Never-resolvable macroeconomic vulnerability. Is IMF the solution? You judge.

 

Article's background and purpose

Economies of many developing countries have evolved on the US Dollar as the reserve currency under the Bretton Woods system and IMF/World Bank surveillance. As a result, sovereign currencies have been managed largely tied to the dollar where respective economies have become highly dollarized through imports and foreign borrowing by the governments. 

In this background, country leaders have got an easy habit of building a dollar reserve funded by foreign borrowing to show the country's economic strength and attract foreign borrowing inclusive of hot capital. As a result, country economies have become increasingly vulnerable to dollar flows where currency shocks and crises have become a way of living in these countries.

A recent article published in the NationNews website, Barbados, on 25 February, authored by Marla Dukharan, has produced a simple diagnosis on the macroeconomic vulnerability confronted by Caribbean countries due to excessive reliance on foreign borrowings. (Read the article here).This diagnosis seems to be equally true for many developing countries.

Therefore, this short article is intended to apply the same diagnosis to shed light on the extent and severity of the macroeconomic vulnerability of Sri Lanka linked to the excessive foreign borrowing-based dollarization.

Vulnerability diagnosis for Caribbean countries

Information highlighted in the said article along with comparative information for Sri Lanka is copied in the table below.

Key vulnerability indicators

• Foreign reserve adequacy and external debt level are the standard indicators of macroeconomic vulnerability to foreign currency.

• In addition, this study uses the discrepancy between the market exchange rate and the ratio of money supply to foreign reserve which is the exchange rate of domestic currency monetization.

• The market exchange rate is largely determined by direct interventions by government and monetary authorities for various motives such as the control of inflation, foreign debt service and import-based growth. Therefore, the market exchange rate is not a realistic exchange rate. As these countries are dollar reserve-based economies, the underlying exchange rate is the ratio of the money supply to the foreign reserve. This is the underlying convertibility of the domestic currency to the dollar similar to the old gold standard. 

• The large discrepancy between the two exchange rates means that 

• Market exchange rate has been highly suppressed (over-valued domestic currency) through official intervention and
• Economies have been excessively monetized through money creation out of small amounts of foreign reserves (dollar as the reserve currency) funded by regular foreign debt flows.
• Domestic money creation has largely taken place in unproductive credit for domestic consumption and imports while mobilization of domestic resources and value additions to generate a foreign currency surplus on real trade has been lagging. In many instances, domestic booms are created through imports causing added vulnerabilities in the future
• Therefore, these economies are highly vulnerable to foreign debt flows. According to data, Sri Lanka stands excessively vulnerable to foreign currency debt.

Vulnerability diagnosis for Sri Lanka

The same set of information is presented graphically below for Sri Lanka annually for 1950-2025 period to gauge the excessive macroeconomic vulnerability due to foreign debt.

Vulnerability base - External debt, foreign reserve and money supply

Vulnerability indicators - Discrepancies of exchange rates and foreign reserve adequacy

Vulnerability detected by indicators

• All indicators show alarming vulnerability of Sri Lanka to foreign debt flows.

• As revealed from discrepancies between different exchange rates, excessive mismanagement of the monetary front linked to foreign debt and reserve without regard to domestic resources and capacity to earn foreign currency surplus has been the root course of the country's macroeconomic vulnerability.

Concluding Remarks

• Although central banks state that they are balancing between the exchange rate, interest rate and liquidity (money printing) for so-called prudent targets to maintain economic, price and financial system stability, the fact is the excessive mismanagement of the so-called balance in the monetary variables as revealed by exchange rate discrepancies presented above and currency crises that hit from time to time.

• As revealed by excessive and unproductive monetization, the banking system is highly vulnerable to foreign currency depending on the extent of credit exposures to import and foreign currency dependent activities of the economy. It is hard to predict the sustainability of domestic currency monetization rate of 2,061 against the dollar in a dollarised economy.

• Given the extent of vulnerability and macroeconomic governance system, this level of macroeconomic vulnerability is not resolvable in decades to come. It is this vulnerability that the economic shocks of the sudden war in Iran have immediately spread to the roads and households of Sri Lanka whose eventual macroeconomic effects are not easy to forecast.

• Therefore, the only hope is the continuation of the IMF and its global debt network to keep Sri Lanka bailing out on a day-to-day basis through new liberal austerity programmes and unrestricted imports. However, its long-term macroeconomic and socio-political vulnerabilities cannot be discounted.

• In this background, policymakers must invent solutions to resolve the root cause of  the debt dollarization and mischievous monetary balancing rather than finding fault with the politics behind the past evolution of the vulnerability.

• The continuation of the same monetary balancing model of borrowed dollar reserve after every crisis must be questioned as there are no balancing gods found in the world.

(This article is released in the interest of participating in the professional dialogue to find solutions to present economic crisis confronted by the general public. All contents in the article are based on the author's research and views on the subject which have no intension to personally discredit characters or ideologies of any individuals.)

P Samarasiri

(BA Hons Economics, University of Colombo, MA Economics, University of Kansas)

Former Deputy Governor, First Central Bank of Sri Lanka

(35 years of experience in staff class in the Central Bank, inclusive of Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 13 Economics and Banking Books and a large number of articles published.)