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‘VAT inflation’ slams markets

VAT inflation
Rs 7,210 million worth of foreign funds left the Treasury (T) Bond and T Bill market last week, causing further downward pressure on the rupee.

This follows a similar Rs 8,792.3 million exit the previous week, taking such exits in the last two weeks to a massive Rs 16,002.3 million (Rs 16 billion).

Such exits are caused due to expectations that the USA's Federal Reserve System (Fed.) for the first time this year will hike its key policy rate known as the Fed. Funds rate when they meet in another two months time in December, i.e. after the November Presidential Election to decide on their rating policy.

These expectations have caused foreign funds to leave the local T Bond and T Bill market and re-park their assets in US based investments for 'better and safer' returns, thereby inducing depreciative pressure on the rupee.

Such exits however are paid for, from the Central Bank of Sri Lanka's (CBSL's) foreign reserves at a discounted conversion rate of Rs 146/90 to the US dollar, whereas in the foreign exchange (FX) market is currently dealing in one week's forwards which closed last week at an inflated price of Rs 148/30/50 to the dollar, thereby causing essentials to rise in price, causing inflationary pressure, as Sri Lanka is an import dependent economy.

On Friday, CBSL's foreign reserves were poorer by US$ 9.08 million (Rs 1,334.21 million) due to such an action, data showed. Conversions are made, based on the current, controlled 'spot' price of Rs 146.90 to the dollar, as CBSL deals in 'spot.'
Meanwhile, the face value of CBSL's money printing increased by Rs 8,246.88 million to Rs 151,526.23 million (net of reverse repos and standing lending facility) Friday over Thursday to meet the Government of Sri Lanka's (GoSL's) funding needs, thereby causing demand side inflationary pressure on the economy.

CBSL's moral suasion instrument is currently controlling both the 'spot' and 'spot next' at prices of Rs 146.90 and Rs 148/05/148/20 to the dollar in interbank trading, respectively.
In normal markets however, where there are no such FX controls, the FX market deals in 'spot', where such transactions are settled after two market days, whereas, as far as 'spot next' transactions are concerned, it's three.

In related developments, as upward inflationary expectations hit the economy with the new VAT hike too coming in to effect on Tuesday (1 November), the Colombo stock market, besieged by the advent of a high interest rate regime as a result, continued to record successive lows at Friday's trading as well, making its thirteenth lowest and fifteenth lowest turnover and share volumes with figures of Rs 288.8 million and 10.78 million respectively, in the calendar year to date.

As a result, the benchmark ASPI fell sharply by 0.21% to 6,424.85 points and the more sensitive S&P SL 20 Index by 0.33% to 3,562.36 points.

Inflation (price hikes) hits the poor, the fixed wage and the vulnerable the hardest. A counter to rising inflationary expectations is interest rate hikes.
CBSL at 7:00 p.m. on Monday (31 October) will set the course of its monetary policy direction, when it unveils its monetary policy report for the current month, then. What the market will look at in this connection is the direction of CBSL's rate setting, policy rates.

With its lending facility currently at 8.50% and deposit facility at 7% respectively, however, a rate hike, to tackle inflationary pressure, with its 'trickle down' effect on market interest rates, is not conducive for the development of the Colombo stock market, with the fixed income market gaining ascendancy for better returns by investors in such a scenario at the expense of the former.