Daily Mirror: 28/05/2005" By Sajeewan Wijewardana
Tighter monetary policies must be imposed by the Central Bank to prevent overheating of the economy with the increased inflow of foreign capital as part of the tsunami aid by foreign donors, the Institute of Policy Studies said yesterday.
The IPS in its latest publication stressed the need to strengthen the country's monetary position after the tsunami to handle and recover from the shock caused by the disaster, to manage the aid effectively, transparently, to avoid large-scale corruption, and secondly to ensure that the economy absorbs the aid inflows without undue pressure on domestic economic stability.
The latest publication "Phoenix from the Ashes? Policy changes and Opportunism for Post Tsunami Sri Lanka" was introduced yesterday at their head office in Colombo, and IPS Deputy Director and Research Fellow Dr. Dushini Weerakoon suggested several possible monetary policy responses to face these challenges in the post tsunami Sri Lanka.
She said that it was typical for economies struck by unexpected natural disasters to experience a brief deceleration in growth, followed by a rebound as a result of the stimulative effect of reconstruction. Most estimates suggest that economic growth in 2005 is likely to dip by about one percent as a result.
She said that the tsunami disaster occurred as the economy was showing signs of deceleration in GDP growth, with fourth quarter growth in 2004 declined to 4.4 per cent compared to 6.6 per cent growth in the fourth quarter of 2003.
"The primary focus centres on the potential problem that aid inflows appreciate the real exchange rate and thereby undermine the competitiveness of the export sector, a process known as the 'Dutch Disease'. The rupee had depreciated by over 7.7 percent against the US dollar from the beginning of 2004 to mid December 2004, and in the backdrop of the disaster and the provision of aid, the rupee appreciated by over 5.7 percent the week following the disaster," she said.
The report states that as capital flows in, the required real exchange rate appreciation can come about through an appreciation of the nominal exchange rate, a reduction in the level of net trade taxes or through an increase in the nominal price of non-traded (domestically produced) goods and services. If either of the first two mechanisms is induced, the overall price level in the country will fall, whilst with the third mechanism it will rise.
Tighter monetary...
Contd from page 1
In the case of the latter, increased inflows of aid are likely to raise the demand for both imports and domestically produced goods and services. While imports can be acquired directly from the world market at fixed world prices, non trade-ables can, by definition, only be supplied by the domestic economy. Unless there is considerable excess supply in the economy, the higher demand for domestic goods will result in an increase in their prices to induce the necessary supply response. Simply put, the real exchange rate (i.e., the price of non-tradable relative to tradable goods) must appreciate to induce the switching of resources from producing trade-ables (i.e., exportable and import substituting goods) to producing non-tradable goods and services. In the process, the real exchange rate appreciates and the tradable goods sector contracts relative to the non-tradable sector. While debt relief and initial aid flows can be expected to have a positive impact in the short run on the currency, particularly because it is a very thin market, there is a danger of an element of overshooting both in equity and currency markets fed by unwarranted expectations. The macroeconomic impact of large aid inflows would depend on the size of the flows, the import composition of the use of these flows and whether these flows are spent effectively and productively. If the aid inflows place pressure on the exchange rate, the effects could be minimized through monetary and exchange rate policies (since tightening fiscal policy is not an immediate option). Permitting a nominal appreciation in line with a ‘free float’ insulates the money supply but can induce volatile movements in the real exchange rate.
To smooth over volatility and stabilize the exchange rate, the Central Bank can intervene to increase its holdings of foreign exchange reserves. But rising net foreign assets in turn become a major source of money supply growth. In order to prevent consequent overheating of the economy and the real exchange rate appreciation-taking place through higher domestic inflation (excessive credit creation), the government can resort to sterilization of the domestic monetary expansion. In effect, it calls for tightening monetary policy in line with capital inflows. Such a policy mix is feasible given that Sri Lanka does not have a fully liberalized capital accounts. Nevertheless, given that a significant volume of credit is expected to be channelled for reconstruction (some at concessionary rates of interest) calls for a phased absorption of aid if the economy is not to be destabilized by rising inflation, the report said.
Tighter monetary policies must be imposed by the Central Bank to prevent overheating of the economy with the increased inflow of foreign capital as part of the tsunami aid by foreign donors, the Institute of Policy Studies said yesterday.
The IPS in its latest publication stressed the need to strengthen the country's monetary position after the tsunami to handle and recover from the shock caused by the disaster, to manage the aid effectively, transparently, to avoid large-scale corruption, and secondly to ensure that the economy absorbs the aid inflows without undue pressure on domestic economic stability.
The latest publication "Phoenix from the Ashes? Policy changes and Opportunism for Post Tsunami Sri Lanka" was introduced yesterday at their head office in Colombo, and IPS Deputy Director and Research Fellow Dr. Dushini Weerakoon suggested several possible monetary policy responses to face these challenges in the post tsunami Sri Lanka.
She said that it was typical for economies struck by unexpected natural disasters to experience a brief deceleration in growth, followed by a rebound as a result of the stimulative effect of reconstruction. Most estimates suggest that economic growth in 2005 is likely to dip by about one percent as a result.
She said that the tsunami disaster occurred as the economy was showing signs of deceleration in GDP growth, with fourth quarter growth in 2004 declined to 4.4 per cent compared to 6.6 per cent growth in the fourth quarter of 2003.
"The primary focus centres on the potential problem that aid inflows appreciate the real exchange rate and thereby undermine the competitiveness of the export sector, a process known as the 'Dutch Disease'. The rupee had depreciated by over 7.7 percent against the US dollar from the beginning of 2004 to mid December 2004, and in the backdrop of the disaster and the provision of aid, the rupee appreciated by over 5.7 percent the week following the disaster," she said.
The report states that as capital flows in, the required real exchange rate appreciation can come about through an appreciation of the nominal exchange rate, a reduction in the level of net trade taxes or through an increase in the nominal price of non-traded (domestically produced) goods and services. If either of the first two mechanisms is induced, the overall price level in the country will fall, whilst with the third mechanism it will rise.
Tighter monetary...
Contd from page 1
In the case of the latter, increased inflows of aid are likely to raise the demand for both imports and domestically produced goods and services. While imports can be acquired directly from the world market at fixed world prices, non trade-ables can, by definition, only be supplied by the domestic economy. Unless there is considerable excess supply in the economy, the higher demand for domestic goods will result in an increase in their prices to induce the necessary supply response. Simply put, the real exchange rate (i.e., the price of non-tradable relative to tradable goods) must appreciate to induce the switching of resources from producing trade-ables (i.e., exportable and import substituting goods) to producing non-tradable goods and services. In the process, the real exchange rate appreciates and the tradable goods sector contracts relative to the non-tradable sector. While debt relief and initial aid flows can be expected to have a positive impact in the short run on the currency, particularly because it is a very thin market, there is a danger of an element of overshooting both in equity and currency markets fed by unwarranted expectations. The macroeconomic impact of large aid inflows would depend on the size of the flows, the import composition of the use of these flows and whether these flows are spent effectively and productively. If the aid inflows place pressure on the exchange rate, the effects could be minimized through monetary and exchange rate policies (since tightening fiscal policy is not an immediate option). Permitting a nominal appreciation in line with a ‘free float’ insulates the money supply but can induce volatile movements in the real exchange rate.
To smooth over volatility and stabilize the exchange rate, the Central Bank can intervene to increase its holdings of foreign exchange reserves. But rising net foreign assets in turn become a major source of money supply growth. In order to prevent consequent overheating of the economy and the real exchange rate appreciation-taking place through higher domestic inflation (excessive credit creation), the government can resort to sterilization of the domestic monetary expansion. In effect, it calls for tightening monetary policy in line with capital inflows. Such a policy mix is feasible given that Sri Lanka does not have a fully liberalized capital accounts. Nevertheless, given that a significant volume of credit is expected to be channelled for reconstruction (some at concessionary rates of interest) calls for a phased absorption of aid if the economy is not to be destabilized by rising inflation, the report said.
said...
What exchange rate policy measures should the Sri Lankan government use in or to stem the occurrence of Dutch Disease? Devalue the currency using a crwling peg?