A cornucopia of crises: Refuge lies in reforms

Originally appeared on The Morning

By Dhananath Fernando

Many people call me and ask what the economic crisis looks like and how they should feel about it. I always say to them, “The economic crisis is like a long night where you can’t fall asleep even when you are sleepy. At the same time, you don’t know when the sun will rise and the night will be over. You are sleepy and tired but still you can’t fall asleep.” 

This economic crisis is the same; the future is becoming uncertain and we are not sure what will happen. As Prof. Riccardo Hausmann said at an Advocata session in September 2020, “An economic crisis comes slowly, and then suddenly.”

The nature of any economic crisis is that it often comes with many other crises. Currently we are suffering from a balance of payments crisis. Simply, it means we do not have enough foreign exchange to buy essentials such as fuel, food, energy, power, and other products that we need to survive on a day-to-day basis.

The second phase is generally the interruptions of services. For example, at present with long power outages, our telecom sector is in trouble; cell towers may not be able to provide the same voice call clarity, service, and internet services as in a normal environment. So every economic activity connected to the internet is going to be affected and the jobs and income will be affected. Many young people who are internet freelance workers will lose their income and the country will erode more foreign exchange inflows.

Another example is if vehicle battery manufacturers cannot get necessary packaging material. After a few months, there will be a vehicle  battery shortage which will impact all vehicles which use batteries to start their engines. All that is just the impact to the common man due to the BOP crisis.

The second crisis is the brewing debt crisis. At the moment the debt crisis has been overtaken by shortages and long lines. But with a $1 billion payment due in July the debt crisis is knocking at our door. We haven’t made any announcements to warn our creditors yet, so the impact of debt restructuring will be felt by our entire financial sector as well as all State Owned Enterprises with credit guarantees provided by banks. 

Economics is always connected with politics. With a BOP crisis combined with a debt crisis impacting the fiscal  sector is affecting the entire political structure. This problem is at a much deeper level where whoever and whenever in power will not be able to have quick fixes. Most of the solutions are painful and already we all have become victims of the pain of shortages of basic essentials such as fuel and electricity. 

However still we can attempt to do a few quick fixes but the actual solutions are with deep economic reforms, which this column has advocated for a long time.

We have to increase the interest rates and remove all forex surrender requirements by the commercial banks to the Central Bank. At the moment interest rates are too low compared to inflation. In simple terms our inflation is at about 17%. Our interest rates are at 7-8%. So if someone deposits money at a bank, the value of the money will fall at 17% and the interest rate is only 8% so the net loss would be 9%-10%. As a result, people are more encouraged to spend money than save. When people spend money, the demand for imports is going to increase regardless of some import controls or licensing schemes.

If you inquire from businesses, generally they have high demand but the problem is they can’t supply because of supply chain interruptions due to lack of foreign exchange. So interest rates have to increase to a viable level to stabilise the economy and minimise pressure on inflation. If an economy is functioning well, we can keep the interest rates low by making it easy to access capital. But in the middle of a forex crisis we can’t afford to keep interest rates low. 

One reason for the LKR to continuously depreciate is the low interest rates. The second reason is the surrender requirement of 50% from the commercial banks to the Central Bank. The simple meaning of this is that all banks have to sell 50% of their USD income to the Central Bank at a lower rate/price. So banks may only have 50% of the balance in the market to give it to the importers and everyone who is asking for foreign exchange. As a result the exchange rate is constantly increasing and people who have foreign exchange are holding it, expecting rates to go up further. 

The final outcome is that there is a massive shortage of USD in the banking system and the black market forex trades have been highly active. It was reported that the Central Bank had suspended the licence of one money exchanger. The prevailing system will most likely exacerbate the problem and forex shortages will further increase. 

We have to immediately clear many grey areas in our stance and policy. Then a clear direction has to be provided on the stance of whether we should approach the IMF or not. Since the IMF’s Article IV report states our debt is unsustainable, it is clear that we have to restructure our debt if we were to get into any IMF programme. Until then only technical advice can be accessed. Even in our debt restructuring, we haven’t been very clear and our messaging has been so weak for markets to make any concrete decisions. Not providing clarity on these critical areas is going to extend the crisis.

The dark night of the economic crisis will last longer than we think if we move at this speed and we may even run out of candles due to the unavailability of naphtha which is a petroleum product. The solution is reforming now! 

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.