Central Bank’s strategy to beat post-Brexit blues- Negotiations for enhanced trade, investments
Posted on July 11th, 2016

By Chandani Jayatilleke Courtesy The Sunday Observer

Deputy Governor Dr. Nandalal Weerasinghe PICTURE: SHAN RUPPASARA

Brexit has already had some negative impact on the global financial markets and the global economy. But its full impact is yet to be felt with the policy changes and geopolitical decisions to be taken by the European Union and the United Kingdom. The UK is now negotiating with the EU for enhanced trade and investments with each other.

The Central Bank of Sri Lanka (CBSL) plays a key role on exchange rate policy, strategy in capital account liberalization, and monetary policy operations. Explaining these issues, Deputy Governor Dr. Nandalal Weerasinghe said central banks around the world have two key instruments to manage such difficult situations. These are exchange rates and interest rates. Central banks can allow exchange rates and interest rates to be flexible and adjust it so that the negative impact from Brexit can be minimized.” Interest rates are controlled to manage local demand. We can either reduce interest rates to boost domestic demand or if the domestic demand is high we can raise rates. Right now we are waiting to see more data to make a decision. We will continue the policy on exchange rates and interest rates we have been implementing over the past couple of months,” Dr. Weerasinghe said in an interview with the Business Observer. For Sri Lanka, the channels through which the impact of Brexit could transmit include reserve revaluation, trade and tourism with the UK and EU, remittances and investment flows from both and the policy responses to Brexit from other countries.

If the economies of the UK and the EU are going to slow down as a result of the vote for Brexit, the demand for goods and services in this region will also be lower which means Sri Lankan exporters would go through a tough time, with lower demand for their export products. This is a key area for consideration,” Dr. Weerasinghe said. Brexit resulted in the Sterling Pound falling to a 31-year record low. The depreciation of the Sterling Pound against the US dollar, if it persists, would lead to an increase in the Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) as a higher weight is assigned for Sterling Pound, depending on Sri Lanka’s trade with the UK, when calculating the REER indices. If this trend continues, it could lead to a reduction in Sri Lanka’s export competitiveness resulting in an adverse impact on the trade balance, and thus on the external current account of Sri Lanka.

Table

The postponement of any monetary policy tightening by the US Federal Reserve will ease pressure on global interest rates applicable to emerging market economies such as Sri Lanka.

Meanwhile, the potential slowdown of the UK economy, as projected by the IMF, would reduce its imports, effecting Sri Lankan exports. The UK could possibly introduce a preferential tariff system like GSP on its own, which could minimize any adverse impact on Sri Lanka’s export performance.

Foreign exchange reserve

By end-April 2016, the Sterling Pound reserve holdings of the CBSL amounted to about 10 percent of total foreign reserves, the third largest in the currency composition of reserve assets. In reserve compilation, all foreign exchange assets are valued at mark-to-market basis in US dollar terms. Accordingly, a sharp depreciation of the Sterling Pound against the US dollar is likely to result in some valuation losses, which, in turn, would lead to a decline in the external reserves of the country.

However, the increase in gold prices could mitigate this impact to some extent. Following the Brexit vote, the price of gold surged to a two-year high reflecting the investors’ preference for the precious metal. If this trend continues, gold prices could continue to increase, Dr. Weerasinghe said.

Impact on capital flow

The volatility experienced with the Brexit is likely to impact international capital markets and affect borrowing costs. This could affect Sri Lanka when it accesses international markets to raise funds to bridge the savings-investment gap. Past experience shows that investors tend to follow a ‘wait and see approach’ and stay out of emerging markets such as Sri Lanka in times of volatility. Such investors tend to invest in safer assets such as gold and opt for safe haven currencies such as the US dollar, he said.

Impact on debt servicing with GBP loans

The outstanding amount of debt to be serviced in Sterling Pound as of end-April 2016 amounted to Sterling Pounds 54 million (equivalent to Rs. 11.3 billion). The sharp depreciation of the Sterling Pound against the US dollar may contribute to decrease the Sterling Pound denominated debt stock in rupee terms. However, the outstanding amount of debt in Sterling Pound only accounts for 0.3 percent of the total debt stock. Given that some imports and loan repayments are made in Sterling Pound, its depreciation could have a positive impact on Sri Lanka, similar to how the Japanese foreign debt component reduced due to a weakening yen in the past.

Impact on FDI Inflow from UK

Last year, the UK contributed around 2.5 percent of FDI inflows, down from around 22.7 percent in 2014. The FDI inflow from the UK from 2005-2015 were as follows:

Table 2

A possible slowdown in UK economic growth could result in a reduction in FDI inflow to Sri Lanka from the UK. This could reduce inflow to the financial account of the BOP of Sri Lanka. It appears that only the impact on garments and textiles is significant, since out of total exports to the UK, garments and textile exports averaged to 83 percent over the past three years. (See Table 2)

GSP Plus and apparel exports

Sri Lanka lost the GSP Plus concession of the EU where no tax was applied to garments and exports from Sri Lanka from 2010. As a result, at present, Sri Lanka only qualifies for the GSP scheme where an import duty of 9.6 percent is charged for garments exported to the EU and the UK.

The normal tax on imported garments (main HS code 61 and 62) in the UK is 12 percent. Therefore, there will be about a 2.4 percent difference between the normal tax and the GSP concessionary tax level.

Hence, the highest impact of Brexit will be on the countries that are currently enjoying zero tax rate under the GSP+ concession.

According to the UK Customs website, a VAT of 20 percent is charged on all garments and textile imports to the country irrespective of the fact whether they are under the GSP or not.

Sri Lanka already enjoys GSP (not GSP Plus) – under which we can still export certain goods and services to the whole of the EU at a relatively low tariff (not zero tariff),” said Dr. Weerasinghe.

However, it is also the time that Sri Lanka is seeking the GSP Plus facility again – to increase exports to the EU. If we get GSP Plus, our exporters will be able to export to the EU at zero tariff and get higher market access. But, the disadvantage is that even if the EU gives this facility, the same will not be available with the UK – because UK will no longer be an EU country.

Yet the UK is the biggest apparel importer for Sri Lanka, in the European region.” This will also affect other countries which have GSP or GSP plus such as Vietnam, Bangladesh and Pakistan. They too will have to renegotiate with the UK for preferential trade access. All these countries will be in the same position until the UK government offers fresh trade concessions to them. This could be an advantage for Sri Lanka if the UK treats all these countries equally. But if the UK considers those countries separately, because their level of income is different, they could be given special treatment or more concessions. Then we will be back to where we are now.

It is only after that process happens we will have better access to the market and if we are given GSP plus facility from the EU then we have a good case to submit, when it comes to negotiations with the UK. This is an important point the government should look into.”

(Tables 3 and 4 provide information on the trade between the UK and EU by Sri Lanka.)

Tourism and remittances

Table 3
Table 4

The UK and Europe are some of the largest tourism markets for Sri Lanka. Since the Brexit vote, their currencies have depreciated against the rupee and many other currencies, making travel to Sri Lanka a bit expensive. This means decreased tourist arrivals and lower spending, which affects total tourism earnings directly. Remittances from Sri Lankans working in Europe may get affected too. We have already seen a short-term impact.”

Importers may enjoy some benefits as goods and services in the UK and EU are going to be cheaper. For example – vehicles made in the UK and the EU could become cheaper and there could be a demand for European cars, which may give a new lease of life for our car importers.

If export earnings are going to be lower, our foreign exchange earnings would get affected. This means the deficit in trade and balance of payments could be higher than projected. This leads us to raise more funds to finance the current account deficit.

But in this uncertain global market situation, will we be able to raise finances from those markets at a reasonable cost? There could be a liquidity crunch as we saw in 2008/9 where global investors would invest only in safe assets – called ‘flight to safety’.

Investors who want to invest in emerging or frontier markets, would re-assess their risk and invest in the most safe assets such as US, German and UK government treasuries, or gold. That’s why we have seen the prices of gold and the US dollar moving up since the vote for Brexit.”

However, yields on the US, UK and German treasuries have come down. That’s because their prices went up because of increased demand from investors who are now moving their investments into these safe assets other investments around the world.

At the same time, demand for instruments of lower rated countries such as Sri Lanka is lower. If Sri Lanka wants to raise capital from global markets, the interest rates it pay could be higher. These rates will depend on the customer – be it government, bank or company. For instance, before the Brexit, the Sri Lankan government’s 10-year securities were traded in world markets at around 7.25% interest and after Brexit it went higher – which means if we go to the market now, we have to pay a higher price.”

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