Bond Travails

Treasury bond yields have climbed nearly 300 basis points in the last eight months since the Presidents takeover of three key ministries that led to elections and a UPFA government taking office.
Bond dealers expect yields to climb further if the government goes on a spending spree funded through the banking system.rn

rnA spending spree also raises the prospects for a spike in the rate of inflation, which has been on a steady decline for a while.rn

rnExternal factors are not helping the finance ministry to keep interest rates low and inflation in check.rn

rnThe pro-subsidy government expects to spend up to Rs. 8bn on a fuel subsidy to protect consumers from international commodity market shocks.rn

rnAlthough prices have fallen from the US$ 41 a barrel peak, supply worries from Iraq, Russia and Nigeria and expected to keep prices high.rn

rnThe government subsidy on fuel has been calculated on a crude oil price of US$ 41 a barrel and an exchange rate of Rs. 102 per dollar.rn

rnAlthough oil prices could comfortably hold below US$ 41 a barrel some foreign exchange traders expect the local currency to weaken further against the dollar.rn

rnThe rupee has already slipped five percent against the dollar this year with any gains from lower than expected oil prices are likely to be wiped out by a weak currency.rn

rnThe finance ministry says over US$ 1.2 bn have been spent on importing fuel during the first half of the year which contributed to weakening the local currency.rn

rnPetroleum imports last year only cost US$ 750 mn.rn

rnThese are only some of the worries of bond investors.rn

rnEasing budget pressure by reducing or eliminating the fuel subsidy will increase costs to consumers and fuel inflation. rn

rnCentral Bank, which likes to minimize volatility in inflation and the exchange rate, says prices are likely to climb from the present three year low.rn

rnLow prices encourage people to spend.rn

rnConsumerism, which took off when the economy recovered from minus growth and improved investor sentiment, could suffer if inflation kicks in.rn

rnPrivate consumption and tourism helped the recovery in 2002.rn

rnLast year exports helped boost growth and the rupee, which strengthened against the dollar.rn

rnLow inflation makes life less complicated for investors, savers and businessmen who are able to plan their activities.rn

rnBut bond investors, who closely watch inflation, since it has a strong correlation to policy interest rates announced by the Central bank, say prices are likely to rise.rn

rnAn LBR survey of six primary dealers, who deal with government securities, found that on average they expect the headline inflation rate to touch seven percent by the end of the year.rn

rnClose to the Central Bank inflation target of six percent and much higher than the current three point seven percent annual average inflation rate.rn

rnTight management of the budget, improved investor sentiment and peace helped growth and price stability over the last two years.rn

rnIn other words the Central Banks keenness to avoid volatility was strongly complemented by sensible fiscal management.rn

rnEconomists say the Central Banks job is about to get much tougher.rnVolatility has crept in.rn

rnThe rupee has been unusually restless over the last few months and higher inflation is about creep in.rn

rnBut unlike the last decade inflation is not going to be a cause of monetary expansion like when Sri Lanka was fighting a war.rn

rnCost-push inflation, the ugliest form a price rise could take, is threatening to raise its head in the face of the expanded role of government.rn

rnInflation that results from a decrease in aggregate supply is called cost-push inflation.rn

rnAccording to Keynesian economics aggregate supply can go down because of two reasons-an increase in wage rates and an increase in prices for raw materials.rn

rnBoth these phenomena are happening in the local economy.rn

rnMore government jobs and salary increases are on the horizon.rn

rnEmployees of the state and private sectors are also striking for higher pay.rn

rnMaterial prices led by energy costs are already on the way up.rn

rnKeynesian theory says that macro economic fluctuations significantly reduce economic well-being.rn

rnInvestors who are used to the stability and clear policy directions over the last two years agree. rn

rnAccording to Keynesian theory, changes in aggregate demand, like the ones caused by higher salaries, higher employment and rise in input cots, have their greatest short-run impact on output and employment.rn

rnThe government is also concerned about a short-term improvement in output and employment.rn

rnBut the impact on prices naturally follows.rn

rnBut Keynesians believe the short run lasts long enough to matter. rn

rnThey often quote Keyness famous statement: “In the long run, we are all dead” to make the point.rn

rnUnfortunately the country needs a government with a long-term economic vision and not a vision geared to win the next election. rn

rn(LBR)rn

-LBR Newsdesk: LBOEmail@vanguardlanka.comrn

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