Sri Lanka’s unprecedented interest-rate hike has helped restore the Central Bank’s credibility, although it’s not enough to remove the risk of a debt default as a political crisis delays an International Monetary Fund (IMF) bailout, according to Citigroup Global Markets.
When interest rates increase to a very high level too quickly, it can cause a chain reaction that affects the domestic economy creating a recession in some cases, several eminent economists said adding that this action was taken too late.
A worsening crisis mutes the impact of disjointed financial lifelines, including a $1.5 billion currency swap from China in December and rice and diesel shipments from India.
The IMF notes that policies required to reduce debt to sustainable levels are neither economically nor politically feasible.
Hence, Sri Lanka’s $1 billion bond maturing in July trades at 67 cents on the U.S. dollar, compared to about 74 cents at the start of February. Haircuts will stretch from China to Wall Street, where market borrowings accounted for 47% of Sri Lanka’s foreign government debt as of April last year.
The Central Bank of Sri Lanka raised the key rate by 700 basis points on Friday, narrowing the negative gap in real interest rates, nominal rates adjusted for inflation to 420 basis points from 1,120 basis points previously.
“While this steep rate hike should help the rupee, stabilising it may require progress on bridge financing, alongside material progress to a Fund program,” Citigroup Hong Kong Chief Economist Asia Pacific Johanna Chua wrote in a report to clients. “We view the risk of default as now very high.”
If interest rates increase too quickly it is more of a risk than keeping it low for prolonged periods and the economy can grind to a halt, a senior economic advsor to the state said .
The problem of access to finance and the cost of borrowing is acute, he pointed out emphasizing that small and medium scale firms with overdrafts will have higher costs because they must now pay more interest.
On the other hand Customers with debts have less income to spend because they are paying more interest to lenders, he pointedout.
He said “ higher interest rates could mean that a person may not be able to get a loan to purchase a house on favorable terms, or that a company will lay workers off instead of financing payroll during a downturn”
An increase in interest rates can affect a business in two ways: Customers with debts have less income to spend because they are paying more interest to lenders.
Sales fall as a result. Firms with overdrafts will have higher costs because they must now pay more interest, economic experts said.
