Mega SWAP facilities could push Sri Lanka to a more severe debt trap: Dr. W. A Wijewardena

Sri Lanka’s current economic meltdown-aggravated by the existing dollar crisis, soaring cost of living and a possible shortage of food in the coming year- has made people question the incumbent government’s promises when it assumed power. Although decision makers conveniently blamed the unforeseen COVID pandemic for this economic downfall, economists believe that several other factors contributed to this catastrophe. For example, imposing tax concessions and import controls have been erroneous policies that caused a reduction in Government revenue. While Sri Lanka is indebted to many of its allies, its foreign reserves have drastically reduced and the country has now opted to selling off its gold reserves. Apart from that the American rating agency Fitch downgraded Sri Lanka’s rating status to ‘CC’ – the lowest rating prior to default. As per the official statistics, the debt servicing during the next 12 months relating to both the government and the private sector has been estimated at USD 7 billion. According to the Central Bank, Sri Lanka only had USD 3.1 billion foreign reserves as at end of 2021. 
In this backdrop, the Daily Mirror spoke to senior economist and former Deputy Governor of the Central Bank Dr. W. A Wijewardena who highlighted the mistakes made in the decision-making process, why the International Monetary Fund (IMF) bailout is a viable option and why Sri Lanka should get rating agencies to reverse the downgrade in order to attract foreign investors. Excerpts : 

• Imposing import controls is an erroneous policy which Sri Lanka had adopted prior to 1977
• Sri Lanka will have to pay a higher risk premium to attract prospective investors
• Gold is a reserve which a country has to use as the last resort when it is on the brink of default
• Central Bank can issue its own digital currency which would be a cost saver as well as a more convenient medium of exchange
• Current situation will lead to non-availability of goods and increase unemployment

 Q  The incumbent Government imposed tax concessions and you say that this was a mistake. Could you explain how this decision contributed to the prevailing economic crisis?

Sri Lanka’s fiscal sector had not been in good health ever since independence and especially during the last 2 decades. Government revenue was falling as a share of GDP, while the government expenditure, mainly its current expenditure, was rising again as a share of GDP. The resultant high budget deficit forced it to borrow from both domestic and foreign sources to finance the gap. The corollary was the gradual increase in public debt causing the Government to spare almost the entirety of its revenue for debt servicing. In this background, it was necessary to reverse the trend by consolidating the budget. The previous government had adopted the strategy of consolidating the budget by increasing revenue because they felt that it was practically difficult to cut expenditure. A slight progress had been made in this connection by increasing revenue from around 11% of GDP to 12% by 2019. What was necessary was to continue this strategy until the revenue level will shoot up to a safe level of about 15%. However, the present administration thought that it should adopt the opposite strategy, namely, consolidating the budget by cutting expenditure. Hence, taxes were cut, but correspondingly expenditure was not reduced. This was exacerbated by the outbreak of the pandemic in early 2020. At this stage, the government should have changed its strategy and gone for the tax system that had prevailed prior to 2020. That was not done and as a result revenue fell by about Rs 500 billion, falling from 12% of GDP to 9% in 2020. The loss in revenue in 2021 is also estimated at around this level and it will be continued into the next few years as well. To finance the budget, the government has borrowed from the Central Bank and commercial banks excessively, causing the money stock to rise by about Rs 3 trillion or 39% during the 23-month period beginning from January 2020. The inevitable result of this strategy has been the acceleration of inflation on the domestic side and the pressure for the exchange rate to depreciate on the external side. That is the source of the present economic crisis, and it is a man-made crisis.

 Q  The government also imposed controls on imports. This created shortages and inflation of prices. Was it necessary to impose import controls at all?

This is an erroneous policy which Sri Lanka had adopted prior to 1977. It does not work because it creates shortages of both consumer products and raw materials adversely affecting the growth momentum. It also leads to the creation of black markets. The low performance of the economy creates shortages of consumer goods leading to increases in prices and cost of living of people. But there was an acute forex shortage which prevented the country to continue with the existing import programme. Under these circumstances, the least cost strategy would have been to curtail the import flow by increasing prices, called rationing by price, by allowing the exchange rate to depreciate. Instead, the Government adopted the more costly strategy of import controls, called rationing by quantity. Sri Lanka had devastating experience of this before 1977. The main advocate of import controls, the former Governor of the Central Bank, W D Lakshman, had lived through this bad experience and he would have been well aware of its disastrous consequences. Hence, it is incomprehensible how he supported the reintroduction of this control cum permit raj to Sri Lanka. 

"The loss in revenue in 2021 is also estimated at around this level and it will be continued into the next few years as well. To finance the budget, the government has borrowed from the Central Bank and commercial banks excessively, causing the money stock to rise by about Rs 3 trillion or 39% "

 Q  We have opted for currency swaps from China and Bangladesh. How do these transactions work?

It is only a temporary relief because the other country agrees to lend foreign exchange to Sri Lanka and the latter responds by providing them with an equivalent amount of Sri Lankan rupees. These are usually for 3 months, but could be renewed for further periods provided the lending country would agree. The operational mechanism is that, say in the case of the SWAP facility with China, the Chinese Central Bank, the People’s Bank of China, will open an account in the name of the Central Bank of Sri Lanka in its books and credit that account with Yuan 10 billion. That money belongs to Sri Lanka during the currency of the SWAP and could be used to import goods from China, which is a relief in the present shortage of foreign currency. The Central Bank of Sri Lanka, as a counter entry, opens an account in its books in the name of the People’s Bank of China and credits the equivalent amount of rupees to that account. That money belongs to China until the SWAP is reversed. China can in the meantime invest that money in Treasury bills or use for financing any rupee cost in the case of projects it has started in Sri Lanka. If they invest in Treasury bills, they can earn about 8% per annum at the current rates. In addition, Sri Lanka should pay interest at about 2% on the SWAP raising Sri Lanka’s total cost to about 10%. The danger here is that if Sri Lanka uses the entirety of Yuan lent to it by China, when the SWAP is reversed, it has to buy Yuan from the market by spending the equivalent value in dollars which it doesn’t have. It will have to use dollars from its forex reserves or if its forex position is not adequate, borrow dollars from some other source. Hence, unlike small SWAPs, these mega SWAPs push Sri Lanka to a more severe debt trap and the country will have to depend on the lender’s mercy to avoid a bigger economic catastrophe. 

 Q  The terms and conditions with which these swaps are done are not transparent. Is that a disadvantage to the borrowing country? If so, why?

These are private transactions done by the Central Bank and therefore there is no compelling reasons to disclose them. But in the name of good governance, it would have been better if the Auditor General conducts a proper audit of the SWAP facility, makes a realistic risk assessment, and submits a report to Parliament, so that the country will know the exact situation.

 Q  In a recent interview you said that rating agencies would rate Sri Lanka depending on accumulation of reserves without incurring additional debts. Are we in a position to accumulate reserves this way?

The only way to do so is to attract foreign exchange flows to formal channels, so that the Bank can buy the surplus in the market. Presently, there is a speculative bubble in which some of the people who have earned forex are waiting until the rate to fall in order to bring that money to the country. There are others who have taken advantage of the lucrative, thriving, and dynamic black market which the Central Bank has created to send their money. Those are known as informal channels. Rather than trying to castigate them as non-patriots, the Central Bank should do what it can do at the least cost. That is, rationing by price as we have already pointed out. In other words, the Bank should stop holding on to the artificially determined exchange rate at Rs 203 per dollar when it does not have dollars to maintain it. The Central Bank has already reached the wall and cannot scale it now. It tries to get a few dollars from here and a few dollars from there to stop a massive flow of waters that are to break the dam which had been structurally weaker and threatening to flood the area downstream. What rating agencies are telling is depreciate your currency, allow the market to operate, and build up reserves by buying from the market. It may be a hard decision for the Central Bank, but in my view, there is no other option available to the Bank. It should not view it as a loss of face.

"The main advocate of import controls, the former Governor of the Central Bank, W D Lakshman, had lived through this bad experience and he would have been well aware of its disastrous consequences. Hence, it is incomprehensible how he supported the reintroduction of this control cum permit raj to Sri Lanka."

 Q  Several international rating agencies have downgraded Sri Lanka’s rating status on long-term borrowings. How does this impact on the economy and overall image of Sri Lanka’s economy?

Rating is a learned and a well-studied opinion given to prospective investors and any downgrade will cause them to think twice before making their investment decisions. In the circumstances, Sri Lanka will have to pay a higher risk premium to attract such investments. It will dry out Sri Lanka’s already weakened forex inflows putting everything, our consumption, production, economic strength, and above all, our ability to continue as a strong non-aligned nation in the international arena. Those countries which have come to Sri Lanka’s rescue in this hour of need have a greater say in influencing Sri Lanka on how it should participate in global politics. There is a fine Sinhala verse to describe it: ‘When a barber’s position has become weaker, even a goat by the side of the road will offer its beard for shaving’. 

 Q  We should have opted for the IMF bailout, but we didn’t consider it as an option. Why do you think the cabinet was divided on this matter?

Obviously, the Government does not want to go through the economic reform programme which it has to agree with IMF to get this facility.

 Q  What would have been the advantages of seeking an IMF loan? 

On several counts; first its loans at about 3.55% are cheaper than the alternative sources like SWAPs that cost about 10%; second, they are for medium to long-term up to 10 years and repayment is in half-yearly installments unlike SWAPs where Sri Lanka has to repay in one payment called a bullet repayment; third, it forces the government to discipline itself relating to fiscal matters; fourth, it is associated with an economic reform programme that will help Sri Lanka to attain long-term growth objectives; fifth, it helps Sri Lanka to regain the lost confidence of prospective investors.

 Q  Are we too late to get this loan now?

As it is, yes, because it takes about 6 months to conclude a programme; It is difficult to say that Sri Lanka could survive that long given the acuteness of the forex crisis it is facing today.

 Q  How could Sri Lanka improve its foreign exchange reserves?

Depreciate the exchange rate, earn confidence of exporters and others wishing to invest in Sri Lanka, and improve the receipt of forex flows through formal channels.

" The cost of living, specifically that relates to food items, is already on the increase. In December 2021, the Colombo Consumers Price Index accelerated to 12.1% with foodflation rising to 22%. This trend will continue in 2022 as well because the government is planning to finance extra expenditure by borrowing from the banking sector"

 Q  Tourism and foreign remittances from migrant workers have been major contributors to the economy. Do you think these two sectors could help Sri Lanka recover from the prevailing crisis? 

Only partially because Sri Lanka’s forex requirements are much more than what it could earn through these channels on a net basis.

 Q  Sri Lanka then opted for money printing and recently the finance minister unveiled a Rs. 229 billion relief package. What is Sri Lanka’s money printing threshold and what happens when it is exceeded?

A country can allow money stock to go up without causing inflation as long as it does not exceed the liquidity requirements caused by the real economic growth. Any increase in money stock above that level is considered excess money supply causing the domestic prices to go up, on one side, and exchange rate to depreciate, on the other. This has been the experience in Sri Lanka as well as globally.

 Q  In a recent Tweet you mentioned that the Central Bank’s gold reserves have reduced from $382 mn to $ 175 mn. Could you explain how gold reserves should be used in a situation like this? 

Gold is a reserve which a country has to use as the last resort when it is on the brink of default. Hence, the sale of gold should be done sparingly when there is no other alternative available. An example is India’s airlifting of 47 metric tons of gold to London in 1991 as a pledge to borrow $ 400 million from Bank of England and Bank of Japan to avoid sovereign default and finance the importation of oil and fertilizers and sale of additional 20 tons to UBS to raise $ 200 million for the same purpose. This was done secretively, but it did not remain a secret for long because The Indian Express broke out the story. It was a loss of face, but the Indian Finance Minister Manmohan Singh later admitted in Lok Sabha that the country had no option because it had run out of all those available reserves to raise quick funds. So, the sale of gold by Sri Lanka today means that the country is in the same situation as India in 1991.

 Q  There’s also a problem of certain banks forcing their customers to convert dollars to LKR. Could you elaborate on this issue?

This has been due to misreading by commercial banks of what is meant by sale of services to foreigners; that was why the remittances by migrant workers to their private foreign currency accounts were also forced converted to rupees. But the Central Bank has now issued a clarification and it is hoped that funds in migrant workers’ foreign currency accounts will be safe.

 Q  What loopholes should be rectified in order to build confidence among foreign investors?

Nothing except getting the rating agencies to reverse the downgrade. For that purpose, as explained earlier, the Central Bank should build reserves not by borrowing, but by buying from the market. A prerequisite to that is allowing the exchange rate to depreciate to a realistic level.

 Q  The world is now open for financial transactions using cryptocurrency. Is the present situation favorable for Sri Lanka to move towards this trend?

Cryptos will compete with rupees and cents issued by the Central Bank. If cryptos issued by unknown private parties are used, the government loses the profits it makes by issuing currency, known as seigniorage. Knowing this, it is unlikely that the Government will permit this. In the alternative, the Central Bank can issue its own digital currency which would be a cost saver as well as a more convenient medium of exchange.

 Q  With all these haphazard and unscientific decisions, should the Sri Lankan public expect a soaring cost of living in 2022?

The cost of living, specifically that relates to food items, is already on the increase. In December 2021, the Colombo Consumers Price Index accelerated to 12.1% with foodflation rising to 22%. This trend will continue in 2022 as well because the government is planning to finance extra expenditure by borrowing from the banking sector, the leading contributor to the increase in the money stock and consequential inflation in Sri Lanka.

 Q  Apart from high cost of living, what are other repercussions that the public would face in this situation?

The non-availability of essential goods and raw materials for industries forcing them to operate below capacity. It will reduce output and increase unemployment adding to the miseries of people prolonging the recovery from the economic downturn caused by COVID-19 pandemic.

 Q  As an experienced economist, what are your suggestions on how Sri Lanka could recover from this economic crisis?

In the short run, acquiring the necessary forex to allow some breathing space and in the medium to long run, negotiating with IMF for a funding facility. It will deliver all the benefits which an IMF package would bring to Sri Lanka mentioned earlier.