The route cause of Sri Lankan econimic crisis - Is it the fiscal mismanagement as CB Governor says or the monetary policy mismanagement he is responsible for? Let us examine the truth

 

This article is intended to examine the above statement made by the CB Governor at a recent interview with the CNBC international business media as published on 21 July 2022.

Although the Governor has made a number of sweeping statements without supporting facts, this article focuses only on his view of fiscal mismanagement as the root cause of the present economic crisis.

He has got a new habit of making such blunt statements to the international media to pretend that he is an independent central banker on the global front to make comments on the Sri Lankan economy above the government and is to serve a full term of 6 years even if the economy is completely collapsed in the present crisis. 

As the Central Bank is now virtually inactive without a foreign currency reserve and the hand in the exchange rate, he has the luxury of seeking to pretend through his media campaign that he is the most active policymaker to get the economy back from the crisis in few months to come through an IMF bailout.

CB Governor’s Remarks made at the CNBC Interview

• The root cause of the present economic crisis lies in decades of fiscal mismanagement. The government has been running large fiscal deficits for about 8% to 9% for long periods. As a result, we have a very high level of public debt which has become unsustainable.

• Sri Lankan authorities have submitted to the IMF and creditors an overall macroeconomic stabilization programme including monetary policy reform, fiscal policy reform and reform of strategic state enterprises where all these together coming as an overall macroeconomic package which will help the economy to achieve so called macroeconomic balance or stability in going forward once an agreement is reached with the IMF and he is confident that economy can be stabilized once funds are received from multilateral donors. Sri Lanka is eligible for US$ 3 bn of funds from the IMF Extended Fund Facility over a period of three years and another US$ 4 bn will be supplemented by other institutions such as World Bank and ADB once the IMF begins dispensing funds.

• The current economic crisis is an opportunity for Sri Lankan authorities to learn from past mistakes and not reverse reforms once the IMF program ends. This is, to me, an opportunity for the authorities to learn a lesson and move in the right direction, even beyond the IMF program. That is the key for us to manage this economy on a sustainable basis. The new President had been involved in the negotiations with the IMF. “I am hoping that that commitment will continue… the sooner the better, so that we can reduce the time of the pain that we are experiencing now”.

• Inflation will be peaking somewhere in next couples of months because it has already happened. It will probably reach close to 70%, but with very tight monetary policy stance we are adopting since April 2022, it will start coming down over a period of time and we are very confident that it will turn around and it will be below around 20% in 12-month period. The current inflation is largely because of the shortages in the supplies and one off adjustment of prices like depreciation of the currency and adjustment in fuel and food prices and adjustments in gas prices. One off adjustment in prices has basically pushed inflation to high territory and also partly because of previous monetary expansion and high printing of money and all these have lagged impact and it is a combination of demand driven plus largely now supply side impact is basically causing inflation. Next two-three months inflation has already has happened. So what we can control as the Central Bank is the future inflation and managing inflation expectations going forward. That is why we are maintaining a very tight monetary policy and we are maintaining high interest rates. This is the reason why we want to curtail the inflation. That is the most important thing for the country as you said inflation is an enemy especially for the poor and they are going to suffer the most and if inflation goes beyond control like turning into hyper inflation or 100%, then no one will be able to do any kind of businesses in Sri Lanka.

(see https://www.cnbc.com/video/2022/07/21/curtailing-inflation-is-most-important-thing-for-sri-lanka-central-bank.html)

However, this article focuses only on the first point due to the space limitation. Therefore, the next article will comprise of comments on other three items.

Is the crisis' root cause fiscal mismanagement or monetary mismanagement?

His statement that the root cause of the present crisis is the fiscal mismanagement is grossly incorrect. While he does not define the fiscal mismanagement, he may have meant it as the budget deficit of 8%-9% of GDP in decades with public debt stock being unsustainable around 100% of GDP. 

This is the standard statement of God fathers of the monetary school which always think that all economic ills are outcomes of fiscal deficits and debt and, therefore, the monetarists of the central banks should be permitted to control the flow of money to drive the economy in the way they wish. This group is internationally networked with the IMF in the center.

However, fiscal deficit ratio and public debt ratio which are the base for his fiscal mismanagement idea are merely accounting ratios used to manage and monitor state financial flows which have no relevance to the wider macroeconomic management carried out and results achieved in the public interest. 

That is why a new school of economists called “Modern Monetary Theory (MMT)” has emerged to recommend the use a wide spread of fiscal spending funded by creation of money without worrying on money-related inflation if the production capacity of the economy improves. Therefore, this is not an economic theory per se, but an approach combining the fiscal policy and monetary policy to guide the macroeconomic policies in the wider interest of the general public.

As presented below, the Governor’s remarks on fiscal mismanagement show that he either does not understand the subject of macroeconomic management (in his mathematics/science background) or attempts to hide the bad outcome of the macroeconomic management strategy he got engaged in a period of more than 15 years during his long career in the Central Bank with all international economic exposures. That period contains the most recent episode that caused the present crisis.

Misleading fiscal deficit ratio

Fiscal deficit-GDP ratio is a meaningless accounting term used by economists in their standard analyses of the economic history without any practical recommendations and, therefore, cannot be used to interpret the fiscal mismanagement.

• First, although the Governor refers to decades of fiscal deficits of 8%-9% of GDP as the root cause of the crisis, the deficit ratio in the past has been mostly below in the range of 4%-8%. In the last two decades, except for five years, i.e., 2000, 2001, 2009, 2020 and 2021, the deficit has been in the range of 5%-7%. Only the 1980 decade had a higher deficit over 9% in the range of 10%-19% and did not cause any crisis of the present form. The deficit rising to 11.1% in 2020 and 12.2% in 2021 is not strange in the global context, given the fight against the global Coronavirus and, therefore, it is not practical to state that those two numbers have caused the fiscal mismanagement and the present crisis.

• Second, fiscal deficit is only an arithmetic accounting-based calculation. It has no meaning for the socio-economic wellbeing created by the fiscal policy. Any sensible person who lives from 1970s through to-date can see the considerable improvement in economic and living standards that the government has created through the fiscal policy during this period, regardless of the micro-level allegations such as loss-making state enterprises and inefficiency and corruption that are common in all countries at various levels. In fact, the present Governor could reach at his comfortable Chair and luxury car, thanks to the decades of the fiscal policy implemented in a global economy model. Everybody knows that the economy runs on the socio-economic capacity created and maintained by the fiscal policy, and not by the monetary policy or by the private sector. Therefore, condemning the fiscal policy as having been mismanaged in decades by just looking at the fiscal deficit-GDP ratio is similar to some professionals throwing out their old parents on to the road or care houses due to some corner domestic issues.

• Third, the fiscal policy has been designed and implemented in the past by elected people who understood the needs of the public and the wider economy and by professionals who understood economic and financial management. The Governor’s remarks mean that Finance Ministers like N M Perera and Ronnie de Mel and Finance Secretaries like W M Tillakaratne, P B Jayasundera and R H S Samarthunga have mismanaged the fiscal policy as they did know macroeconomic management as much as he knows. If so, it is surprised how the so-called “fiscal mismanagement” happened even when the leading economists of the Central Bank including the present Governor and his monetary colleagues also officially were in the fiscal management team. However, he forgets this when he plays before the camera at media or COPE shows as reported frequently.

Meaningless term of unsustainable public debt

The use of the public debt-GDP ratio to define the debt sustainability/unsustainability is an attempt made without the knowledge of basic economics as well as the common sense. Therefore, his view of the debt unsustainability is not helpful for establishing the view of the decades of the fiscal mismanagement.

• First, public debt-GDP ratio also is an arithmetically calculated accounting ratio which does not reveal what has been created by the debt underlying the ratio. The socio-economic wellbeing and capacity and underlying income stream created by the debt must be measured before declaring debt as unsustainable. The present meaning of debt unsustainability generally refers to the difficulties confronted in servicing the debt stock. Therefore, it is largely a result of the debt profile inherited from the past debt issuance strategies and practices and the present stream of revenue on the debt utilization in the past. It is well known that the poor state revenue collection system is mainly responsible for the debt service difficulties and not debt per se.

• Second, unlike in debt in a business firm, the public debt has a wide socio-economic role not assessable from the debt numbers. As the public debt is considered as the most safe and liquid financial asset, the public debt has to rise with the growth of the economy in order to provide a base financial asset to investment and savings portfolios of households and businesses including banks and financial markets. In fact, the monetary policy is also conducted on the deals of public debt as money is primarily printed on the acquisition of public debt instruments issued both locally and externally. If central banks are to operate on private financial assets, both central banks and economies will confront collapses frequently due to the high-risk exposure.

• Third, nobody has established any relationship between the public debt level and economic crises so far. While there are instances of debt crises in countries from time to time due to state debt servicing difficulties, the greatest number of crises in the world including developed countries with global reserve currencies has occurred due to private sector debt management problems where the governments have had to bailout the private sector and economies through new fiscal spending and public debt. This has been the global norm in the last two decades for resolution of the crises including the Asian financial crisis 1997/98, global financial crisis 2007/2009 and global Corona crisis since early 2000.

• Fourth, for the most part of the last decade's debt ratio in Sri Lanka has been below 80% of GDP towards 70% and there has been no room for debt unsustainability or economic crisis as the Governor claims. The debt ratio has started moving above 100% only since 2020 with the crisis emanated globally on the Coronavirus. Everybody knows that such extraordinary periods occur in the globe from time to time and the governments as the public guardians have to spend for the welfare of the public. In contrast, the debt level from the end of the 1980 decade towards first half of the 2000 has prevailed above 90%, even above 100% up to 105%-110%, without such an economic crisis.

• Fifth, the term “unsustainable debt level” now presented is only a politically created concept for Sri Lanka. This has appeared first time in the IMF Article IV Consultation Report for Sri Lanka released on 25 March 2022. This is a crude view of the IMF without facts where Sri Lankan authorities including the Central Bank have failed to provide and establish the facts to contrast with the IMF in the current context.

• Sixth, the IMF has provided loans to about 90 countries including Argentina and Pakistan to fight the Corona crisis knowing that the public debt in most of those countries is unsustainable and exceptionally risky in IMF view. Therefore, the IMF version of the debt unsustainability is only an ad-hoc, baseless opinion, similar to other opinions such as middle-income trap launched from time to time to show their economic expertise.
• Seventh, the public debt manager has been the Central Bank from its inception in 1950 where the public debt subject has been mostly handled by the monetary policy group including the present Governor. Therefore, if the present debt stock is not sustainable, it is the failure of the Central Bank and, therefore, those Central Bank officials must be held accountable for the economic crime in fairness to the public who now suffer due to the debt crisis.

The real root cause of the crisis is the monetary policy mismanagement

Everybody knows that the origin of the present crisis in Sri Lanka is the acute shortage of foreign currency in the country due to the mismanaged foreign reserve and exchange rate by the Central Bank. In terms of the Monetary Law Act (MLA), the management of the foreign reserve and exchange rate is an integral part of the Central Bank’s monetary policy that should provide the foundation for money, credit and finance for the economy. 

However, the Central Bank has followed a disaggregated approach to the monetary policy in non-compliance with the MLA in the past two decades and that has caused the crisis as highlighted below.

• First, the monetary policy was confined to a facility for the overnight inter-bank market based on policy interest rates by calling it as inflation control targeted policy. Everybody knows that interbank market liquidity management has nothing to do with inflation control as calculated from the Consumer Price Index. However, the macroeconomic inflation control requires the distribution of credit to match the production and its utilization to suit the needs of the economy.

• Second, the monetary policy did not focus on or use instruments to generate a foreign reserve on the strength of the economy's real sector. Instead, the Central Bank as the manager of the public debt went after government foreign debt to build the foreign reserve. This is the reserve used to manage the exchange rate arbitrarily without much volatility and to fund the BOP deficit. This is what the Central Bank described as the external sector stability of the country’s import dependent economy without a real sector to generate a competitive BOP position.

• Third, for this purpose, the Central Bank aggressively engaged in issuance of dollar denominated Sri Lanka Development Bonds and International Sovereign Bonds and sale of Rupee government bonds to foreign investors through private bond placements supported by Central Bank currency swaps. Meanwhile, IMF loans also were raised in intervals as a practice to boost the foreign reserve and the country confidence. Everybody knows that these debt deals led the macroeconomic management through both the foreign reserve and fiscal resources financed by foreign debt and had created an extraordinary macroeconomic risk of concentration to volatile foreign capital markets.

• Fourth, domestic market-based fiscal financing also was arranged through a massive scale of private placements of bonds with more than 90% (nearly Rs. 4,582 bn against Rs. 459 bn announced for auctions in 2008-2014 period in violation of both the Securities Ordinance and market principles) of bond issuances controlled by the Central Bank under the cover at heavily controlled interest rates which resulted in fiscal indiscipline and prevention of market development. In fact, interest rates were controlled and suppressed arbitrarily through such private placements to be consistent with unannounced targets of the monetary policy. In that context, the monetary policy team led by the present Governor testified at the Bond Commission 2017 that the private placement system was used as the instrument to control the yield curve/interest rate structure whereas the suspension of the system in February 2015 led to the loss of powerful policy instrument. Everybody knows that debt issuance is a fiscal instrument and not a monetary policy instrument. As such, the private placement system was heavily used to fund the government regularly even prior to the due dates of funding requirements (known as pre-funding) which led to the undue fiscal complacence. The sale of bonds privately to foreign investors supported by Central Bank currency swaps also was a popular source to fund the government while financing the foreign reserve of the Central Bank.

• Fifth, as a result of heavy dependence on foreign debt-based foreign reserve, nearly 70%-90% of the Central Bank balance sheet and money printing depended on the foreign reserve where the domestic monetary operations in the inter-bank markets were carried out to finetune the daily banking liquidity in response to foreign debt flows. In that perspective, the monetary policy was only a facility to mismanage the bank liquidity outside the prudential norms. Therefore, the Central Bank did not have a real sector focused monetary policy as required in the MLA whereas the credit distribution across the economy was a risk-based business of the banking sector.

It should be stated that the present Governor was at the top next to the then Governors in managing the above-mentioned model of monetary policy and fiscal financing for more than 15 years and decision-making daily. All eleven sovereign bond issuances amounting to US$ 17,550 mn since 2007 (an aggressive US$ 9,900 mn in four years of 2016 to 2019), two mega IMF loan programs amounting to SDR 2,724.3 mn in 2009 and 2016 and US$ billions worth of currency swaps could not have been achieved without his top-level association next to the Governors at that time. It is in that reason he was able to get fast-track promotions and international exposures, probably the only officer of the Central Bank history to achieve such a career development without any innovative operations introduced by him to the Central Bank operational mechanism.

How the crisis broke out through the Coronavirus

In this background, supply chain disruptions caused by the Coronavirus dismantled the foreign financing model of the country. As a result, the Central Bank used the existing foreign reserve to defend the exchange rate and to fund the rising BOP deficits in 2020 and 2021. The steep deterioration in the external sector of the economy was shown daily and monthly from the Central Bank trade and monetary data. For example, the BOP deficit rose from the beginning of March 2020 to US$ 2,328 mn in 2020 and US$ 3,961 mn in 2021 with a corresponding decline in the Central Bank net foreign assets. 

While the exchange rate was maintained highly overvalued despite rising BOP deficits and disappearing foreign inflows to the government, exchange rate was kept fixed at Rs. 200 a US Dollar since May 2001 until 7 March 2022. 

The gross inflows to the Government which were around US$ 5,534 mn in 2018 US$ 6,561 mn in 2019 fell more than 50% to US$ 2,002 mn in 2020 and US$ 2,435 mn in 2021. In this background, the Central Bank’s gross foreign reserve declined to US$ 1.6 bn in November 2021 from US$ 7.9 bn in February 2020 at the beginning of the spread of the Coronavirus in the world.

This is how the country got into an acute shortage of foreign currency which caused a sudden and significant reduction in imports along with import controls. The sudden float of the currency on 7 March 2022 without a policy package to prevent a speculative attack on the currency led to a steep depreciation of the exchange rate by about 80% in a few days. 

This acute shortage of imports and excessive depreciation of the currency led the soaring inflationary pressures at historic levels now being confronted by the economy. Meanwhile, the Central Bank did not change the monetary policy model to fund the productive sectors of the domestic economy although same policy model continued to fund the inter-bank market and government on short-term basis.

This is the root of the present crisis where the present Governor was in the Central Bank till the end of 2020 being the inception of the crisis. During that time, he appeared a few times in the TV discussions and commented that a BOP problem was not developing due to historic reduction in oil prices due to the global spread of the Coronavirus and lockdowns.

Unethical media behaviour of the present Governor

However, the present Governor now behaves in the social media group and international media as he is the only central banker with the clean hand not involved in any of acts that has contributed to the present crisis, despite his direct responsibility to the monetary policy mismanagement including the foreign reserve and exchange rate (as briefed above) that exposed the fiscal policy and the economy to heightened systemic risks and the eventual crisis. 

His comments on the policies of the government and the President are not warranted for the Central Bank. In fact, it is the statutory responsibility of the Central Bank to maintain the stability of the economy on all fronts. However, the Central Bank Governor behaves like an independent spokesman above the country’s President while defaulting public responsibilities of the Central Bank. Therefore, the discipline of high-ranking public officials needs to be ensured without delay for the stability of any government.

His decision as the Governor to default the government foreign loans on 12 April 2022 without the due approval of the Parliament and to historic increase in interest rates so far by 8% (i.e., 7% on 8 April 2022 and 1% on 7 July 2022) has led the government and the economy to further down towards a complete collapse in the near future. Even a man on the road with common sense knows that a country with a term structure of interest rates above 30% with an arbitrary default of foreign debt will sooner or later fell to the bottom of the crisis.

There is no controversy that his monetary policy finally led to the dire economic difficulties confronted by the general public which fueled the civil and political unrest to this level including the historic expel of the former President of the country just after two and half years of his election by a historic majority of votes.

Further, early warning signs prevail that the country will end up in a collapse if the government is unable to consolidate the policies and officials for the targets of the recovery of the economy.

(This article is released in the interest of participating in the professional dialogue to find out solutions to enormous economic difficulties presently confronted by the general public consequent to the global Corona pandemic and subsequent disruptions and shocks.)

 

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 10 Economics and Banking Books and a large number of articles published)