Central Bank Defends Liquidity Injections Amid “Money Printing” Controversy

By Dhananath Fernando

Originally appeared on Ada Derana Business

A fresh controversy has erupted following reports that Sri Lanka’s Central Bank (CBSL) injected nearly 100 billion rupees into the banking system by October 25. Given that money printing was the major cause of the country’s financial crisis, this news has sparked considerable attention. CBSL has defended its actions, arguing that these liquidity injections do not equate to money printing.

What is the CBSL’s Argument?

CBSL asserts that these liquidity injections were necessary to address persistent imbalances among banks. Despite an overall surplus of funds in the banking system, this liquidity is unevenly distributed. Foreign banks operating in Sri Lanka hold significant liquidity surpluses but remain cautious about interbank lending due to strict risk management guidelines. As Sri Lanka’s sovereign rating is still ‘Default, this limits their exposure to local financial institutions. As a result, foreign banks deposit excess rupees with the Central Bank rather than in the interbank market.

While this was a serious problem in the midst of the crisis things have improved since: interbank call market (clean or unbacked) trading volumes, once as low as zero 1-2 billion rupees daily, has now returned to Rs10bn to Rs20bn (averaged 10 billion last month). Repo volumes (backed by T-bills) are back around 30 to 70 billion rupees, which is higher than pre-crisis levels.

Notably, auction data shows the central bank offering more than what banks bid for, with some banks bidding close to the deposit rate, indicating a willingness to lose bids—yet CBSL still provided new funds.

Given the much healthier interbank volumes, the CBSL should avoid undermining the working of the interbank market. The CBSL should be the last resort for a bank facing a liquidity crunch, not the first.

The Core Issue: Temporary vs. Longer-Term Impact

The debate centers on whether these injections are temporary or enduring. If CBSL swiftly withdraws the new money by selling Treasury bills or foreign exchange, the money supply remains stable. However, if these short-term purchases are repeatedly rolled over, the increase in money supply could become more long-term. Critics warn that this scenario is no different from lending money to the government, potentially triggering balance of payments problems and inflation, thus jeopardising the ongoing economic recovery.

A Matter of Terminology

CBSL’s reluctance to label this as “money printing” is essentially terminological. Regardless of whether the funds are lent to banks or the government, the impact on the money supply is fundamentally the same. Therefore, interventions must uphold the principle of currency stability, given the grave consequences of unchecked money creation.

Acknowledging CBSL’s Efforts

It is It is important to acknowledge that since September 2022, the CBSL has done an admirable job in restoring monetary stability. The critical task now is to maintain this hard-won stability. These points are presented to promote a healthy academic debate on an issue of great importance, not to cast blame on any specific entity or person.

Potential Alternative Strategies

What alternatives could CBSL have considered?

Purchase Foreign Exchange from Banks: Where balance of payments conditions permit, CBSL could continue the practice of buying foreign exchange, injecting rupees but reducing foreign currency in the If the injected rupees were later used for imports, CBSL could sell foreign exchange back, maintaining balance and avoiding exchange rate issues.

Use the Standing Lending Facility: Lending at the Standing Lending Facility Rate of 9.25% would ensure banks only borrow for urgent liquidity needs. As this penal rate is higher than the interbank rate, it discourages long-term dependency and helps avoid a lasting increase in the reserve money supply.

Reduce the Standing Deposit Facility Rate: If the CBSL wishes to lower rates, it could reduce the rate on deposits held at the Central Bank, which would encourage banks to lend more in the interbank market. However, this would also lower overall interest rates and must be carefully managed. To support reserve accumulation, interest rates need to remain at an appropriate level to curb credit and keep imports in check.

The Balancing Act

CBSL faces the difficult task of supporting the banking sector while safeguarding monetary stability. Any intervention must be carefully weighed to mitigate risks such as inflation and currency destabilisation.

Sri Lanka’s economy is entering a dangerous tailspin

Originally appeared on Daily Mirror

By Ravi Rathnasabapathy and Rehana Thowfeek

Sri Lanka has just entered the deepest economic crisis in its history. Shortages and rising prices that people face today are only the first inkling of what lies ahead. Unless decisive action is taken, it can go into a destructive tailspin. 

Downgrades and forex shortages mean foreign banks will only accept upfront payments for imports until credibility is restored. This means the country is now in a hand-to-mouth existence: imports are restricted to the quantum of foreign exchange inflows. These inflows are shrinking. 

Production of goods and services, for both exports and domestic consumption is contracting due to shortages of fuel, power and other inputs. Exporters are losing orders as overseas buyers, concerned about the inability to supply and missed deadlines are switching orders to other countries. Tourist numbers dwindle due to long power cuts, lack of fuel for transport and the closure of restaurants due to lack of gas. 

Lower exports lead to even lower foreign exchange receipts, which in turn limits production even further. With each cycle, the noose tightens further, until eventually most activity ceases. 

The shrinking supply of goods and services within the economy leads to increases in prices, as spending outpaces production. Businesses become unviable due to their inability to function at normal capacity and people lose their livelihoods. As activity shrinks, individuals and businesses alike find it difficult to repay their bank loans and the pressure shifts to the banking sector. This cycle continues until most economic activity grinds to a halt. As the country is pushed into a subsistence existence malnutrition and hunger become widespread.

The crippling effects of the inability to import are similar to that of being under international sanctions except that these have been self-inflicted. Now that the downward cycle has started, it is very difficult to stop as the forces of destruction gather momentum and speed. Until the appointment of the new governor last week, Sri Lanka was in free-fall. The best hope now is to arrest the descent and stabilise it at some point. The governor has taken only the first step on the path to stabilisation but much more needs to be done.

It is clear from the people’s protests that the public have lost confidence in the government. What people don’t realise is that multilateral agencies, international banks and rating agencies have also lost confidence. The government budgets the last two years were replete with errors: overestimated revenues, irreconcilable differences and unrealistic assumptions. Abrupt changes in polices and asinine statements by officials underlined these concerns; one international bank entitled its update “Denial is not a Strategy”. Even before the default many foreign banks refuse to accept letters of credit from Sri Lankan banks unless guaranteed by an international bank.    
A key benefit of an International Monetary Fund (IMF) programme is that it will restore confidence. The mere fact that the government budgets and forecasts are being reviewed by the IMF signals that they are based on realistic assumptions and reasonable estimates. Together with concrete steps towards repairing public finances it will restore some confidence among lenders and pave the way for bridge finance – to relieve some of the crippling shortages that are choking production and livelihoods.

Returning to growth is not impossible but this means addressing the structural issues within the economy, a matter that is all but impossible due to the thicket of vested interests that have grown during the past two decades.

Stabilisation – averting complete meltdown
The major cause of the disequilibrium in the economy was the excessive money printing carried out by the Central Bank since 2019. Money has been printed to finance government expenditure at an alarming rate. The huge increase in government spending results in strong demand for goods and services within the economy. High levels of demand feed into local products and services as well as for imports. Historically, whenever the government has run a large budget deficit financed by the Central Bank credit, it has always resulted in a current account deficit.
The first step to addressing the problem of money printing is to borrow from the domestic market, instead of the Central Bank. Given the enormous sums being borrowed, the government needs to offer a sufficiently high interest rate to attract the required quantum of funds. This is why rates have been raised sharply. Higher rates will reduce consumption by the private sector (which also reduces imports) but may also affect investment, so such high rates, while unavoidable to stabilise the present situation, cannot be maintained in the long term.

For rates to reduce, the levels of government borrowing must reduce. This means cutting the budget deficit. This will have to be approached in two ways: an increase in taxes and a reduction in expenditure.

Increases in personal taxes will reduce the government deficit and therefore the government borrowing requirement reducing the pressure on interest rates. Higher taxes can help curtail private consumption (including import consumption) but may also impact savings and therefore investment. Increases in corporate taxes could curtail investment.

To minimise the negative effect on investment, the government should not rely on taxes alone, expenditure must be cut but the recurrent expenditure is very rigid (mainly salaries, interest and pensions), so reducing capital expenditure is more feasible both politically and practically. Resistance will however be encountered due the corruption involved, especially in highway projects. Reducing the drain from state enterprises and the disposal of idle or underutilised assets are other avenues to close the deficit. Some trimming of unnecessary current government expenditures can increase available fiscal space for social transfers.

Since the majority of the government expenditure is spent on salaries, pensions and interest, a recruitment freeze and a freeze on increments will halt further expansion. All discretionary expenditure unless directly welfare-related must be frozen along with capital expenditure at least in the short term. All transfers and support to state-owned enterprises must cease.

The imbalances will be resolved due to a combination of factors: contraction of demand due to higher interest rates and higher prices which follow from the adjustment of prices to the realistic exchange rate. Prices will need to rise to the market-clearing rate, critically energy prices, which are dependent on the exchange rate. This, however, delivers a huge negative shock to the poor, so it must be cushioned with social transfers.

These are purely stabilisation measures. If carried out properly, this can restore the economy to its state in 2019 but at a higher price level, higher unemployment, lower levels of output and higher levels of poverty. Those in the middle and lower-income groups will be pushed further down the income spectrum: large sections of the middle class will find themselves poor and the poor will be left in abject poverty. Due to low levels of productivity growth will be stagnant at 1-2 percent.

Some of the destruction that has been wrought on businesses will be permanent. The rate of increase in prices will slow to tolerable levels but prices for the most part will not decline from the current high levels. Lower incomes and high prices lead to much lower living standards for most people. The low levels of productivity within the economy mean that prospects for escaping poverty remain poor but on the positive side, things will stop getting worse.
If people are to have some hope, then growth needs to be restored, which means addressing the problem of productivity.

Growth – Restoring prospects for recovery 
The people will have little prospects unless growth returns but growth is impossible unless the barriers that impede it are addressed. 

Sustained economic growth and productivity improvement are intricately linked. These are two sides of the same coin: a faster rate of economic growth cannot be maintained without productivity improvement. Higher productivity must be achieved in all sectors of economy, including the government, public sector and agriculture, where it is weakest.

At its simplest, productivity is a measure of an economy’s ability to produce outputs (goods and services) from a given set of inputs. The more productive the economy, the more value it is able to generate, either through more efficient allocation of inputs, greater productive efficiency in converting inputs into outputs or through innovation – coming up with new products and processes. Achieving sustained economic growth ultimately depends on an economy’s ability to increase its productivity over time, so improving productivity should be the key long-term goal of economic policy.

Many of the barriers to increased productivity are the result of policies and regulations of past governments. Misguided or poorly implemented measures to protect or encourage particular sectors have stifled the competitive forces that drive productivity resulting in higher costs of production. Competitive intensity is a key driver of productivity. It is only in a highly competitive business environment that firms have a strong incentive to adopt best-practice techniques, and technology and engage in innovative activity. This works in three main ways. 

First, within firms, competition acts as a disciplining device, placing pressure on the managers to become more efficient. Secondly, competition ensures that more productive firms increase their market share at the expense of the less productive. These low productivity firms may then exit the market, to be replaced by higher productivity firms. Thirdly and perhaps most importantly, competition drives firms to innovate, coming up with new products and processes, which can lead to step-changes in efficiency. Protectionism shields them from these competitive forces and eliminates a vital incentive, stunting long-term growth. 

Increasing competition means opening the country to investment and trade, reducing the tariffs and regulatory impediments to both. This can help reduce consumer prices and prices of inputs. Import competition spurs local businesses to greater efficiency. With sound macroeconomic policies in place imports can flow in freely.

Within the government, productivity must be addressed through the process of privatisation of commercial activities that could be more productively undertaken by the private sector and the closing down of non-viable state-owned entities, reforming the legal foundations of the economy and substantially increasing the efficiency in critical government functions. For example, increasing the efficiency in the areas of tax and custom procedures and reducing trade and regulatory barriers to enhance competitiveness, digitisation and better systems that improve efficiency and ease of doing business.

Policymakers have no idea of how grave this crisis is or how bad things could get. It is a classic debt and balance of payments crisis, which, if mishandled, can result in a complete meltdown of the economy. The government has appointed, at long last, competent officials in the governor and the treasury secretary aided by a solid team in Indrajith Coomaraswamy, Shanta Devarajan and Sharmini Cooray. They must have unwavering support from the executive and legislature. All political parties need to work together towards resolving the political deadlock and restoring political stability to ensure economic change can be achieved without delay. 

Policy actions: Not quite enough

Originally appeared on Daily FT, Lanka Business Online and Groundviews

By Dr Roshan Perera and Dr. Sarath Rajapatirana

Key macroeconomic indicators signal an economic crisis

A reading of key macroeconomic indicators reveals the extent of the economic crisis Sri Lanka is faced with. Indicators in all four sectors of the economy (i.e., the real sector, fiscal sector, external sector, and monetary sector), have been at their worst level in recent years, and in some cases, at levels never before seen in the post-independence history of this country. 

Growth was negative in 2020 and continued in the negative territory in the third quarter of 2021. This was obviously partly due to the pandemic as well as the measures taken to curtail its spread. However, growth in Sri Lanka continued to remain subdued while other countries in Asia were firmly on a path to recovery. Macroeconomic instability will continue to negatively impact investor sentiment and growth prospects in 2022. This will be further exacerbated by the impact of the war in Ukraine, as the region accounts for a large share of tourist arrivals and is one of the key destinations for Sri Lanka’s tea exports.

Inflation as measured by the CCPI has reached double digits (15.1% YoY in February 2022). These levels were last seen only during the last stages of the civil war. Many countries around the world have also been experiencing an uptick in inflation due to higher commodity prices, especially energy prices and supply side issues due to pent up demand with the opening of countries.

However, in Sri Lanka, an extremely loose monetary policy due to excessive money printing by the Central Bank of Sri Lanka (CBSL) to finance the Government’s deficit has pushed inflation to double digit levels. Further, core inflation – which excludes food and energy – had risen to 10.9% by February 2022, reflecting the demand pressures in the economy. Food inflation has risen even faster, with the year on change reaching 25.7% in February 2022. The recent outbreak of war in Ukraine sharply increased energy prices, with Brent crude oil prices rising to over $ 100 in March 2022 – levels last seen in late 2014.  With domestic fuel prices adjusting to higher international prices, inflation is likely to increase even further.

Meanwhile, the fiscal sector continues to deteriorate. Ad hoc tax changes made at end-2019 resulted in tax revenue declining by around Rs. 500-600 billion in both 2020 and 2021. This decline will continue in 2022 unless measures are taken to reverse this trend. Consequently, tax revenue collection has fallen to the lowest level in history (8% of GDP). This has led to widening fiscal deficits and interest payments absorbing more than 70% of Government revenue.

The significant contraction in revenue with no adjustment to Government expenditure increased the fiscal deficit to 11.1% of GDP in 2020. This is likely to have increased further in 2021. A deficit of this size was last witnessed in 2009 (9.9% of GDP) and 2001 (10/4% of GDP). The sharp decline in revenue and the worsening fiscal position led to international rating agencies downgrading the sovereign, effectively locking Sri Lanka from international capital markets. Hence, the Government resorted to domestic sources to finance the widening fiscal deficit. However, with a cap on interest rates, it fell on the CBSL to do the heavy lifting.

Consequently, money supply rose to unprecedented levels, mainly driven by credit to the Government from CBSL, as the net foreign assets (NFA) of CBSL turned negative for the first time ever. Net Credit to the Government (NCG) in 2021 increased by Rs. 1.454 billion (38.2% YoY) with CBSL being the main provider of credit. Credit to the private sector increased by only Rs. 810 billion (13.1% YoY) during the same period.

The extent of the monetisation of the fiscal deficit is seen by the sharp increase in CBSL’s holdings of Government securities from Rs. 75 billion at end 2019 to Rs. 1,417 billion at end 2021. This has further increased to Rs. 1,529 billion by 11 March 2022. By artificially suppressing interest rates to keep Government borrowing costs low, the CBSL was forced to purchase Government securities not taken up in the primary market. This had increased reserve money (base money) by 35% (YoY) in 2021. The increase in base money would have been even higher if not for the decline in CBSL’s NFA to a negative Rs. 386 billion due to the use of foreign reserves for debt service payments and to support the ‘fixed’ exchange rate.

On the external front, the Government’s large foreign debt repayments and its inability to tap foreign capital markets due to the sovereign downgrade led to the use of foreign reserves for debt service payments. Consequently, the country’s official foreign reserves fell to precarious levels. To address the imbalance in the external sector, the Government restricted imports of many goods. The CBSL also imposed a 100% margin requirement on importation of selected “non-essential” goods.

Notwithstanding these import controls, the trade deficit (the difference between exports and imports) widened in 2021. In addition, in September 2021, CBSL fixed the exchange rate within a band of Rs. 200 to 203 per US Dollar and instructed banks to carry out transactions within this narrow band. Since demand for US Dollars outstripped supply at this “fixed” rate, a black market developed.

On 7 March 2022, when CBSL allowed “greater flexibility” of the exchange rate, the US Dollar was trading at around Rs. 260-270 in the black market. The large deviation between the official exchange rate and the black-market rate led to a significant decline in foreign inflows. Workers’ remittances, which hitherto helped cushion Sri Lanka’s trade deficit, had declined by 23% to $ 5.5 billion in 2021, with the decline continuing in 2022.

Recent policy actions not sufficient to stabilise the economy

To address the deteriorating macroeconomic environment on 4 March 2022, the CBSL revised its policy rates by 100 basis points, thereby raising the Standing Deposit Facility Rate (SDFR) to 6.50% and the Standing Lending Facility Rate (SLFR) to 7.50%. In the same monetary policy announcement, CBSL as the Economic and Financial Advisor, proposed several policy measures to be taken by the Government to address the current economic situation, such as;

• Introducing measures to discourage non-essential and non-urgent imports urgently

• Increasing fuel prices and electricity tariffs immediately, to reflect the cost

• Incentivising foreign remittances and investments further

• Implementing energy conservation measures, while accelerating the move towards renewable energy

• Increasing government revenue through suitable tax increases on a sustained basis

• Mobilising foreign financing and non-debt forex inflows on an urgent basis

• Monetising the non-strategic and underutilised assets

• Postponing non-essential and non-urgent capital projects

However, a few days after this announcement on 7 March, CBSL permitted “greater flexibility in the exchange rate”. Although the CBSL indicated that it was of the view that transactions in the foreign exchange market should be conducted at not higher than Rs. 230 per US Dollar, by 11 March, the US Dollar was trading at Rs. 265/275.

This was partly due to confusion in the market with parallel announcements being made by the Cabinet regarding increasing the incentive payment to Rs. 38 per US Dollar from the current rate of Rs. 10 per US Dollar for repatriations by migrant workers. Maintaining the exchange rate at these levels would require further policy action while restoring the confidence of migrant workers to use formal channels for their remittances.

While the monetary policy tightening cycle has commenced more needs to be done as inflation and inflation expectations remain elevated. The last time inflation was at these levels in 2009, policy interest rates were at 10.50% (SDFR)/12.00% (SLFR) and the 91-day Treasury bill rate was close to 16%. Higher interest rates are also necessary to maintain the interest rate differential given the Federal Reserve Bank of the US has signalled it will continue to raise interest rates to address “surging inflation”. The difference between the current policy interest rates and market interest rates also provides an arbitrage opportunity for investors to make supernormal profits. This opportunity is higher given the large liquidity deficit in the overnight market, which stood at Rs. 704 billion as at 11 March 2022.

Tackling inflation also requires bringing down aggregate demand in the economy. Excessive money printing by CBSL has increased currency in circulation by Rs. 290 billion (59%) from end 2019 to end 2021. The large tax cuts in 2019 have left around Rs. 1 billion in the hands of individuals and businesses. In addition, although workers remittances did not come through formal channels, there was a thriving informal system known as the ‘Hawala’ or ‘Undiyal’ system, by which remittances came into the economy. The increase in cash in the economy has elevated demand for both domestic and imported commodities, thus exerting upward pressure on domestic prices and increasing demand for foreign exchange to support higher imports.

Suppressing imports, particularly of cars, has also left money in the hands of dealers. This excess money in the system is likely to have driven the boom in the stock market and pushed up land prices and the market for second-hand vehicles. The higher money supply in the economy has thus driven speculative activities rather than being channelled into growth-enhancing economic activities. Addressing the build-up of aggregate demand pressures requires, in addition to further tightening of monetary policy, raising taxes and curtailing the monetisation of the deficit through CBSL financing.

Further, the exchange rate should be the mechanism through which imports are discouraged and exports incentivised. Imports in 2021 increased by 28.5% from 2020. However, the increase from 2019 was only 3.5%. Further, the main increases were in medicines, fuel, textiles, base metals, machinery and equipment, and building materials.

Allowing the market mechanism to determine prices would be the most efficient way to ensure that goods get allocated to their highest use. This is particularly important in the case of fuel, which is priced significantly below cost. Interference in the market mechanism leads to shortages and the development of a black market. There are plenty of examples in the recent past that amply demonstrate the impact of administrative price controls on the availability and quality of goods in the market. In addition, controlling the price or supply of commodities leads to a transfer of “profit” to those who control the market while taxing consumers in terms of time and effort expended to source goods.

Sri Lanka faces twin problems of an internal imbalance with high domestic inflation and an external imbalance with external outflows well in excess of inflows (in other words, a deficit in the balance of payments). The root cause of the twin problems is the Government continuing to run fiscal deficits and financing these deficits through high-cost external borrowing and monetary expansion. Addressing these issues requires policy action on several fronts. However, first, a debt restructuring programme needs to be put in place to give the country some breathing space to stabilise the macroeconomy and to implement growth enhancing reforms. 

A comprehensive macroeconomic stabilisation programme and overall economic reform agenda will impact key economic variables; some desirable and some not so. Low-income groups will be particularly affected by these policy adjustments. Hence, attention needs to be paid to ensure an adequate safety net to protect the most vulnerable in society from the fall out of policy adjustments.

The current Samurdhi programme is woefully lacking in terms of adequacy and targeting. There needs to be a more comprehensive social protection scheme. The additional cost of the programme could be funded through savings from the fuel subsidy (which currently disproportionately benefits richer households), reversing the tax cuts and reallocating Government expenditure (1).

References

1. Tackling the COVID-19 economic crisis in Sri Lanka: Providing universal, lifecycle social protection transfers to protect lives and bolster economic recovery, UNICEF Sri Lanka Working Paper, June 2020

Dr. Roshan Perera, Senior Research Fellow, Advocata Institute and former Director, Central Bank of Sri Lanka.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.

Borrowing from Peter to pay Paul

Originally appeared on The Morning

By Dhananath Fernando

There’s a childhood memory engraved in my mind, of an incident with a fellow schoolmate concerning an act of borrowing. Back then, we borrowed money from each other constantly to eat sweets and junk food and buy video game gadgets. A particular friend of mine had the habit of borrowing a little money every week and settling the same again after a week’s time right on schedule. After a few weeks, I realised he borrowed the same amount of money from another friend as well. 

Like a well-planned roster, he proceeds to settle his debt with the other friend in a week’s time. One day my frequently borrowing friend did not settle my money as he promised. When I confronted him on the matter, he plainly stated that he settled the amount owed to me with the money he borrowed from my other friend and vice versa. At this one instance, the other friend had refused to lend money to my frequently borrowing friend so he was unable to settle with me. 

But what was particularly amusing was what he said after. “What I have been borrowing and settling for the past few weeks is money from the two of you to each other. So to resolve the matter, the two of you must settle with each other because it’s your money. Not mine.” 

Sri Lanka’s debt servicing is a much more complex version of what my classmate did; we settle our creditors by borrowing from someone else. Most sovereign countries do the same. However, this can only be done when someone agrees to give us money. Similar to the incident with my friend, the moment people refuse to lend us money, the cycle starts collapsing. That is exactly what happened to Sri Lanka. As a result, the country has lost its credit rating by international rating agencies and has thereby lost market access. 

The current strategy we follow is requesting lifelines from our bi-lateral partners as a form of assistance. As a result, in just five days, India threw in about $ 1.4 billion worth of credit lines and swaps to secure our fuel, medicine, essential supplies, and debt repayments. 

Initially, China provided us with a swap of 10 billion Yuan as a back-up, which the Central Bank absorbed as reserves according to their data. 

At the same time with some of the bi-lateral partners, our relationship has not been professional. We cancelled the LRT project with Japan, which is our main bilateral creditor as well as the main funder for one of our main multilateral partners, the Asian Development Bank (ADB). To make matters worse, we keep the trade channels such as vehicles and spare parts closed, which is precisely where the bilateral relationships can be strengthened. 

Our mismanagement of bilateral relations is reflected, even with China. Recent events, such as our shortsighted handling of diplomatic relations over the fertiliser issue, with China blacklisting a state bank for not honouring payments, illustrates this issue. 

Economically and geopolitically, we have lost market access for borrowing on one hand, and on the other, we have somewhat tarnished the relationship with our friends at a time when we need their assistance the most. So far, we have been very lucky to still have their continuous support regardless of the setbacks even though the fault is on our end entirely. As a recommendation, the Government should not take the silence of some bilateral partners lightly, but work double-time to restore trust and understanding in business and trade. 

The current strategy of paying our International Sovereign Bonds through bilateral swaps and depending on credit lines for essentials will eventually come at a geopolitical expense. We become more vulnerable with our past track record of working with our bilateral partners. 

In this context, the Central Bank increased policy rates by 50 basis points, a policy move in the right direction. However, this comes – unfortunately – too late to stop the inflationary pressure constantly building, probably due to the faulty use of Modern Monetary Theory, which we have been following for some time now. The policy rate revisions will encourage people to save more money instead of spending more. This will somewhat ease the pressure, but at the same time slow the economy down. But we can’t afford to accelerate the economy with a historic balance of payment crisis which was already exacerbated by a price control on US Dollars (USD) in an attempt to encourage imports and discourage exports. 

Surprisingly, policymakers have not taken any reforms to overcome the situation, believing that debt servicing through borrowed money will solve the problem. Very high hopes have been kept on tourism but the same thing that happened to remittances will happen to tourism when we try to keep the exchange rate very low. We encourage people to keep the USD in grey markets so people will become further reluctant to sell their hard-earned USD to the Central Bank. 

At the same time, we need to understand tourism also increases the consumption of the economy where, with USD inflows, there will be a fair share of USD outflows concurrently. Thus, keeping all our eggs in the basket of tourism would not be advisable at all. If policymakers recall, at the beginning of the pandemic, remittances were at a record high. With mounting debt, our policymakers replied that our solutions remained in our remittances, which today are in decline due to our own policy failures. In this context, there are certain areas for restructuring that policymakers have to consider if they were to come out of the crisis: 

1. Restructuring of our social security net. A market pricing-based digital cash transfer system with better targeting than Samurdhi is recommended to provide poor people the opportunity to keep their noses above the water to navigate through the economic reform period

2. Restructuring and Reforms on the State sector and State-owned enterprises are a must. Listing the debt of State-owned enterprises, privatisations, consolidations and outright sale of some of the assets owned by State-owned enterprises is required for the private sector, including land. Government care has to be limited through a reasonable voluntary retirement scheme

3. Restructuring and Reforming in our Central Bank .The current tools of excessive interventions by the Central Bank on interest rates, exchange rates and every part of monetary policy has to be refined

4. Restructuring and reforming our tax system and tariff system is a must. Currently, our income and corporate tax systems are too complicated and it has to be simplified if policy makers are interested in increasing revenue. The complicated tariff structure has to be simplified with three tariff bands. Bringing down tariffs will also help the Government increase the revenue and boost trade

5. Restructuring and reforming our production structures for it to be aligned with global production and supply chains is vital to increase export revenue. At the same time, a deregulation drive has to be initiated to ensure conducive business environment for locals and foreigners

6. If our debt is unsustainable, we have to consider a restructuring of debt, but with the above-mentioned reforms. Attempting to do a debt restructuring without a solid commitment to reform will worsen the problem and debt restructuring could become a frequent event causing us to lose our credibility and market access if we fail to do the necessary reforms

All these ideas are not new and not a first mention in this column. These have been repeatedly spoken of by countless economic experts. It is simply that the call to action rate is very low. Policymakers whose job is to change policies and get things done. Not to behave like my classmate – paying debts with borrowed money, wiping their hands clean, and shifting the responsibility elsewhere at the last minute.

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.

Debt restructuring: Between a rock and a hard place?

Originally appeared on The Morning

By Dhananath Fernando

According to news sources, the President has requested the Chinese Foreign Minister to assist Sri Lanka in restructuring our debt. The Finance Minister too has indicated to Japan and India, our long-standing bilateral partners, the need for more assistance to overcome the economic crisis Sri Lanka is going through. 

In a recent press conference, the Central Bank of Sri Lanka (CBSL) Governor also mentioned that discussions for a new loan from China to restructure our debt is underway. 

However, it seems that the President and the CBSL Governor have given the term ‘restructuring’ two different meanings. One as run by the Global Times, the Chinese Communist Party-run newspaper, which said: “After President Rajapaksa’s request to restructure debt, Song Wei, a research fellow at the Chinese Academy of International Trade and Economic Cooperation stated that interest-free loans offered by the Chinese Government are applicable for debt relief while the concessional loans raised through the market cannot be written off.” 

However, as measures for debt restructuring, the CBSL Governor suggested taking more swap agreements, paying International Sovereign Bonds (ISBs) and bilaterally skewing our debt profile from market borrowing. Considering all this, we are yet to know what would be the final decision.

In Sri Lanka’s external debt profile as at the end of 2020, about 57% was borrowed from financial markets (34% from ISBs and 8% from China Exim Bank). 

In my view, we cannot evaluate debt restructuring without really understanding the problem. The issue at hand is that Sri Lanka borrowed money in US Dollar terms with a short maturity at high-interest rates and invested in assets on non-revenue generating non-tradable assets. As a result, we had to borrow money at even higher interest rates to service the interest of previous debts which has snowballed to a point where Sri Lanka has lost access to capital markets.

So the choices are not between ‘good’ vs. ‘bad’. The choices are between ‘worse’ vs. still ‘worse’. That is why it is called an economic crisis. Either measure will result in a catastrophic impact on the people of Sri Lanka. So in this context let us evaluate debt restructuring. 

The objective of any debt restructuring is to avoid a similar situation in the future and ensure sovereign debt sustainability. So a debt restructuring plan without an economic reform plan to improve competition, trade, and efficiency of the economy will not bring us any sustainable solution. Rather, it will worsen the situation. 

Secondly, debt restructuring is also a very difficult process for a country like Sri Lanka with a limited resource base. Countries such as Argentina and Ecuador defaulted but they have large reserve bases including oil to get back on a path of recovery. But Sri Lanka is a small $ 82 billion economy with no experience on debt restructuring.

Debt restructuring is not an easy process given Sri Lanka’s debt profile. Usually, senior creditors such as the International Monetary Fund (IMF), the World Bank, and the Asian Development Bank (ADB) are unlikely to restructure debt as it is provided at a concessional rate and with a longer maturity period. In restructuring multilateral debt, generally, a new programme would be introduced to recover the previous debt. 

Restructuring bilateral debt is complicated. The debt of Paris Club members has to be negotiated at the Paris Club. Australia, Austria, Belgium, Brazil, Canada, Denmark, Finland, France, Germany, Ireland, Israel, Italy, Japan, South Korea, the Netherlands, Norway, Russia, Spain, Sweden, Switzerland, the UK, and the US are the members of Paris Club. So any bilateral debt restructuring from the above nations have to be at the Paris Club. According to data, 10% of our creditors are members of the Paris Club, with Japan being the main bilateral creditor for Sri Lanka.

Our debts with China and India, who are not Paris Club partners, have to be negotiated outside the Paris Club. Generally, any bilateral creditor would not agree to single-handedly bear the entire restructuring loss of one particular country. They will request other partners to assist. Even in the case of China, according to NewsIn Asia, Long Xingchun, a senior research fellow at the Academy of Regional and Global Governance of the Beijing Foreign Studies University, stated that restructuring loans with China alone is insufficient to help the island nation tide over its difficulty, which needs a package plan with other involved parties.

The geopolitical situation in Sri Lanka will give way to more geopolitical externalities in debt restructuring with bilateral partners. But it seems we have to move towards that direction as we have very limited alternatives at hand. 

Additionally, bilateral partners will also request to share the debt burden with commercial creditors including ISB holders. This is because in debt restructuring, the main objective is to distribute the loss as much as possible. 

Restructuring commercial debt has to be dealt with by international law and it is somewhat an expensive and time-consuming process to reach a consensus with all creditors. According to global debt restructuring expert Prof. Lee Buchheit, it can take about nine months to a few years based on the profile of the debt. 

In debt restructuring, there are four parameters generally considered. 

1. Reducing debt stock or principal amount commonly known as haircuts

2. Adjusting the interest rates to be paid or coupon rates commonly known as coupon adjustment

3. Extending the repayment or maturity period

4. Mix and match of all above

The general practice is creditors ask to conduct a debt sustainability study of the country before deciding the adjustment or deciding which parameters of restructuring are to be used. The only credible organisation to conduct an independent study is the IMF, and that is why in most of the debt restructuring processes, the countries are under the IMF programme. In Sri Lanka’s case, in the event of a restructuring as our President requested, we have to disclose all debt including the debt owed by the State-Owned Enterprises because the restructuring burden will be calculated across the board. 

Creditors are generally very reluctant to restructure debt especially when it is due to financial mismanagement. In case of a natural disaster or a negative externality, the negotiation would be easier compared to a situation concerning economic mismanagement. 

So the available choices for Sri Lanka are very limited and every choice may have its own set of consequences. Reserves are declining and people often complain about shortages of essentials and interruption of utilities. Businesses are complaining about the inconvenience of working with banks due to difficulties in opening Letters of Credit (LCs). Creditors and investors are embroiled in suspicion and confusion with constant credit rating downgrades. Debt restructuring will be complicated and an open Sri Lanka for geopolitical sensitivities will affect political stability. 

The choices at hand are difficult. This column has continuously highlighted the need for reforms since the beginning of the pandemic with full knowledge that delays will limit the alternatives. We need to shift gears and move forward with hard reforms before people become hard on reforms. 

References:

• https://newsin.asia/china-to-revise-lankan-loans-repayment-schedules/

• https://newsin.asia/china-to-revise-lankan-loans-repayment-schedules/

• https://www.youtube.com/watch?v=I1hezyj2YxA&list=WL&index=1&t=7182s

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.