Populist tax cuts could fail to tame Sri Lanka’s inflation

Despite ad hoc attempts to tame inflation through populist measures, soaring international crude prices could prompt Sri Lanka’s Central Bank to think long and hard about hiking short-term rates next month, market watchers said Wednesday. Despite ad hoc attempts to tame inflation through populist measures, soaring international crude prices could prompt Sri Lanka’s Central Bank to think long and hard about hiking short-term rates next month, market watchers said Wednesday. The bank opted not to tinker with its key policy rates in August, though galloping inflation is threatening to undermine the island’s continued economic recovery from last year’s tsunami.

The repurchase rate, which drains money from the banking system, remains at 8.25 percent, the reverse repurchase rate was left at 9.75 percent, the Central Bank said Wednesday in a statement posted on its website.

Policy rates were last raised by 50 basis points in June.

Sri Lanka’s Central Bank has raised its benchmark interest rate twice this year to help damp inflation that has been accelerating due to higher global oil prices.

Slippery Slope

Inflation measured by the Colombo Consumers Price Index or CCPI, has crept up to 10.8 percent in July (from 9.4 percent in June) on a point-to-point basis, but the five member monetary board played it safe.

“Recent tax revisions by the Government would help contain further inflationary tendencies, even though soaring international petroleum prices continue to threaten price stability,” the statement said.

With a possibility of presidential and parliamentary hustings due shortly, the government recently announced series of populist tax cuts.

In return, the cash strapped Treasury, is generously forfeiting over Rs. 8 billion through value added tax exemptions on diesel, milk powder and gas.

To negate the effect, the government upped value added taxes by 20 percent (up two percent) from Aug 1., on luxury goods such as refrigerators, cookers and hair dryers. Excise duties were also recently jacked up on imports of cars and heavy vehicles that are older than five years.

But the move will still leave the Treasury clutching straws with a revenue shortfall of around Rs. 10 billion (below the estimated Rs. 387 billion).

“Cutting back on taxes won’t solve the problem, bring down prices is an election gimmick. We keep electing populist governments into power, but that also gives us problems on the fiscal side in the long run,” said Dudeepa Ratwatte, CEO of First Capital Asset Management.

The monetary policy committee also seems to be been lulled into some sense of false security, opines economist Harsha de Silva. “The whole idea is to have appropriate domestic policies to effectively deal with the exogenous oil shock. Both fiscal and monetary. Policy makers need to get a dose of reality.”

“Instead of attempting to consolidate the gains of appropriate monetary policy, the Central Bank seems to have decided to once again go down the slippery slope of introducing unsustainable subsidies by removing VAT with the full knowledge that the treasury is unable to meet revenue targets. This will most certainly lead to inflation increasing further,” de Silva said.

Sri Lanka’s US$ 20 billion economy is picking up the pieces from the Dec. 26 tsunami that killed 39,000 people and left half a million homeless. So far, growth rate accelerated to 4.8 percent in the first quarter from a year earlier, up from the fourth quarter’s 4.4 percent expansion.

Export earnings in the first six months of 2005 rose 11.5 percent from a year earlier as the country shipped more tea and garments.

The tsunami also helped replenish the island’s dwindling stockpile of reserves with gross official reserves topping US$ 2,378 million for the six months to June, from US$ 2,196 million by end December 2004.

The bank said a steady flow of private remittances (up 21 percent to June 2005), debt relief and officials inflows to the government, gave stability to the domestic foreign exchange market. The rupee has also strengthened by 3.6 percent against the US dollar todate.

But continued political uncertainty continues to dampen investment climate, says Ratwatte.

“My biggest concern is that all the uncertainty is hurting big investment from coming here. That’s the biggest drawback,” he said.

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Monetary Policy Review – August 2005

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