainty and a volatile geopolitical environment remain yet to be seen. The question at the heart of Sri Lanka’s economy is whether its citizens are richer or poorer than they were eighteen months ago. And, it only requires simple arithmetic to arrive at the answer.