Sri Lanka’s dictatorial open economy: Management of exchange rate by force

If the Government, the Central Bank and if interested the commercial banks want to bring about a real change, they should engage in helping rural entrepreneurs enabling them to access finances without any hindrance and promote exports which will give a lasting long-term solution to the exchange rate problem rather than engaging in hide and seek games 

Thursday, 3 June 2021

Sri Lanka is facing a severe financial crisis of which the origin was the deficit budgeting policy of the successive governments. Deficit is financed by debt either domestic or foreign. Since there were budget deficits in successive years as well the governments having to borrow to repay the debts. As a result, Government debt has increased. 

Deficit budget is a result of either reduction of the income or increase of the expenditure. If a government reduces taxes mainly of the businesses which is the main source of revenue, the government expects a growth of the economy by the increased economic activities of such businesses. 

Likewise, when the capital expenses of the government are increased the economy should grow. Even by increasing the recurrent expenses there is a stimulation to the economy. If the economy has grown to the expected levels the debt would have been a smaller percentage of the grown economy which is measured as Gross Domestic Production. 

There is another issue as well. In the late 1990s Sri Lanka became a lower middle-income country. Thereafter it was much difficult to get concessionary foreign loans. Eventually Sri Lanka has moved to get foreign funds through commercial loans of which the interest rate is high and most of the time the repayment period is shorter. Therefore, annual repayment of the foreign debt is being increasing. The Government is facing difficulties to repay the debt instalments due to the long-term deficit of the current account. 

Over a long period, the export revenue of the country is lower than the import expenses. The difference is the trade deficit. This is covered to a great extent by the inward remittances of the migrant workers. However, successive governments did not treat these migrant workers well. The present Government gave lesser priority when bringing down these workers during the COVID time.

 

IMF

This is the issue faced by the Government and the country. The present Government does not like to go to the IMF requesting relief since IMF imposes conditions. Successive governments and especially this government say that the IMF conditions are not good for the country. 

What are those conditions? The main condition is to reduce the budget deficit which is the root cause of all these problems. The Government does not want to do that since there will be political issues, which means when the Government expenses are reduced or the Government taxes are increased people will get affected and they will not vote for the Government next time. Neither the Government nor the Opposition dare to tell the truth to the people since all of them are concerned of their votes and not of the sustainability of the country.

 

China

Hence the Government goes to China and asks for loans, who gives loans without any hesitation and will not ask the Government to reduce the budget deficit. Therefore, the Government is also happy and the people are also happy but the basic problem will continue aggravating the situation further. They are postponing the problem to the future generations. However, people who are like the crabs in the pot will have to suffer. 

Since the Government has no money to meet the debt, it restricts imports not in a systematic manner but in an inconsistent manner. Just like King Dutugemunu fought the wars with his brother at the initial stages, according to a famous folk story. Therefore, people will have to suffer.

 

Central Bank

The Central Bank of Sri Lanka has also joined this process. Their job is to manage the exchange rate. They are creating history in Sri Lanka. The Central Bank has reduced the interest rates in Sri Lanka which is a good thing. They will sustain it by force even though the interest rate will go up since the Government started to shift from foreign borrowing to domestic borrowings. 

The Central Bank can print the money left and right to fund Government requirements. The problem would be to contain inflation. Since it is a current issue, the figure cannot be adjusted as some expenditure was transferred to previous year in the Annual Report of Central Bank 2020 to reduce the budget deficit in 2020.

 

Rupee depreciation and forex reserves

The Central Bank imposed restrictions on importation of certain categories of motor vehicles and some items categorised as non-essential items for a period of three months on 19 March 2020 by Direction No. 1 of 2020. However outside of the Direction minimum supplier credit of 90 days and 180 days was imposed on the importers. Irrespective of that the rupee depreciated against the USD from 181 to 199 from March to mid-April 2020. Since there was reduced crude oil consumption during the period of COVID restrictions the rupee was stable during May-November 2020.

The import bills with 90-180 days of supplier credit, started becoming due for payments from November 2020 which contributed to a depreciation of rupees beyond Rs. 187 against dollars during November-December 2020 provoking importers entering into forward exchange contracts desperately to mitigate the exchange risk. The rupee depreciated above 193 in December 2020 while the Central Bank successfully intervened with their forex reserves to cross the year at Rs. 187 per Dollar. However, In January 2021 the rupee further depreciated to the level of 196.

The Central Bank on 25 January 2021 by Direction No. 2 of 2021 directed licensed commercial banks not to enter into forward exchange contracts with importers for a period of three months which was the only instrument available for importers in Sri Lanka to mitigate forex risk. This restriction was further extended until further notice and this act prevented the forex market from portraying the real exchange rate.

The Ceylon Petroleum Corporation was forced by the authorities to borrow dollars from the State banks to pay their commitments rather than purchasing dollars from the market. That was one of the reasons of increasing the dollar deposit rates.

The Central Bank issued the gazette 2215/39 on 18 February 2021 imposing a mandatory conversion of 25% of exports immediately upon the receipt of such proceeds and the proceeds should be received within 180 days from the date of exports. The Central Bank was not aware that some of the exporters used to get USD packing credit loans to finance their exports so that when the proceeds come, they had to first settle the loan and thereafter they have hardly anything leftover. 

Later the direction was amended several times and finally on 9 April 2021 by gazette 2222/60 the minimum mandatory conversion requirement was brought down to 10% of export proceeds and such conversion should take place not immediately but within 30 days of the receipt of the proceeds. 

 

Dollar shortage and exchange rate losses

The USD/LKR rate crossed the Rs. 200 mark in March 2021 due to continued shortage of dollars in the domestic market. This led to exchange rate losses for importers who were deprived of booking their import bills via forward contracts from January onwards due to restrictions. 

It was announced on 23 March 2021 that the Central Bank entered into a currency swap with the Central Bank of China for $ 1.5 billion and a term loan of $ 500 m was obtained from Chinese Development Bank on 12 April 2021.

On 17 April 2021 the State banks intervened in the market with the blessings of the Central Bank, to artificially bring down the USD/LKR rate to 193 within a day, through sale of dollars over $ 60 million. However, it could not be retained at that level.

Towards the end of April 2021, the Central Bank allowed the licensed commercial banks to get together and determine on peg for USD/LKR rate which initially started with 199-200 (Bank Buying and Bank Selling Rates respectively). Later it was adjusted to 200-202 with a bid-offer spread of 2 Rupees. Generally, the bid-offer spread is around 0.50 in the interbank market. 

 

Severe scarcity of dollars

At the beginning of May 2021, the Central Bank prevented commercial banks from participating in the interbank forex market to square their forex open positions, so that the banks had to do it internally within the banks. This worsened the situation and created a severe scarcity of dollars in the market.

The Central Bank had meetings on daily basis with the commercial banks to address the issues prevailing in the forex market, but it was evident on subsequent events that these meetings were mere compensatory ones without addressing the real issues. 

The widened spread between bank buying and selling rate of USD/LKR made banks happy as they could earn an arbitrage profit by exploiting the foreign exchange earners in the country in spite of severe shortage of dollars in the market. The peg was further widened to 199.50-202.00 on 10 May 2021 where exporters were further penalised by banks due to a lowering the bank buying rate with a wider bid-offer spread of Rs. 2.50. 

The Central Bank adjusted the bank buying rate downwards expecting the exporters to get frightened of falling exchange rate and induce them to sell their dollars. It was not successful, and the commercial banks collectively adjusted the two-way price to 200-203 on 13 May 2021 with the blessings of the Central Bank.

 

Market collusion by commercial banks

Identifying that the exporters were not eager to convert their foreign currencies since they get higher deposit rate in dollars, commercial banks collectively acting as a cartel decided a ceiling on dollar deposit rate of 5.50% per annum. It should be noted that commercial banks deposit dollars in Sri Lanka development bonds at 7.5% which is now 2% more than the rate they pay to exporters.

The commercial banks were benefited.  They could make money on one hand by having a high spread with the direction of the Central Bank in squaring off their dollar positions internally and on the other hand by keeping a higher margin of the dollar deposit rates and rates of Sri Lanka development bonds where the banks invest. Both cases were at the expense of the foreign exchange earners of the country.  This type of manipulation of exchange rate and dollar deposit rates by banking system of the country including the regulator can be identified as a market collusion. 

The commercial banks initially gave priority to the import bills open under letters of credit (LC) and they have delayed the payments of non-LC bills. Now they are rejecting the request of the clients to open LCs with the full blessings of the Central Bank due to the severe shortage of dollars in the market.  I understand that there are certain foreign obligations of the local companies which were not met in a timely manner, causing embarrassment to those local companies.

Bankers know that it is not appropriate or sometimes suicidal to finance long-term projects with short-term loans. What they are doing is exactly the same, finding out a short-term solution to a long-term problem.

 

Who decided USD/LKR rate of Rs. 185?

It appears to be that the intention of the Central Bank is to keep the USD/LKR rate around the level of Rs. 185. Who decided this level? Was it by the Central Bank and the Monetary Board or someone outside of the Central Bank has imposed it on them? 

The Central Bank or whoever that party is should realise that exchange rate of a country cannot be managed in this manner causing severe difficulties to the players in the market. At present the rupee is overvalued, causing much difficulties to the exporters and foreign exchange earners who brings valuable foreign exchange to the country. The local currencies of some other countries such as Indonesia, India and Vietnam are undervalued and hence the exporters of those countries are at an advantage. 

The Central Bank and the person, if any, who decides the level where the exchange rate should be, are not sensitive to the fact that it is solely exports which will help the country to come out of this situation. 

It is basic knowledge that managing an economy is a balancing act. When someone is engaged in a business, he cannot fix the bottom line since the bottom line is an effect of several causes including sales and expenses. One cannot fix even sales since sales is an effect of several causes including customer management. Similarly, only an insane person can think that the exchange rate of a country can be managed in this manner. The exchange rate is an effect of the level of exports and imports of a country. In addition to that there are other causes such as foreign remittances and foreign loans. Sri Lanka is having a long-term deficit in the trade balance and also the current account. Higher level of imports is being set off to a certain extent of exports and worker remittances.

 

Best bet for Sri Lanka

The best bet for Sri Lanka is to increase the manufacture-based exports. Import substitution is good but export promotion is better. When there is import substitution, it can substitute to the level of consumption of our population which is 21 million. There are no such restriction in the exports. If capable we can cater to the entire world.

Successive governments have neglected this and they were engaged in petty things like what the Central Bank is doing in respect of the exchange rate today. There are many entrepreneurs who can do exports who are spread throughout the country and waiting without funds. Although they need capital, they cannot get a short-term loan even, since all the banks in Sri Lanka ask them a collateral which they are unable to give. I have first-hand experience in this respect.

If the Government, the Central Bank and if interested the commercial banks want to bring about a real change, they should engage in helping rural entrepreneurs enabling them to access finances without any hindrance and promote exports which will give a lasting long-term solution to the exchange rate problem rather than engaging in hide-and-seek games.