Originally appeared on The Morning.
By Dhananath Fernando
Sri Lanka has always been consistent about two things. First, finding a villain to blame for incidents that have taken place in the past for Sri Lanka’s performance. Second, waiting for a hero to rescue us all with magical powers without making sure the systems and markets work.
We always fail to evaluate reasons and economic context and understand the behaviour of people from an economic angle. A recent example is politicians claiming the economic crisis was a result of the Aragalaya and blaming the people who protested against the hardships they were going through, without realising that the economic crisis is what led to the Aragalaya.
In a new turn, fingers have now been pointed at exporters, claiming that they have not brought money back into the country and accusing them of being part of the problem. In my view, the figures mentioned in relation to claims that exporters have parked funds outside are unrealistic. Some Sri Lankan companies have scaled their operations very successfully around the world, which has been done legally. For instance, there are energy investments in Bangladesh and Senegal and manufacturing plants in Africa and neighbouring India. Even our IT sector is expanding to the Middle East and to different regions around the globe using legally owned foreign exchange.
This is obviously illegal and remedial action needs to be taken, but what is more important is to understand why it happens. We need to understand the reasons behind this and understand the reality with a solution-oriented framework. In most cases, the enemy is within, though we try to find the enemy outside.
In my view, there are three main factors that influence such malpractices
Market intervention by the Central Bank
When central banks infuse more money into the system to maintain artificial interest rates, the exchange rate comes under pressure or the currency depreciates. The fear of currency collapse makes people withdraw money or avoid bringing money into the country.
Not only exporters, but even Sri Lankans who were sending remittances stopped sending their money through the banking system. Instead, they sent money through unofficial means at a depreciated exchange rate. When domestic prices are rising due to money printing or import controls, their families back home naturally need more money to buy goods.
However, exporters cannot keep unlimited amounts of money outside the country. Exporters need money to run their local operations, so they have to convert their export proceedings and get Sri Lankan Rupees to run the operation. When interest rates are kept artificially low, there is an incentive to borrow domestically and delay the conversion of dollars into rupees.
However there is a limit to what exporters can borrow. Even if they borrow domestically, it cannot contribute to a foreign exchange shortage unless the Central Bank printed money to maintain an artificially low policy rate through discount windows or reverse repo operations.
If banks give extra loans to exporters, they have to cut down on other loans (to housebuilders, for example) or they have to pay higher rates and get deposits and reduce the consumption of their customers. Banks do not have to reduce other credit if the interest rate is maintained artificially through the injection of new money.
The policy of the Central Bank has simply created a highly unstable financial situation and it is human behaviour to protect one’s hard-earned money, so they will obviously keep their money outside. Understanding this should not require any financial expertise; even basic logic is enough. This is understood by our unskilled workforce contributing to our economy through remittances.
To return to the matter of exporters, the margins are low in trading businesses and export quantities have to keep moving; a business cannot run without money. We have to reevaluate the numbers and it is unlikely that more than 10% of the proceedings will be repatriated, which is a figure that leans more towards the higher side. Even that is profits or value created by exporters.
If the money comes, the exporter will use it and it will trigger demand. If money is not brought back, it will not become imports and instead becomes a private foreign reserve. While it may contribute to higher interest rates, this type of activity will simply reduce imports and not create forex shortages.
There were claims that some exporters sent goods to Singapore or Dubai and re-sold the goods to third countries while keeping some money there.
We need to understand why people try to keep money outside the country. Who wants to bring money into an unstable country? Dubai and Singapore do not have central banks that print money and people not only import and export freely, they can also freely send capital in and out.
Sri Lanka, on the other hand, has exchange controls. Again, this is due to money printed to keep interest rates artificially low, which is exerting pressure on the exchange rate. Economists call this the impossible trinity of monetary policy objectives. A central bank cannot hold an exchange rate and allow the free flow of capital if it also prints money to control interest rates.
Exchange controls can be seen as a tool used to delay interest rates. It is worthwhile to recall the scale of Central Bank interventions and controls during this crisis. The Central Bank places price controls on Treasury bills and printed money. Exchange controls were also tightened further instead of correcting interest rates and stopping money printing.
The Treasury placed import controls on hundreds of items. The Central Bank increased margins for Letters of Credit (LCs). Moreover, forward markets for foreign exchange were killed, putting importers at risk and also damaging businesses that had hedged their imported input costs. Exporters were forced to convert their dollars early, which created problems for some exporters who had been in the habit of giving credit to customers to win business from competitors.
Additionally, forced conversion rules were imposed on service receipts. Some service workers and those others who used to bring these to the country and save them in foreign exchange accounts then kept their money abroad. Unlike goods exporters, service exporters have larger margins.
By this time, banks were facing a capital outflow and were unable to renew their credit lines and in some cases dollar-rupee swaps. Forced dollar conversions reduced dollar liquidity and brought these closer to default.
There are also concerns as to whether it is a violation of property rights for banks to force account holders to convert dollars without their consent. Foreign exchange controls are in any case a violation of property rights.
This very column previously warned of the potential drying up of forex with such market interventions. In simple terms, in a context where LKR is not hard pegged to the USD with floating interest rates or if there are no floating rates, all additional money supplied to the financial system to keep rates down evaporates in the form of imports, even with under-invoicing.
Trade barriers – High and complicated tariff structure
Making tariff structures complicated is an incentive for corruption. The level of corruption that takes place at customs is no secret and the more complicated the system becomes, the more room for corruption. Simply, when the cost of corruption is lower than the legal procedure, the incentives are in place for corruption.
This column has on many occasions recommended a simple tariff structure with three bands so that paying import tariffs becomes easier than taking on the cost of corruption. This was proved by Prof. Premachandra Athukorala in a practical research he undertook, where bringing down the tariffs by half on selected HS codes ensured that the Government income from those particular imported items doubled. Too many restrictions and intervention are the genesis of black markets and corruption. One of the easiest ways to minimise corruption at Sri Lanka Customs is to make our tariff structure simple, low, and consistent.
Poor business environment
Overall, Sri Lanka’s business environment is extremely poor. We have to ask ourselves why our own people leave the country and why they are reluctant to bring their money into the country. The answer is not complicated; we may act rationally or emotionally at times, but when it comes to money, we all tend to make rational decisions, especially when there is a tangible cost or benefit associated with it.
It is obvious that people consider all alternative options to protect their hard-earned money. This is one reason remittances were not sent through official channels. Family members still received the money and imports still took place, but without going through the official channels. Any imports paid for with unofficial funds – such as open account imports – reduce the demand for dollars from exports.
Now that the Central Bank has raised rates and reduced money printing, leading to reduced exchange rates, people are sending their money through official channels. This shows that most people prefer to send their money through official and legal channels if a stable and consistent system is available.
It has been a while since Standard and Poor’s, Fitch Ratings, and many other international agencies warned about Sri Lanka’s worsening economic crisis. As such, our economic environment was extremely poor, which was why people did not feel that it was safe to bring their money into the country. The same happened even in Africa – with the crisis in Zimbabwe, many had bank accounts in Cape Town to protect the value of their money.
Final thoughts
One has to be careful about harassing exporters. Exporters, especially subsidiaries of foreign countries, have other countries to operate in.
Under-invoicing exports is wrong, as it will reduce profits within the country. This is a tax fraud. However, reducing profits cannot contribute to forex shortages since any money that is not spent in the country will also reduce imports.
Sri Lanka wishes to be a hub for South Asia. It wishes to become a place where companies set up regional headquarters. If currency instability and exchange controls exist, these will not be set up in this country. Moreover, there are also rules on transfer pricing.
If Sri Lanka possessed monetary stability, if there were no exchange controls, and if its tax rates were reasonable – the US has been pushing for a global corporate tax rate of 15% – companies would not try to take profits to safer places.
Exporters and importers have been harassed over the years. Framing exporters as the reason for the crisis instead of solving our own problems will simply make the situation worse.
Can we really put the entire weight of the economic crisis on our exporters, forgetting the bond scam, Easter attacks, droughts, Covid-19, borrowing money at very high interest in USD, and investing in unproductive projects? The enemy is within, but we are always looking for a culprit outside. In politics, sometimes a well-told lie is worth a thousand facts.
The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.