Deconstructing the Central Bank’s Economic Road map

Last week the Central Bank unveiled its six month road to recovery in ensuring the country’s macroeconomic and financial stability. Headed by the Governor of the Central Bank Sri Lanka introduced this road map in a backdrop where Sri Lanka’s foreign reserves have depleted while debt repayments mounted. A group of young economists and researchers joined an online discussion titled ‘Sri Lanka’s economic crisis: Fact or Fiction” to discuss and deconstruct the new road map.

“What impact would the recent road map presented by the Central Bank have on the economy going forward?” asked K. D. Vimanga, Policy Analyst at Advocata Institute during a recent discussion. Guest Deshalde Mel, economist and research director at Verite Research and former economic advisor to the Ministry of Finance said that the road map was much looked forward to by markets to get some sense of direction, given the recent changes at the Central Bank.   

He said that a lot of the materials that were presented had already been signalled previously in terms of the overall approach towards reserve management. “Many of these have already been disclosed by the Central Bank.“There were a few different new areas that were touched on, one of them being the initial signalling that the central bank would consider buying back international sovereign bonds if the market would be conducive for it,” de Mel said.   
The challenge with this subject is typically when the issuer starts to indicate buying back bonds, then typically those prize margins start shrinking. We’ve already seen that with the 2022 January issuance. And as usual the government should have the reserves to do so. So the market would take into account those factors as well. The other somewhat new approach was the crystalisation of the government’s intention of converting some of the dollar deposits of export and corporate sector in particular into rupees,” de Mel said. He added that they were looking to do this conversion within a period of six months. “It was the first time that it was outlined in an official policy statement, a somewhat new measure.”  

“The road map confirmed some of the measures that the government has been looking at in terms of debt management.” he said. Particularly the path that they decided to take without seeking an anomalous programme but to continue to seek an alternative mechanism of settling external debt liabilities and managing the economy through home grown solutions,” de Mel opined. Sri Lanka losing access to the global capital market is the biggest constraint we have in this context.  

"The fact that Sri Lanka has lost access to the global capital market is one of the biggest constraints we have in this context"

Is the Governor too optimistic?

“I can assure you that the criticism that Sri Lanka will be facing difficulties is misplaced. We have shown that the situation can be managed, and it will be done so in the next few years,” the moderator said quoting the Central Bank Governor Ajith Nivard Cabraal. The next question to follow was is the governor being too optimistic?
Deshalde Mel pointed out that as a key policy maker, the Central Bank in general has to take a positive approach. “You can’t go into a challenge with a negative attitude but with the view that this can be solved.” What is needed is a concrete plan in terms of addressing some of those key issues. And the critical issue here is in terms of debt management, de Mel said, highlighting Sri Lanka’s ability to meet its external maturity debt liabilities. 

 
 “In my opinion the critical lever is going to be how Sri Lanka can regain access to global capital markets,” he explained. “What typically middle income countries would do is to raise capital from global financial markets, refinance the capital portion of the maturing debt, service the interest and keep going in that manner. The fact that Sri Lanka has lost access to the global capital market is one of the biggest constraints we have in this context.”  
“In the road map it was mentioned that SL needed to raise its credit rating. That’s a key milestone in the process of solving the issue. But even though the road map specifically mentioned improving our credit ratings, there wasn’t more specificity around exactly how it tackles that particular objective. The global markets in particular would be looking into a little bit more clarity on how SL seeks to do that,” the economist said.   

"The roadmap confirmed the government’s approach to seek an alternative mechanism of settling external debt liabilities and managing the economy through home grown solutions"

Is it a solvency or a liquidity problem?

“The debt issues that Sri Lanka has had isn’t a new phenomena,” said de Mel answering what he believed was a somewhat tricky question in terms of classifying the economic issues Sri Lanka is facing. “The difference is the critical issue of losing access to the global capital market.”   
According to de Mel, that is where the liquidity crunch has superseded that Sri Lanka faces right now, and still the path to address that is to regain access to the global capital market. He assumes that the debate is due to the government looking at instruments such as swaps which are typically short term instruments in terms of addressing liquidity. Whereas Sri Lanka would need to raise longer term capital as well.  

"Not enough clarity on improving Sri Lanka’s credit ratings, although a plan has been mentioned"

Asking private entities to convert dollars into rupees

When asked about the process of getting the export dollars towards the treasury and whether there’s a way of capturing these dollars and making use of it, de Mel explained that this is somewhat new to Sri Lanka. “What the government has been arguing is that if these dollar inflows have been coming in, insufficient amounts have been converted into rupees and thereby insufficient dollars are being bought into the banking systems. So what the central bank is asking is for the private entities to convert those dollars into rupees with a banking system and make those dollars available for general transactions.” He believes that this is a temporary measurement taken by the government given the pandemic situation. But the signal it gives to the market could be quite concerning. 

 
What would the long term impact be and how is it going to affect future investments and their decisions?
“First of all we need to contextualise the foreign exchange crisis that we are facing right now,” he clarified. SL has had constraints with the external sector for a while and there’s a substantial amount of debt repayments. In addition to that, we lack access to the global capital market. That’s where reserves shrink and create the kind of pressures that we’re seeing now.”   

Some people think that with the return of tourism, everything will be okay but I think that’s an overly optimistic view, he added. “When tourism gets back in full gear, it would certainly help in terms of mitigating the pressures on the external sector but it doesn’t solve our problems entirely. It can either help us in some of our external debt payments or it can help us reduce the import restrictions. But it certainly can’t repress both.”  

“To address both those problems, we need access to the global capital market for which we need to upgrade our credit ratings. What would concern markets to some extent is that when we have situations where we have prolonged disruptions in access to raw material inputs and intermediate imports for the production process. That certainly is something that would create concerns for investors in the longer term. Therefore the macroeconomic stability of a country is a critical input for them,” de Mel said.   

"Return of tourism can aid our external debt payment or restrict imports. It can’t do both"

Rollback of deficit financing is a welcome move

De Mel mentioned that with the pandemic, many countries including SL started to reduce interest rates quite dramatically. We also had a high budget deficit. So in order to maintain low interest rates with a budget deficit, it requires some degree of deficit financing.   

“While the pandemic is going on and the economy is in recession, having that kind of interest rate regime and deficit financing to support the low interest regime can be a stable and short term sustainable position to take. He thinks that Sri Lanka delayed the phasing out of deficit financing to some extent once the economy started to recover. And that started to put pressure on the reserves and the currency as well. Therefore rollback of deficit financing is certainly a welcome move in terms of macroeconomic management and stability but we don’t want to allow interest rates to increase too sharply as well. That has to be a managed process so that we don’t disrupt economic activity in general,” he explained.   

Why is the government averse to debt reconstruction which appears to be the most obvious solution to the debt crisis?
Sri Lanka never had to restructure its debts and typically that’s something that countries want to avoid doing, the seasoned economist said. Once we reconstruct our debt, credit rating lowers to where we are right now. That’s a negative signal in terms of global markets and it can also have a fairly longer term impact on your overall cost of borrowing in global markets in the future.   

“But, when your debt does come to a level that becomes difficult to manage, it’s often the only option you have as well. Our government has taken a view that we still have options we can perceive before looking at a debt reconstruction. I think the current view is the expectation that tourism in the next few months could provide some respite along with some of the plans that have been outlined in terms of divestment of government assets. It looks like the government is trying to pursue those alternative measures as far as possible before they consider a restructuring.   What do you think the government got fundamentally wrong when it comes to the macroeconomy and what can we learn from it?

At that time a lot of reforms or adjustment methods that needed to take place gradually over a long period of time, came in together at the same time, de Mel said. “So we had significant fiscal adjustment and monetary adjustment, all coming in at the same time which certainly created some headwinds for economic activity as well. In ideal scenarios you would want to face those gradually so that you don’t have any disruptions in terms of economic activity. But given the time constraints that the government faced in terms of managing these debt repayments, it was essential that we maintained access to global capital markets to maintain our ratings.”  

“It was compounded by the fact that there were a lot of shocks to the economy as well throughout those years with droughts, the constitutional crisis and Easter Sunday attacks. Those reforms should have started earlier ideally around 2015. It took some time for those to get going. Therefore it backlogged a lot of the reforms and became difficult to get the timing right with the debt management as well,” de Mel opined.   

It all fundamentally comes down to improving our credit rating and regaining access to the global capital market, de Mel reiterated. “That’s the only way we can come out of this situation. If we rely on the generosity and willingness of other governments to support us in this situation, we’ll be relying on uncertain inflows like divestment of strategic assets or on sectors like tourism that can support but don’t have the magnitude to address all the problems.”     

This discussion has been edited and condensed for clarity