Foreign Currency Pandemic in Sri Lanka – How the Non-compliance with Economic Principles and Laws by the Relevant Authorities led to the Pandemic and the Vaccines and Surgeries Immediately Required to take the Pandemic under Control

 

Economic Behaviours of the Public

Such are governed by economic principles and laws. Economic principles (natural economic laws) represent natural laws relating to economic behaviours of the public. In contrast, economic laws are the statutory rules imposed by the state as to how people should control their economic behaviours in the common public interest as the state considers fit from time to time.

• Economic Principles

The subject of Economics has evolved to document economic principles based on various assumptions relating to economic behaviours of people. In general, people act in markets as buyers (demand) and sellers (supply) competitively to get their economic needs satisfied with maximum benefits. Accordingly, all market participants are driven by the self-interest which in turn best satisfies the others’ interest as well than any rules imposed by the state to that effect if markers are free. The reason is that a person will end up satisfying his interest only if his act satisfies others. 

The price so determined in the market through demand and supply is a natural price which acts as the force to equate or balance diverse actions of buyers and sellers (market participants) and to solve basic economic problems confronted by the human being in matching resources with needs. Accordingly, the view of the great economic philosopher Adam Smith (known as the father of economics) on the market mechanism is the foundation for almost all economic principles.

Some economic principles also are termed as laws due to their strict application, for example, law of demand and law of supply. Although people are not aware of such economic principles enumerated in Economics, their behaviours are naturally governed by such economic principles.

• Economic Laws

Economic laws are the rules imposed by the state or a select group of public representatives to limit the economic behaviors of the public under economic principles within the competition permitted by such rules. Therefore, these rules are expected to promote fair market operations towards general public interest as the state considers appropriate. Various price controls, taxes, state licenses and state business enterprises are common examples for economic rules. Accordingly, the state attempts to intervene in the public through such laws. The number of such economic laws effective at present are countless and there is a large number of state authorities to administer them. It is well known that the principal source of state corruption also arises from administration of such economic laws/rules.

• The Conflict between Economic Principles and Economic Laws

The eternal conflict between economic principles and economic laws is well established. The price control system, i.e., maximum price and floor price, is a good example. This conflict eventually leads to adverse consequences to the public although some economic laws are helpful in protecting identified categories of the public in certain times.

The non-compliance with economic laws also is well established. The non-compliance is primarily seen from the respective state authorities due to their failures to administer the laws in letter and sprint. The present reports on severe shortages of commodities, significant increases in prices and lack of product quality standardization show good examples. The lack of resources and negligence involved in administering these economic laws by the state authorities are the major reasons for their failures.

In the event, the relevant authorities fail to perform on economic laws, people continue to behave on natural economic principles and markets operate accordingly although political leaders call them black markets. The fine example at present in Sri Lanka is the foreign exchange/currency market and the acute shortage of foreign currency in the country, despite underlying monetary laws governing foreign currency in the country.

Present Foreign Currency Pandemic in Sri Lanka - Salient Features

Everybody knows that almost all shortages of commodities and price escalations and thereby collapse of living standards of the general public in present Sri Lanka are attributable to acute shortage of foreign currency, especially US Dollar supply in the country, although Dollars are abundant in the US and international markets. As the Corona pandemic disrupted the global supply chains on goods, services and capital, foreign currency flows of Sri Lanka also got disrupted causing a heavy BOP deficit and erosion of the country’s foreign reserve.

We all know that, despite the open economy policy strategy followed in Sri Lanka since November 1977, Sri Lanka has been a highly import dependent economy with a large current account deficit in the BOP funded primarily by foreign currency inflows through the state’s foreign borrowing. Further, such foreign borrowing also has been the source of the country’s foreign reserve. Meanwhile, the exchange rate of the Rupee against the Dollar has been heavily controlled at lower levels, despite the BOP deficits, by the supply of Dollars out of the foreign reserve to the market to meet the excess demand for Dollars arising from the lower prices. This is a typical price control law administered/imposed by the state.

The motive behind this price control is two-fold. The first is to control the domestic inflation. As the economy is largely import dominant, domestic price structure also is largely determined by local prices or cost of imports in local currency. Therefore, the control over the exchange rate at low levels helps control the domestic inflation. The second is to keep the state’s foreign debt service payments in local currency. If the exchange rate rises, the amount of local currency required for foreign currency denominated debt service also rises causing further budgetary and debt problem. This can be controlled by keeping the exchange rate under control.

However, this control has been a highly risky administration of the relevant laws as the economy has been running at rising BOP current account deficits and foreign borrowings of short-term nature. Therefore, the maintenance of the foreign reserve and control of the exchange rate have been highly vulnerable acts to the economy and the general public.

In addition, fiscal measures awarded to export promotion and foreign investment inflow have not been fully effective although those sectors are seen elevated in comparison to levels prior to 1977.

Economic Laws relating to Exchange Rate and Foreign Reserve in Sri Lanka

In this regard, the governing law is the Monetary Law Act (MLA), the Monetary Board/Central Bank of Sri Lanka and Minister of Finance are the statutory authorities to administer relevant laws in the public interest. Some of the important statutory provisions in the MLA are stated below. In addition, Minister of Finance and the Monetary Board enjoy a large number of public economic laws un the Foreign Exchange Act to ensure that foreign currency operations are kept healthy for Sri Lanka.

• Section 3 – The Minister of Finance to determine the par value of the Sri Lanka Rupee (fixed exchange rate) or alter the par value or refrain from the determination of the par value on the recommendation of the Monetary Board. Sri Lankan government policy during the past two decades is the refrain from determination of the par value. Accordingly, exchange rate has been a flexible one determined by market forces with the intervention by the Central Bank at times.

• Section 5 – Objectives of the Central Bank since 2001 – Economic and price stability and financial system stability with a view to encouraging and promoting the development of the productive resources of Sri Lanka. Prior to that since 1950, one of the four objectives was the preservation of the par value of the Rupee and the free use of the Rupee for current international transactions.

• Section 63 (1) - The Monetary Board shall endeavour so to regulate the supply, availability, and cost of money as to secure, so far as possible by action authorised by this Act, the objects mentioned in section 5; and shall for such purpose have regard to the monetary needs of particular sectors of the economy as well as of the economy as a whole.

• Section 63(2) - In determining its domestic monetary policies, the Monetary Board shall especially consider their effects on Sri Lanka’s international financial position as evidenced by the relation of domestic to world prices and costs, by the level and composition of exports and imports, by the international balance of payments, and, ultimately, by the ability of the Central Bank to maintain the international stability of the Sri Lanka rupee and its free convertibility for current international transactions.

• Section 65 - In determining its international monetary policy, the Monetary Board shall endeavour to maintain the par value of the Sri Lanka rupee, or where no determination of such par value has been made under section 3, maintain such exchange arrangements as are consistent with the underlying trends in the country and so relate its exchange with other currencies as to assure its free use for current international transactions.

• Section 66(1) - In order to maintain the international stability of the Sri Lanka rupee and to assure the greatest possible freedom of its current international transactions, the Monetary Board shall endeavour to maintain among the assets of the Central Bank an international reserve adequate to meet any foreseeable deficits in the international balance of payments.

• Section 66(2) - In judging the adequacy of the International Reserve, the Monetary Board shall be guided by the estimates of prospective receipts and payments of foreign exchange by Sri Lanka; by the volume and maturity of the Central Bank’s own liabilities in foreign currencies; and, in so far as they are known or can be estimated, by the volume and maturity of the foreign exchange assets and liabilities of the Government and of banking institutions and other persons in Sri Lanka. So long as any part of the foreign currency assets of Sri Lanka are held in currencies which are not freely convertible by the Central Bank, whether directly or indirectly, into special drawing rights or such other common denominator prescribed by the International Monetary Fund or into foreign currencies freely usable in international transactions, or are frozen, the Monetary Board shall also take this factor into account in judging the adequacy of the International Reserve of the Central Bank.

• Section 67(1) - The International Reserve of the Central Bank may include the following assets: gold; assets in foreign currencies in the form of documents and instruments of types customarily employed for the international transfer of funds; or demand and the time deposits in central banks, treasuries, and commercial banks abroad; or securities of foreign Governments; or foreign notes and coins; and either the whole, or such maximum percentage of the whole, of the holdings of such drawing rights in the Special Drawing Rights Department in the International Monetary Fund according as may be determined from time to time by the Monetary Board.

• Section 67(2) - The Monetary Board shall endeavour to hold at least a nuclear reserve in gold or currencies freely convertible by the Central Bank, whether directly or indirectly, into gold. The board shall particularly consider the prospects of stability and convertibility of all of the currencies in the International Reserve as well as the anticipated demand for such currencies.

• Section 68(1) - Whenever the Monetary Board anticipates that there may develop a deficit in the international balance of payments of such magnitude as to cause a serious decline in the International Reserve, or whenever there is an imminent threat of a serious decline in the International Reserve, or whenever the International Reserve actually falls to a level which the board considers to be a threat to the international stability of the Sri Lanka rupee, or whenever international payments or remittances are being made which in the opinion of the board constitute an actual or a potential threat to such stability or are prejudicial to the national welfare, it shall be the duty of the board to adopt such policies, and to cause such remedial measures to be taken, as are appropriate to the circumstances and authorized by this Act. The Monetary Board also should submit reports to the Minister of Finance on the extent of the problem, measures already adopted and measures proposed to be adopted by the government.

• Section 72 - In order to ensure the free use of the Sri Lanka rupee for current international transactions, the Central Bank may buy any quantity of foreign exchange offered, or sell any quantity of foreign exchange demanded, by any commercial bank in Sri Lanka (also with the government, state institutions, foreign governments and foreign financial institutions).

• Section 74(1) - The Monetary Board shall from time to time determine the rates at which the Central Bank will buy and sell foreign exchange.

• 76 (1) - The Monetary Board shall determine the minimum rate at which commercial banks may buy spot exchange and the maximum rate at which they may sell spot exchange. Where the Monetary Board has certified the legal parity of a currency in accordance with section 73, the maximum and minimum exchange rates established for such currency shall not differ from such parity by more than four and one-half per centum.

• Section 76A(4) - The Central Bank may buy and sell foreign exchange at such rates as the Governor or an officer authorised by the Governor for the purpose may deem appropriate.

Failure of Administration of Economic Laws by the Monetary Board/Central Bank

In review of above laws, it is not difficult to notice that the Monetary Board has failed to use its monetary policy instruments in a manner that helps build up a healthy/quality international reserve from economically strong flows on trade and capital underlying the economy.

Therefore, the root cause of the present economic disruption in Sri Lankan economy is the non-compliance with the economic laws by the Monetary Board. Instead, if the public had been permitted to act under natural economic principles largely free from rules arbitrarily imposed by the Monetary Board under such economic laws, the market mechanism would have helped the faster recovery from the Corona pandemic without getting into this degree of foreign currency crisis and living difficulties. In this regard, following facts are presented.

• Non-compliant Monetary Policy to ensure credit delivery to economically priority sectors

During the past two decades, the monetary policy was narrowly confined to assist bank dealers to manage their overnight liquidity at policy interest rate targets set by the Monetary Board for inter-bank overnight lending operations. Two policy interest rates at present are Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR). Accordingly, the Central Bank conducts so called open market operations (OMO) to accept any excess bank funds overnight at SDFR and to lend to deficit banks overnight on the collateral of government securities at SLFR.

Further, the Central Bank also conducts auctions of overnight and very short-term repos/reverse repos in government securities to mop up excess bank liquidity or inject new liquidity to the inter-bank market depending on the levels of the inter-bank overnight interest rate (within the policy rates corridor) preferred by the Monetary Board. For example, the preferred rate at present is close to the SLFR (6% at present) and, therefore, repo auctions are conducted at rates closer to the SLFR to mop up liquidity from the banking system. In addition, the Central Bank provides any amount of funds against the collateral of government securities free of interest charge to dealers for repayment within the day under the payment settlement facility.

Therefore, the Monetary Board undertakes money printing operations conveniently to control the inter-bank overnight interest rate within the policy rates corridor. As such, this is also a state price control operation. However, unlike in the case of any other price controls by the state authorities, the Monetary Board believes that it can control this price as it wishes because it can print or supply money in amounts required to keep that price in the inter-bank market.

However, the majority of money printing is determined by the lending to the state and net purchase of foreign currency by the Central Bank. As such money also causes changes in flows of funds in the inter-bank market, the control of this price for a long time is not that easy. In that case, the Monetary Board revises policy interest rates arbitrarily by giving various technical reasons to advocate an inflation targeting monetary policy without knowing the correlation between the overnight inter-bank interest rate and consumer price inflation.

Therefore, the delivery of credit to various sectors of the economy such as export industries and supply chains, tourisms, imports, import substitution industries, etc., is a bank risk-based business without any macroeconomic priorities. It is common experience that banks fund low risk trade credit for profit motive. However, the Monetary Board as provided for in the MLA has not administered the laws to supply and regulate credit to generate net inflows of foreign currency to the economy. As modern monetary economies function on credit, the monetary policy laws must be administered to streamline credit for the sustainable health of the macroeconomy. This is what is meant by the stability of the economy as an objective of the monetary policy.

The Central Bank has wide refinance lending and bank credit regulation powers for this purpose. Accordingly, the monetary policy in fact is the credit delivery policy across the economy whereas the above mentioned OMO is only a small element. Therefore, the Monetary Board has grossly noncompiled with the economic laws relating to the monetary policy. In fact, there is no provision in the MLA for administering the above mentioned SDFR operations as the authorized OMO in the MLA is the trade in government securities in the secondary market.

• Non-compliant Foreign Reserve Management and International Stability of the Rupee to ensure healthy and sustainable Balance of Payment Flows

                    Non-compliant Foreign Reserve Management

Strategies followed by the Monetary Board to maintain the foreign reserve are mainly two. One is to raise foreign borrowing from the international markets for the state. In this strategy, the Monetary Board simply gets the foreign currency proceeds underlying such borrowings to its foreign reserve and remits Rupees to the state. Accordingly, two main borrowing sources of foreign currency were the issuances of Dollar denominated Sovereign Bonds and Sri Lanka Development Bonds and the sale of Treasury bills and bonds to foreign investors under various placements.

For example, total issuance of sovereign bonds rose exponentially from US$ 500 mn in 2007 to cumulative US$ 18,050 mn in 2019 mostly on an annual basis with interest rates ranging from 5.125% to 8.25%. The aggressive issuance was intended to build a sovereign yield curve for Sri Lanka so that the country can easily tap foreign funding in a market environment.

The second strategy is the issuance of short-term foreign currency swaps which are of two categories. The first category is the offer of dollar swaps to foreign investors in local government securities privately arranged through local banks. This helps mitigate the exchange risk of foreign investors to attract foreign investments at a cost to the state. In this category, several banks also borrowed from abroad in foreign currency and swapped the proceeds with the Central Bank at agreed exchange rates on private placement basis.

These currency swaps are non-interest-bearing foreign currency reverse repos in which the Central Bank purchases foreign currency at the current exchange rate and simultaneously agrees to sell same amount of foreign currency at an exchange rate now agreed at the maturity of the swap agreement, irrespective of the market exchange rate prevailing at the swap maturity date. Accordingly, investors are better off by investing their rupee proceeds under swaps in local government securities for a good return while covering the exchange risk from the Central Bank. Last year, the Monetary Board launched a new swap scheme with 100% exchange risk cover in respect of foreign investments in both government securities and private securities.

Present Lebanon is a good example for getting into a currency crisis due to heavy dependence on such financially engineered currency swaps to build the foreign reserve and to keep the exchange rate highly overvalued at a huge cost to the state. Therefore, the Lebanon government has caused a forensic audit on the foreign reserve and currency swaps of the Lebanon central bank. It was recently reported that the audit has not commenced as the access to required information has not been given to auditors by the central bank.

The second category is the short-term borrowing from international financial institutions and foreign central banks at agreed interest rates. In addition, when the foreign reserve confronted with a severe erosion with the exchange under the threat, borrowing from the IMF from time to time also helped the replenishment of the foreign reserve and international confidence in the economy.

Accordingly, the Monetary Board worked on arbitrary targets of Dollar billions of foreign reserves and conducted various marketing campaigns to raise state foreign borrowing to achieve such reserve targets. Therefore, nearly 70%-90% of money printing or Central Bank’s assets accounted for the foreign reserve assets where the monetary policy lost its independence. This is in fact the Monetary Board using its statutory duty of public debt management to comply with foreign reserve laws, instead of the use of the monetary policy as mandated in the MLA. 

Therefore, the Monetary Board in fact has been funding the import dependent economy through state’s foreign borrowing. Such borrowing and reserves were operated through rollovers of borrowing and reserves under the flow concept used in finance However, foreign reserve management as set out in the MLA is not similar to profit-seeking portfolio management by gambling investment banks/fund managers, but has a wider public interest in both sources and uses of foreign reserves which is well understood from the current plight of the country's foreign reserve affecting all from government and businesses to the beggar on the road.

As a result, both public debt management and reserve management were messed up causing the state and the economy into the trap of rollovers of foreign borrowing. Therefore, this kind of macroeconomic management has exposed the country to immense vulnerability to shocks. In this background, the global Corona pandemic shock disrupted the economy as the Monetary Board could not continue this borrowing model while foreign currency earnings in the BOP plummeted consequent to disruption of the global supply chains. This is the reason for shrinking living standards confronted by the general public at present.

                    Non-compliant Exchange Rate Stability Management

Further, although mandated in the MLA, the Monetary Board has failed to maintain the exchange rate consistent with the underlying trends in the economy to assure free use of the Rupee in exchange of foreign currencies for current international transactions. This is revealed by drastic import controls and non-availability of foreign currencies for imports and foreign travels from the licensed banks at the exchanges rate for the US Dollar stipulated by the Monetary Board at present. Therefore, this exchange rate is a non-operating rate prevailing outside the provisions of the MLA.

Further, banks authorized/licensed by the Monetary Board under the Banking Act and Foreign Exchange Act to provide foreign exchange services to the eligible public are violating such foreign exchange licenses as they have failed to sell foreign currency to the public for legally permitted foreign payments of current nature. This has caused an unofficial bar on many essential imports such as milk powder and intermediate goods resulting severe shortages of such commodities. Therefore, the Rupee is effectively non-convertible for foreign currencies for current international transactions.

It is common sense that the exchange rate for the US Dollar cannot be kept at such low levels unless the Monetary Board has enough foreign reserves in US Dollar to be supplied to the market at those rates. However, the level of foreign reserve is out of the hand of the Monetary Board due to two major reasons. First, the printing and supply of the Dollar is at the hand of the US central bank’s monetary policy whereas the Monetary Board in Sri Lanka has no handle on it.

Second, the Monetary Board only has the monetary policy relating to Sri Lankan currency. However, the Monetary Board did not gear its monetary policy to attract a healthy and sustainable flow of Dollars to the country so that its foreign reserve is kept at healthy and sustainable levels as prescribed in the MLA although the Monetary Board had the detailed set of market information which was not available to any other party.

In fact, the Monetary Board now follows a multiple exchange rate system or differentiated exchange rates for stipulated transactions, for example, payment of additional 10 Rupees for a US Dollar (depreciated exchange rate) of inward remittances. However, the scarcity of foreign currency transactions at these rates reflects the inappropriateness of these rates in current market conditions. Prior to this instance, a multiple exchange rate system was followed from 1968 under the Foreign Exchange Entitlement Certificates Act and abolished in 1978 consequent to open economic policies and relaxation of exchange controls.

Therefore, despite the foreign currency business licenses, banks also are effectively in violation of the conditions in their banking license as they do not sell foreign currency even for currency account transactions (e.g., imports and foreign services). Further, the Monetary Board not selling foreign currency to banks to keep the exchange rates stipulated by itself under the MLA is another violation of section 72 of the MLA.

Therefore, such stipulated exchange rates are same as controlled prices of commodities stipulated by the state which become non-operative due to the inability of the state to supply such commodities in adequate quantities to meet the excess demand. As such, functioning of a real market so called “black market” in terms of natural economic laws/principles in place of artificially imposed state economic lows is a well-known fact. Further, knowing the fact that the exchange rate stipulated by the Monetary Board is non-operative, the Central Bank’s periodical economic reports mislead the public, especially students, by quoting such exchange rates to state that the exchange rate stability has been maintained by prudent macroeconomic policies.

Keeping the exchange rate fixed despite the acute shortage of foreign currency to show that the local currency value is protected has no meaning of economics. If the domestic prices of imports such as fuel can be increased to cut the demand and save foreign currency without any empirical study on demand elasticity, there is no rationale for keeping the exchange rate constant because market-based changes in the exchange rate also will produce more favourable results such as encouragement of exports, inward remittances and import substitution and discouragement of imports as predicted in general economics. The currency depreciation policy is considered more directly favourable to the economy and the BOP than raising the administrative prices of imports in an ad-hoc manner.

Therefore, the artificial control of the exchange rate at highly overvalued levels to state that the protected currency is a strength of the macroeconomic management as stated by some political leaders is a gross misconception. As such, a statement that the exchange rate has heavily depreciated from Rs. 4.76 per US$ in 1950 to Rs. 202.75 at present (by 4,159%) is a grossly misstatement made without any knowledge on simple exchange rate economics and exchange rate policy regimes adopted during this period.

The Role of International Monetary Fund (IMF) in the Global Economy

• Design Features

The IMF is one of leading supra national institutions managed by member countries to promote the global development and stability. The IMF together with the World Bank was established in 1944 by a consortium of 44 countries to rebuild the global economy disrupted by the World War II. While the World Bank was entrusted with the provision of assistance for the long-term economic development of member countries through loans, investments and technical support, the IMF was mandated to police the international monetary system agreed by the member countries for international payments and monetary co-operation to support global trade and investments as a key part of the economic development (see a technical article on the IMF in the EconomyDiscovery bolg).

The international monetary system so created was the gold exchange standard to govern the currency systems and exchange rates. Until such time, currency and international payment system were based on gold. However, under the new system, the US fixed its currency value as one ounce of gold equal to 35 dollars and undertook to buy and sell gold freely at that exchange rate. Meantime, other member countries fixed their exchange rates of their currencies for the US dollar and agreed to maintain the exchange rates with diversion within 1% margin. This is known as the Bretton Woods Agreement. Accordingly, member country currencies were indirectly linked to the gold through the dollar instead of the direct link with the gold hitherto. As a result, the gold standard was abolished. This new system is known as the fixed exchange rate system.

Accordingly, the IMF was entrusted with the policing the system through surveillance of country exchange rate management and providing short-term credit/liquidity to countries confronting fundamental deficits in their BOP to support their foreign reserves and payments without default so that fixed exchange rates are maintained for the stability in the international trade and investment flows.

However, this system collapsed in 1971 when the US government suspended the gold convertibility of the dollar. As a result, developed member countries moved to flexible or floating exchange rates while other countries followed mix systems such as continued fix rate system and managed floats. At present, international monetary system functions largely on flexible exchange rates determined by market forces.

• New Developments

However, the IMF continued with their policing and credit support to BOP deficit countries. Accordingly, IMF credit schemes have been expanded to suit international financial requirements of member countries in responses to various crises. At present, IMF offers nearly 9 short- and medium-term credit schemes to suit the BOP difficulties confronted by member countries.

In addition, the IMF launched a new currency system known as SDR (Special Drawing Rights) in 1969 to augment the intranational liquidity available for payments. The SDRs have been allocated among the member countries based on the ownership quotas in the IMF. The total amount of SDR in issue so far is 660.7 bn. All financial transactions between the member countries and IMF are carried out in SDR.

At present, many developing countries follow managed float exchange rates through frequent intervention by the respective monetary authorities. For this purpose, they maintain a foreign currency reserve to protect the exchange rate at administratively determined levels as required in their macroeconomic management strategies. Therefore, it has been the intentional practice of most of these countries to borrow from the IMF regularly to build their foreign currency reserves to fund foreign payments arising from the BOP deficits while managing the exchange rates.

Accordingly, the IMF provides credit and technical assistance to fix structural BOP problems of member countries, mainly developing countries with vulnerable foreign reserves. Therefore, the IMF is not a lending institution operating with profit motive, but a multi-lateral institution promoting global economic stability through international trade and investments. Accordingly, the IMF presently promotes policies for reduction of income disparities and pollution in addition to their conventional policy focus on inflation control and flexible exchange rates through country monetary and fiscal policies.

• Corona Pandemic Financial Assistance from the IMF

At the onset of the Corona pandemic, the IMF announced a special allocation of US$ 50 bn to provide instant credit to member countries confronted with BOP deficits and its preparedness to lend urgently to member countries based on information relating to Corona-related expenses outside normal conditions. The IMF also stated that it was prepared to utilise its full fund base of about US$ 1 trillion if necessary. The IMF is generally engaged in offer of US$ 250 bn of credit facilities to member countries.

Latest information reveals that the IMF has granted nearly US$ 168 bn to 87 countries to assist resolution of Corona induced BOP difficulties. In addition, debt relief was provided in four tranches to 29 countries for the total debt service of US$ 850.7 mn.

In addition, in last August the IMF made a fresh SDR allocation to member countries in order to augment the international liquidity to support the countries hit by the Corona pandemic. Nearly 42.3% of this SDR quota was received by developing countries whereas 3.2% was received by low-income countries. It was like a supply of life-saving oxygen. Sri Lanka also received US$ 787 mn.

• The Nature of IMF Conditionality

Contemporary comments are frequently made by Sri Lankan policymakers that IMF financial assistance to resolve the acute foreign currency shortage and BOP difficulties presently confronted by the country under the present macroeconomic management system is not sought due to unfavorable conditionality that would be imposed by the IMF. They state that such conditionality would involve in cutting fiscal expenditure, cutting state sector employment and privatizing state enterprises which are not favourable for the country and, therefore, the government is prepared to resolve the foreign currency problem through a domestic formula.

Some comment that this strategy is similar to the brave decision resorted to by Malaysia to resolve the Asian Financial/Currency Crisis 1997/98 through internal policies without seeking IMF assistance while other Asian countries resorted to the IMF support. However, this is not a suitable comparison as Malaysia was considered as one of Asian Tigers in economic strength. However, Sri Lanka is a country who had to borrow US$ 250 mn recently from Bangladesh, a low-income country who even borrowed about US$ 732 mn from the IMF under the Corona relief financial support.

Sorts of conditions imposed by the IMF support to countries depend on the root courses and magnitude of BOP deficits and shortage of foreign currency confronted by the respective countries. Therefore, IMF officials investigate information to assess the magnitude of the problem and causal factors in the macroeconomic context. Accordingly, conditions are imposed to discipline the policy mix to prevent occurrence of similar macroeconomic problems in the medium-term. As many developing countries confront such BOP problems due to similar policy mix followed to manage their economies, such IMF conditions also are similar in nature.  Some of key conditions that Sri Lanka complied with in the past are listed below.

1. Exchange rate must be allowed to determine in the market where central bank intervention is permitted only to smoothen excessive volatilities such as unacceptable speculative attacks. In most countries, the key culprit behind the protracted BOP deficits and currency crises is the Central Bank habitual intervention to keep the exchange rate overvalued to control import prices and foreign debt service cost. This is similar to attempt of price controls in commodity markets.
2. Quarterly average targets are given to build up the foreign currency reserve through purchases of foreign exchange from market surpluses on trade and investment transactions. Therefore, proceeds of currency swaps and arranged foreign loans to governments are not counted in the foreign reserve targets.
3. The IMF considers rising budget deficit as a major cause for BOP deficit. Therefore, the government is required to improve the tax revenue and streamline the spending to cutdown the budget deficit and debt gradually. Deficit targets are given accordingly.
4. Quarterly average targets are given for money printing or reserve money. In reserve money targets, direct central bank lending to the government is barred. However, the trade of government securities by the central bank in the secondary market for monetary policy purposes is not restricted.
5. State enterprises are required to follow commercial-based operations competitively with the private sector. The IMF generally promotes private sector and market dominance in the economy. Accordingly, administrative price controls are recommended to phase out. However, IMF recommends fair market regulations, especially in banking and financial markets to ensure the financial stability.
6. Therefore, these conditions are expected to promote largely market economies open to global trade and investments seeking comparative advantages. Therefore, the developing world has gone under macroeconomic policy reform with the financial and technical support of the IMF since 1980s, especially after the collapse of the Soviet Union and reunification of Germany. Therefore, the present global economy has evolved largely with the support by the economic safety net of the IMF and World Bank. As such, a country like Sri Lanka trying to evade this global safety net by having brave talks of personal nature is a suicidal attempt caused to the general public.

As such, the IMF is not a lending institution that runs after member countries and offers loans to suit the terms and conditions sought by member countries. Almost all loan schemes are conditional upon policies recommended to fix fundamental BOP problems. Therefore, the IMF is the multi-lateral institute most popular in developing countries although politically motivated allegations also are leveled against the IMF in some countries, mainly due to dominance of the US in the IMF.

• Benefits to Member Countries from IMF Lending

An engagement in a loan programme with the IMF is not just an individual financial transaction to a member country. The IMF is an important conduit in the global financial/economic safety net system to bailout countries from economic/financial distress. While the IMF credit helps restore foreign currency reserves to honour international payments, it also helps improve the country’s creditworthiness that counts on macroeconomic management discipline underlying the IMF programme. As a result, credit rating agencies tend to upgrade the credit rating of the country as the IMF credit programme is expected to improve credit repayment ability in general because credit rating does not depend on positive minded views and numerical plans just presented by the political authorities.

International investors who respect transparent mechanisms consider external sources of information such as credit rating and international credit transactions of countries to make investment decisions in market environment. In general, investors who respect market-based governance systems pay attention to economic reports of the IMF. Other multi-lateral institutions also take information relating to transactions with the IMF for making their decisions. Therefore, countries who are under IMF programmes tend to use such information in their marketing programmes seeking borrowing and investments. Therefore, the IMF is a helpful confidence booster.

• IMF Lending Programmes implemented so far for Sri Lanka

Since 1965 Sri Lanka has implemented 16 IMF programs with a total loan amount of SDR 4,426.2 mn where 86.4% or SDR 3,822.4 mn has been received. The most recent programme for SDR 1,070.8 mn was agreed in June 2016 and terminated prematurely in early 2020 after receiving SDR 852.2 mn. However, the present government policy so far is to resolve the present currency crisis without IMF programmes.

A similar policy was attempted in 2008 too. Accordingly, the Monetary Board kept the exchange rate highly overvalued during the period mid-2008 and March 2009 by spending nearly US$ 2.3 bn of foreign reserves despite the rising BOP deficit. However, the government later implemented an IMF programme with SDR 1,653,6 mn (US$ 2.6 bn, being the largest for the country) to restore the foreign reserve. The programe was implemented for three years July 2009-July 2012.

In fact, the establishment of the present deposit insurance scheme in 2010 which is now happily used to bailout bankrupt finance companies due to fraud and failed regulation was a fulfilment of condition in the IMF programme. This was attempted in several years prior to the IMF condition, but failed due to domestic reasons. Further, the current level of market-based economy is a composite result of IMF conditions agreed in the past for IMF programmes.

Again, the Monetary Board adopted a currency appreciation policy during 2010-2011 by spending nearly US$ 3,560 mn of foreign reserves against the advice of the IMF and Economists. However, the government who strongly opposed to this policy depreciated the currency by 3.5% through a national budget proposal presented in November 2011 and instructed the Central Bank to adjust its monetary policy accordingly. Subsequently, the Central Bank allowed a largely market determined exchange rate system. This has been largely in operation with Central Bank intervention from time to time until the Monetary Board recently stipulated the exchange rates for bank transactions with permitted public.

Immediate Way Forward to Rescue the General Public from the Present Foreign Currency Pandemic

Actions stated below will boost the confidence in the policy framework and stability of the foreign currency front and induce international trade and finance flows favourable to Sri Lanka in the near future. For this purpose, the government must launch a centralized macroeconomic governance system enacted through a special legislation in place of the present fragmented macroeconomic management system which is administered by various state institutions without a national level coordination towards principles and targets.

Therefore, the present sort of ad-hoc policies such as increase in fuel prices, reduction of the budget deficit, tightening of the monetary policy and excessive control of foreign currency-based transactions followed to manage the foreign currency flows of the economy will only aggravate the present crisis as there is no assurance that the economy can have a net foreign currency receipt of at least US$ 6 bn to deal with the next year alone. Therefore, the country needs a surgical package to rescue the economy from the chronic BOP deficits from the short to medium and long-term. In this regard, some thoughts are highlighted below.

Therefore, quick arithmetic plans presented with the sort of good business management talks to raise foreign currency inflows under already failed foreign borrowing and asset selling instruments of privately arranged placements without any transparency by hiding behind so called “radio silence agreements” to show artificial target numbers at month-ends will no doubt fail. Further, the request made to the general public to roughout the life on the top of the Corona pandemic is possibly a violation of fundamental rights assured by the Constitution as the relevant authorities have ample policy instruments statutorily mandated to resolve the crisis in the short to medium-term if they comply with natural economic principles and stipulated economic laws by leaving out personal beliefs which have no public interest.

• Government/Finance Minister

The immediate government action should involve primarily in three categories. First, the government/Finance Minister should immediately depreciate the currency/exchange rate to a level about Rs. 250 per US Dollar and instruct the Monetary Board to adopt a monetary policy to maintain greater stability of the exchange rate consistent with underlying trends of the economy in compliance with the provisions of the MLA.

This was the action taken by the government in November 2011 as against the Monetary Board’s policy to keep the exchange rate highly overvalued/appreciated at a huge cost to the public. In order to raise foreign currency inflows to the country, it may be necessary to keep the exchange rate a little undervalued similar to the policy adopted by China. However, it is the global experience that the overvaluation of the exchange rate will discourage inflows and cause currency crises through foreign currency outflows.

Simultaneously, the government must arrange a foreign currency bailout package from a consortium of friendly countries and multi-lateral institutions including the IMF within next two months. It requires initially at least US$ 6 bn of inflows over next six months period. In this regard, multi-lateral support such as the IMF is crucial to promote international confidence in the country because any significant support sought from a particular country at a desperate bankrupt situation like this will certainly result in the compromise of the geopolitical strength of the country. This is same for even a household or a business company. Further, while openly criticizing the transparent IMF facilities, the government going for privately arranged facilities from other parties with confidentiality under so called radio silence unknown to the public would no doubt cause irregularities that will induce immense operational risks to the government.

Third, the government should review the effectiveness of fiscal incentives provided so far for foreign currency inflows and the state institutional mechanism such as Board of Investment and Export Development Board and require those institutions to deliver their statutory duties without delay subject to new targets stipulated by the government.

• Monetary Board/Central Bank

Next, the government through the Minister of Finance should require the Monetary Board to mobilize the monetary policy and foreign exchange laws selectively to support economic activities that are helpful to reduce BOP deficits and improve the foreign currency reserve. In this regard, immediately, the Monetary Board should withdraw foreign currency rules that violate both economic principles and economic laws and then implement a medium and long-term credit distribution programme oriented for export promotion, import substitution and inflow of foreign investments so that the economy will get transformed to a foreign currency earner with underlying macroeconomic fundamentals, given the country’s resource base open to the global economy. Refinance credit schemes supported by mandatory bank lending under the MLA should function as the core of the monetary policy in place of the present overnight bank liquidity target-based OMO model. The external foreign currency bailout programme whether it is IMF-based or otherwise is a task of the government and not of the Monetary Board.

Fatal Consequences if Rescue Actions are further delayed

In modern monetary systems with the exposure to the global economy and foreign currency, running the economy for long-time with fundamental BOP deficits funded by the short-term foreign borrowing and rollovers is similar to sugar addicted human body. The high sugar content gradually damages all organs of the body and, therefore, it is difficult to predict the trigger that will cause the near-term death of the person.

Similarly, current acute shortages of foreign currency and imported consumer goods and significant price escalations are some of clear symptoms of the critically sick economy caused by the risky management of BOP deficits. In view of many experiences in other countries, the trigger is highly likely to be a banking/financial crisis as the exposure of the banking/financial system to foreign currency flows is very high. In this context, the currency mismatch of the banking system can cause a credit and liquidity crisis at any time. In this regard, the recent use of the banking system to raise foreign funding for the government to manage BOP deficits is a significant vulnerability. However, it is an established fact that nobody can predict the trigger until it is pulled accidentally somewhere due to the prevailing vulnerabilities. Therefore, banking and financial supervisory authorities should be on high alert to act in the event of any such trigger-pull.

In that event, living standard of the general public will confront the worst catastrophe in the century. Accordingly, the loss of economic peace among the public in the country will certainly cause a national disaster in the near-term by underlying geopolitics that does not respect the humanity.

Therefore, if both government and Monetary Board seem to fail to arrest the currency crisis soon, the best option will be to reintroduce the Currency Board System that existed until the establishment of the Monetary Board under the MLA in 1949. The Currency Board is similar to present systems available in island economies such as Hong Kong and Singapore that we all like. Under the Currency Board System, the Monetary Authority will print money only when it purchases foreign currency from the economy. Therefore, people will rebase their all-economic activities for the target of foreign exchange earnings and the global economy for living.

Given the country's resource base and competitive opportunities available in the global economy, it would be catastrophic if the public has to return to pre-1977 living standards as a domestic policy solution to the current foreign currency pandemic caused by same policy-making authorities in violation of all economic principles and economic laws as briefly highlighted in this article. 

(This article has been compiled to assist the general public and policymakers to understand some views on the nature of the foreign currency-related difficulties they are confronting at present, the authorities responsible and broad policy solutions based on author’s knowledge and experience on the subject.

(Sinhala readers can refer to the author’s book “ජාත්‍යන්තර ආර්ථික විද්‍යාව” published by Sarasavi Book Shop for a detailed account on this subject)

P Samarasiri

Former Deputy Governor, Central bank of Sri Lanka