Sri Lanka’s hard goods exports were 877.6 million US dollars in April, up from 848.6 million US dollars a year ago, in a holiday month which usually has a 20 percent downturn.

Remittances were 543.8 million US dollars, up from 454 million last year.

Tourism income was estimated at 225.7 million US dollars for April, which is from a survey and may not be as reliable as import export data from customs or remittances data from banks.

Gross services which include tourism was 558 million US dollars.

Foreign exchange earned by Sri Lankans from exports, remittances and gross services were 1,977 million US dollars in April 2024.

Merchandise imports were only 1,435 million US dollars, leaving a surplus of 542 million dollars.

Sri Lanka’s central bank has started to release more service data in 2024 giving a broader picture beyond the Merchandise trade account.

Turning in their graves?

In Sri Lanka there is a strong belief in the trade deficit.

Macro economists also dangle the ‘current account deficit’ as an excuse for monetary instability after printing money to enforce rate cuts, dredging up doctrine from the days of classical mercantilism in the 17th century, and dressing it up with a new label (the current account deficit vs the commercial balance).

Economic textbooks may be directly to blame for the revival of Mercantilism as well as the bureaucratic policy rate, analysts say.

The Mercantilist doctrine of the commercial balance was comprehensively refuted by classical economists including Smith, Hume, Mill, Thornton, and Torrens in particular who had micro-knowledge of note-issue operations.

In the last century German-Austrian and Swedish economists directly challenged Keynes but the doctrine has persisted among Anglophone academics in particular as inflationism worsened from the 1960s with Fed activism.

In countries with inflationary central bank operations, large numbers of perfectly sane people believe that goods can be imported indefinitely without dollars being earned (the seller not getting any dollars), triggering a chronic merchandise ‘trade deficit.

They also believe that it is a ‘problem’ or that the trade deficit contributes to external instability or currency depreciation.

The obsession with the trade deficit seems to be driven by a belief that hard goods were ‘superior’ to services.

Students of history say similar attitudes were seen in the writings of nationalists who criticized the shift to coconut which was a commercial crop in areas like Kurunegala during British rule.

Sri Lanka’s central bank however has not discriminated against any hard work done by the people, or suggested that services workers were inferior.

Sri Lanka has a private savings rate of around 30 percent of GDP, which also broadly applies to those earning foreign income.

Savers may directly invest in assets, or put money banks as deposits either after conversion to rupees or as dollars in forex accounts.

Banks in turn will give them as investment credit to borrowers, which will turn into imports or build up dollar balances by investing them abroad.

Sri Lanka’ central bank in April collected about 420 million US dollars from the banking system, creating rupee liquidity.

Domestic Operations

When private credit is weak – or when money is not printed to enforce a policy rate claiming that inflation is low with statistics defeating economic principles – the central bank can sell sterilization securities into banks (in the current case Treasury securities in its portfolio) mop up the liquidity and build fx reserves, East Asia style, through deflationary domestic operations.

The government can also borrow rupees through Treasury bills, buy dollars and settle foreign loans and end up with a rupee debt instead of a dollar debt, as happened before potential output targeting and flexible inflation targeting, preventing the build-up of dollar debt and an eventual default.

At the moment large volumes of excess liquidity remain in the banking system, which can be used up as private credit recovers, pressuring the exchange rate unless the dollars that created the liquidity is sold (unsterilized intervention).

The central bank can also prevent imports from being generated through investment credit by steadily selling its securities portfolio if it wants to keep the reserves.

Imports can also increase when foreign aid resumes and the government re-starts infrastructure projects. Sri Lanka government’s net foreign borrowings, except in stabilization years, is usually positive.

After re-structuring loans, Sri Lanka’s debt repayments will reduce, and only interest will have to be paid for several years. (Colombo/June01/2024 – Recast with revised data to show gross services which include tourism. Gross services data only available for two months)

Prices measured by the widely-watched Colombo Consumer Price Index fell 0.6 percent in the month of May. The index fell from 195.2 points to 194.1.

The food and non-alcoholic price index fell 1.2 percent to 232.6 points from 235.4 a month earlier.

Since September 2022 food prices are down 5.79 percent.

Sri Lanka’s central bank has been operating deflationary policy and also allowing the rupee to appreciate over the past year bringing down traded price in particular which some non-traded items continued to go up as the price structure adjusted to a collapse of the currency in 2022.

Educations, recreation and culture, while food, clothing and also transport seems to have finished inflating in response to the currency collapse.

Analysts have said that the monetary stability is coming from external anchoring (currency appreciation or stability amid deflationary policy) and the domestic anchor (triggering 5 to 7 percent inflation) is temporarily in abeyance.

Meanwhile growth recovered to 4.5 percent in the last quarter despite a foreign reserve build up in non-inflationary growth.

Singapore’s economic architect told then President J R Jayewardene to not to depreciated the currency and the country will be able to achieve non-inflationary growth.

Singapore does not have a policy rate to engage in money printing to suppress rates and trigger external instability. (Colombo/May31/2024)

“While the medium term inflation outlook remains compatible with the current level of policy interest rates and inflation expectations are well anchored, the Board observed the need for a further reduction in market lending interest rates in line with policy interest rates and other benchmark interest rates, which is imperative for the easing of domestic monetary conditions and domestic economic recovery,” the central bank said in its monetary policy statement.

The central bank said the effect of value added tax hike in the inflation index had been offset in the inflation index by falling fuel, electricity and LP gas prices.

The electricity and gas sectors have said the appreciation of the currency (after deflationary monetary policy) was the reason they were able to cut prices, indicating that it was the central bank that was fully responsible for the energy price falls.

The full statement is reproduced below:

The Central Bank of Sri Lanka maintains policy interest rates at their current levels

The Monetary Policy Board of the Central Bank of Sri Lanka, at its meeting held on 27 May 2024, decided to maintain the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank at their current levels of 8.50 per cent and 9.50 per cent, respectively. The Board arrived at this decision after carefully assessing the current and expected macroeconomic developments and possible risks on the domestic and global fronts with a view to maintaining inflation at the targeted level of 5 per cent over the medium term while supporting the economy to reach its potential. While the medium term inflation outlook remains compatible with the current level of policy interest rates and inflation expectations are well anchored, the Board observed the need for a further reduction in market lending interest rates in line with policy interest rates and other benchmark interest rates, which is imperative for the easing of domestic monetary conditions and domestic economic recovery.

Headline inflation is expected to converge to the targeted level over the medium term, despite transitory volatilities

Headline inflation, as measured by the year-on-year change in the Colombo Consumer Price Index (CCPI, 2021=100), showed some uptick to record 1.5 per cent in April 2024 compared to 0.9 per cent in March 2024, mainly due to an acceleration in non-food inflation. However, on a month-on-month basis, both food and non-food prices declined. Recent movements in inflation indicate that the uptick in inflation driven by the Value Added Tax (VAT) amendments in January 2024 has been partly offset by the latest price developments underpinned by the downward revisions to the electricity tariff, and fuel and LP gas prices.

In addition, the moderation in food prices and the muted demand conditions also contributed to the low level of inflation. Meanwhile, core inflation, which reflects underlying demand pressures in the economy, also remained at subdued levels reflecting low demand pressures in the economy. Incoming data suggests that headline inflation is likely to be below the targeted level of 5 per cent in the upcoming months due to the combined impact of the administered price adjustments and eased food prices,
although some upside risks remain.

However, inflation is expected to eventually align with and remain around the target level over the medium term, supported by appropriate policy measures.

A further decline in market lending interest rates is warranted
The overall market interest rate structure has adjusted downwards in response to the monetary policy easing measures implemented thus far. The yields on government securities continued to decline, further aligning with the current level of policy interest rates. With the decline in average deposit interest rates in the banking sector in recent months along with the moderation of benchmark interest rates, further space has been created for overall lending interest rates to adjust downwards in the period ahead. Moreover, elevated interest rates on selected loan products are yet to be adjusted downwards in line with the overall interest rate structure. Flows of credit to the private sector have only recorded a marginal expansion thus far during the year, in spite of the notable monetary policy easing and the improvement in overall liquidity conditions. A further reduction in retail lending interest rates could facilitate the pickup in private sector credit, thereby supporting the ongoing recovery of economic activity.

The external sector strengthened further

As domestic economic activity gathered momentum in recent months, the cumulative merchandise trade deficit is expected to have widened during the four months ending April 2024 compared to the same period in 2023. Buttressed by tourism related inflows, the services sector recorded a notable net inflow in recent months, while workers’ remittances remained elevated. Gross official reserves increased notably to US dollars 5.5 billion (including the PBOC1 swap) by end April 2024, supported by considerable net purchases by the Central Bank from the domestic foreign exchange market amidst increased foreign currency inflows. Meanwhile, the Sri Lanka rupee recorded an overall appreciation of around 8.0 per cent against the US dollar thus far in 2024.

Policy interest rates are maintained at their current levels

In consideration of the current and expected macroeconomic developments highlighted above, the Monetary Policy Board of the Central Bank of Sri Lanka, at its meeting held on 27 May 2024, was of the view that it is appropriate to maintain the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank at their current levels of 8.50 per cent and 9.50 per cent, respectively. The Board noted that there remains space for market lending interest rates to decline further given the prevailing accommodative monetary policy stance and the continued decline in the cost of funds of financial institutions. The Board re-emphasised the need to pass the benefits of eased monetary conditions to the borrowers without further delay.

The Monetary Policy Board will continue to observe incoming data and assess risks to the inflation outlook, among others, and stand ready to take appropriate measures to maintain domestic price stability in the period ahead while supporting the economy to reach its potential.

Sri Lanka’s central bank has since September 2022 provided monetary stability including the elimination of forex shortages with deflationary policy by overshooting its 5 to 7 percent domestic inflation target, providing a strong foundation for growth and economic activities to recover.

However, volatility in the exchange rate was proving troublesome for some businesses as the currency could no longer be used as a unit of account to denominate future prices.

No Credibility?

“I heard the word price stability. Yes, that’s good we have, we have got that,” Gerard Ondaatjie, a business executive and hotelier said at a recent forum at the Central Bank.

“But would there be a more important word? Exchange range stability? Because I’m not convinced that we are on an exchange rate stability path.

He said that the head of Sri Lanka’s Standard Chartered Bank has said at the same forum, that once imports are opened the exchange rate will start sliding.

Economic analysts using classical principles have pointed out that the current exchange rate stability and also appreciation is an outcome of deflationary monetary policy deployed by a reserve collecting central bank amid weak private credit, enabled by a market interest rate.

Exchange rates and the balance of payments are an outcome of monetary and exchange rate policies of a note-issue bank and credit, as explained by classical economists before the emergence of inflationist ideologies led to external trouble from the last century.

When a BOP surplus is created by consistently mopping up liquidity from dollar purchases, at a market interest rate, a reserve collecting central bank can either fix the exchange rate, depreciate or appreciate the currency by purchasing more or less dollars against the intervention currency, than the domestic money it has recently sterilized.

Sri Lanka had the worst import controls since the 1970s from 2020 to 2022, but they failed to halt forex shortages and a currency collapse, due to inflationary monetary policy.

The current monetary stability comes as imports except cars are re-opened, commercial banks are repaying credit lines and also collecting dollars for government forex loans repaid in rupees and the central bank itself is collecting billions of dollars in reserves while also repaying forex swaps.

Regime Warning

But some analysts have warned that Sri Lanka is likely to face forex shortages and depreciation and a second default, as soon as inflationary operations (reverse repo or standing liquidity facilities backed injections) resume to enforce rate cuts made to boost ‘growth’ by denying monetary stability.

This could happen when private credit recovers, as had happened in the past decade, if inflationary rate cuts resume, analysts using classical principles (impossible trinity/ISLM-BOP) have warned.

Related Sri Lanka interest rates are dictated by the IMF reserve target, not inflation

Excess liquidity from dollar purchases (coming from the lack of a clean float), could also lead to depreciation if the exchange rate is not defended when private credit using the liquidity resumes.

Under so-called flexible inflation targeting, interest rates are bureaucratically decided based on historical 12-month inflation and statistical models, apparently without regard to current or future domestic credit trends in a bid to generate 5 to 7 percent inflation.

Data shows that Sri Lanka has triggered multiple currency crises and capital flight by the time money is injected to generate 4 percent inflation, since the end of the war with the country not having a clean float to accommodate a domestic anchor.

There is unlikely to be a different result this time as statistics cannot defy laws of nature, discovered by classical economists, which brought sound money, free trade, free capital flows, as well as individual freedoms before the bureaucratic policy rate, analysts say.

There appears to be no successful clean floating country with a 5 to 7 percent inflation target. Russia, the latest entry to clean floats after the US froze its reserves, is also on a learning curve stumbling along with a 4.0 percent inflation target and 16 percent policy rate at the moment.

The Bank of Russia was the central bank that invented modern style exchange controls in 1906 and communism arrived within a decade.

Sri Lanka has to run sufficiently deflationary policy at a market interest rate irrespective of what the historical 12-month inflation rate is, not only to keep the BOP in balance but also to meet IMF reserve targets (ISLM-BOP + IMF/NIR target), analysts have warned.

Countries that have external anchors eventually end up with very low interest rates as Sri Lanka did before a central bank was created and the external anchor was dumped in 1977.

Unit of Account

Ondaatjie said the recent appreciation had also created problems for businesses that make transactions with foreign customers.

Tourism was an example.

Hotels were finding it difficult to price because the exchange rate was at one level when the price was given but at a different rate (stronger) when the customer eventually paid.  In hotels, customers may book six months or more ahead, industry officials say.

“I look at this in terms of looking at a planning horizon of let’s say your revenue channels. You are doing your costing on your exchange rate,” Ondaatjie explained.

“The tourist industry is saying right now we did our costing at 350, 360 (to the US dollar). But when the remittance comes, it is at 300.”

The rupee, which was around 365 to the US dollar in January 2023, fell to 303 to the US dollar by June 2023. Since then the exchange rate has been broadly stable after spiking to 320 to the US dollar.

The currency appreciation had also led to a fall in electricity prices and fuel this year, key inputs for the tourism sector.

Exchange rate stability will also reduce the cost of building materials and vehicles if the rupee is kept stable beyond the 12-month short-term horizon of flexible ‘inflation targeting’.

Global currencies were fixed with self correcting central banks or free banks until the 1920s, with all gold area countries for example maintaining exchange rate parity with a common anchor, except when money was printed during wars, leading to instability.

However, with the bureaucratic policy rate and active open market operations being devised by the Fed in the 1920s, currencies started to depreciate during peacetime in the 1930s, and money began to lose key attributes that made it useful for businesses, including being a unit of account.

Depreciation also triggered a wave of tit-for-tat import protectionism in the 1930s, with inflationists, who were growing in number, spreading an ideology that depreciation boosted manufactured exports, despite the industrial revolution being founded on fixed exchange rates.

After the end of World War II, to re-establish free trade and the usefulness of money as a unit of account and a medium of exchange for external trade, the Bretton Woods system of soft-pegs was set up.

The soft-pegs collapsed in 1971 amid aggressive macro-economic policy through open market operations – mainly by the US – to boost growth or employment.

Most East Asian nations in the 1980s including larger countries like China from 1993 to 2005 maintained highly successful exchange rate anchors and imported US stability of the 1980s and 1990s by mostly running deflationary policy (selling central bank securities to banks and taking in ‘deposits’ instead of buying government securities) and building up foreign reserves bigger than the domestic monetary base.

The Euro area solved the unit of account and medium of exchange problem by setting up a currency union and enabling a large free trade regime.

Several countries in Europe outside the currency union also ran orthodox currency boards (they were running fixed exchange rates with Deutsche mark earlier) or currency board like regimes, until they switched to the Euro itself.

Denmark (7.46 to Euro), Bulgaria (1.95 to Euro) are still running currency board like arrangements to solve both the unit of account and domestic stability problems.

External Anchor

Meanwhile Ondaatjie said having a stable exchange rate would bring domestic monetary stability to Sri Lanka.

“That is also more important, because the exchange rate will create price stability,” Ondaatjie said.

“Because we are an import driven country. Essential items are imported.”

Ondaatjie was eerily echoing the words of Singapore’s economic architect Goh Keng Swee who advised then President J R Jayewardene in 1980.

At the time the IMF’s Second Amendment had deprived Sri Lanka of an exchange rate anchor without a credible replacement, helping macro-economists drive the island into a fresh IMF program amid a strong economic recovery. The US was also hiking rates to counter ‘Great Inflation’ coming from its floating rate at the time.

The IMF program came within two years of the most radical economic reforms made in the island, perhaps since trading monopolies inherited from the Dutch East India Company were abolished by the British colonial civil service liberals over a 100 years earlier, analysts say.

Goh noted that Jayawardene’s reforms were considered “politically impossible” by many.

Goh, who believed in strong exchange rates for domestic stability without a policy rate, advised President Jayawardene not to depreciate the currency.

He was going against the doctrine that was prevalent after the Second Amendment to IMF articles, of depreciating the currencies of countries without a doctrinal foundation in sound money and therefore susceptible to basket, brand, crawl and similar statistical doctrines.

“Exchange rate policies involve many complicated technical issues which I do not want to discuss here,” Goh, who had a deep knowledge of operational frameworks of note-issue banks and had re-created a currency board on separation from Malaysia, told JR in his report.

It will not be possible to stop depreciation until inflationary policy is stopped, he said. Goh told JR that the central bank’s Treasury bill stock was the most important indicator to watch.

“On balance, the disadvantages of a depreciating rupee will, I believe, outweigh the advantages”, he said, rejecting IMF’s post 1978 doctrine of monetary debasement.

“About a quarter of rice consumption is imported. All wheat from which four and bread are produced is imported.

“The same holds true of kerosene and milk powder. Bus fares ware largely determined by the rupee price of imported oil and spare parts. Fertilizers are also mostly imported.”

Related How Sri Lanka rejected Singapore monetary advice and politicians, people paid the price

He warned in 1980 that Sri Lanka could slide into 100 percent inflation like Poland at the time, if the central bank continued to inject money by purchasing Treasury bills. In 2022 the central bank created 70 percent inflation, 30 percent short of the level warned by Goh.

Sri Lanka was sliding into hyperinflation and possible dollarization, analysts say when Central Bank Governor Nandalal Weerasinghe hiked rates, killed private credit and restored rupee stability by generating a BOP surplus from around September 2022.

At the time the exchange rate externally anchored at 360 to the US dollar, through a surrender rule and dollar sales for imports including oil.

No Exchange Rate Anchor Under Current Regime

Meanwhile Governor Weerasinghe said under the current doctrine the central bank was not providing a fixed exchange rate.

“The core objective is price stability,” he explained. “The argument is, can price stability, or low inflation be by maintaining a stable exchange rate? In very simple terms, price stability is what you measure as inflation.

“In an economy like here, if you look at the overall price level, about 75 percent of the prices are domestically produced and the exchange rate has about a 25 percent impact.

“If we think that we can fix prices by fixing 25 percent of the prices, I think that is not going to work. You need to stabilize domestic prices, because this is a larger domestic economy, compared to the external economy.

“That is why we have this monetary policy regime.”

Currency Competition

Some nations got over the problem of bad central banks with a policy rate, and restored domestic stability by using more than one currency, one of the latest being Cambodia in East Asia (US dollars and the Riel without monetary policy).

Dollarization usually happens when people have no confidence in the central bank’s notes and the agency loses the ability to enforce legal tender laws, with politicians no longer willing to protect its money monopoly by punishing the public for transacting in a foreign currency.

Cambodia has become progressively more externally oriented in the low 3 percent inflation coming from the fully fixed exchange rate (dollars) over the past two decades.

Since the Riel collapsed in 1999 leading to market dollarization, Cambodia’s exports have climbed from very low levels to 34 billion US dollars, according to IMF data, or 77 percent of GDP as foreign investment also came with the stability coming from the fixed exchange rate.  

In 2023, the country of 16 million people welcomed 5 million tourists.

Sri Lanka’s Port City area is also expected to have absolutely fixed exchange rates with currency competition and is expected to easily trade with the rest of the world.

Dollarization is also happening in other ways with renewable energy firms also asking for and getting dollar denominated tariffs.
(Colombo/May25/2024)

However, the COVID-19 pandemic in 2020 and an unprecedented economic crisis in 2022 shattered his dreams. Once an aspiring entrepreneur, he became a bank defaulter.

Facing hyperinflation, an unbearable cost of living, and his family’s daily struggles, Sanath sought greener pastures again—this time in the United Arab Emirates (UAE).

“I had to pay 900,000 rupees ($3,000) to secure a driving job here,” Sanath (45), a father of two, told EconomyNext while having a cup of tea and a parotta for dinner near Khalifa University in Abu Dhabi.

Working for a reputed taxi company in the UAE, Sanath’s modest meal cost only 3 UAE dirhams (243 Sri Lankan rupees). Despite a monthly salary of around 3,000 dirhams, he limits his spending to save as much as possible.

Sanath has been in Abu Dhabi for 13 months but had to wait six months before driving a taxi and receiving no salary.

TOUGH REALITIES

“I had to get my UAE driving license. I failed the first trial, and the company paid 6,500 dirhams on my behalf, agreeing to deduct 500 dirhams monthly from my salary,” he explained.

“So far, I have repaid only 3,000 dirhams.”

To raise the 900,000 rupees for the job, Sanath borrowed money from friends and pawned jewelry.

“I don’t know if I was cheated by the agent, but I must repay that money and also send money for my family’s expenses,” he said, glancing at a photograph of his family in a Colombo suburb.

Working night shifts in busy Abu Dhabi, Sanath said, “If I can secure 9,000 dirhams monthly through taxi driving, I will earn 3,000 dirhams in the month after deductions for the license fee and any traffic fines.”

Sanath came to Abu Dhabi with seven other Sri Lankan men through an employment agency in the Northwestern town of Kurunegala.

“Only two of us have withstood the tough traffic rules and payment deductions for offenses,” he said. Some of his colleagues are still job-hunting, while others have returned to Sri Lanka.

Sanath is one of around 700,000 Sri Lankans who have left the island in the last two years due to the economic crisis that forced the country to adopt difficult fiscal and monetary policies, including higher taxes and costly borrowing, exacerbating the cost of living.

FOREIGN EXCHANGE EARNERS

From January 2022 to the end of March 2024, at least 683,118 Sri Lankans migrated for foreign employment through legal channels, according to the Sri Lanka Foreign Employment Bureau.

They have sent $11.31 billion in remittances through official banking channels during the same period, central bank data shows.

Many Sri Lankans leave on visit visas, hoping to find jobs later, often guided by friends already working abroad. The economic crisis has pushed them to seek better opportunities abroad, despite the risks.

Sri Lankan authorities struggle to stop such risk-takers, who sometimes resort to illegal migration, despite warnings about human trafficking.

In Myanmar, 56 Sri Lankans caught in an IT job scam were detained earlier this year, and the government is still repatriating them.

At least 16 retired Sri Lankan military personnel have been killed in the Russia-Ukraine war after being misled by unscrupulous recruiters. Officials estimate that over 400 retired military officers may have left for similar reasons.

DISPERATE TO LEAVE

In March, Foreign Minister Ali Sabry warned against visiting any nation on open visas, urging Sri Lankans to emigrate only through registered agencies.

Despite the risks, many Sri Lankans are desperate to leave.

Abu Salim, a 32-year-old former rugby player, came to Dubai on a visit visa hoping for a banking job, which he never got.

Now freelancing in an insurance firm, he said, “I survive, and my relatives don’t see my struggle. It’s stressful, but still better than Sri Lanka right now.”

Suneth, a former top garment merchandiser, is also job-hunting in Sharjah after quitting his initial job in Sharjah.

“My worry is the visa. I must find a new job before it expires,” he said.

Many Sri Lankans in the UAE work multiple jobs, compromising their sleep and health to make ends meet. (Abu Dhabi/May 24/2024)

With India being the top source of tourists to the county, the tie up will strengthen bilateral relations co-operation, Central Bank Governor Nandala Weerasinghe said.

Enhancing cross border payments was a priority among policymakers, and in Sri Lanka the central bank was also supporting cashless payments, he said.

PhonePe, which uses India’s Unified Payment Interface will now allow Indian tourists visiting the country to pay at large network of merchants which use the LankaQR system of LankaPay.

“This partnership is bound to provide greater convenience to Indian Tourists and Business Travelers in making seamless UPI payments at all LankaQR merchant points in Sri Lanka via PhonePe app,” LankaPay Chief Excutive Chanda de Silva said.

“We are excited about the potential of this collaboration that would enhance payment experience to Indian tourists and business travellers during their stay in Sri Lanka and also provide the merchants with a cost-effective proposition to card payments.”

India has seen a surge in online transactions especially through mobile phones, India’s High Commissioner in Colombo Santosh Jha said.

In 2008, India was the world’s most unbanked which banking penetration of less than 20 percent, High Commissioner Jha said.

In the last decade banking penetration had shot up to over 80 percent. In 2016 India mostly used cash, and now has the highest volume of digital payments globally.

“The digital transformation of India has been driven by the interoperable and open protocols such as the UPI,” he said.

He said the need to pay taxes and government benefits to the citizens gave birth to India’s digital identify number and the unique identity authority.

Governor Weerasinghe said Sri Lanka’s digital payments were also growing but not at the pace of India.

Sri Lanka however has had a banking system spread out around the country, and a unique identity card with a number – which can be presented at the user’s own volition – for decades.

People receiving government subsidies in Sri Lanka not only had bank accounts but also a savings component in their own banking system, and they could also get a loan if they needed from the inception of the program, observers point out.

A new scheme subsidy schemed launched last year required all recipients to have accounts in the larger system and only about 156,000 did not already have accounts in the designated banks.

Central Bank data shows that Sri Lanka which has a population of about 20 million already had about 20 million debit cards, with some having cards from multiple banks.

There have been claims that Sri Lanka is ‘overbanked’ and needs ‘consolidation’.

(Colombo/May16/2024)

“When we look at foreign incomes and payments due in the future I do not see the exchange rate will move up and down a lot,” Governor Weerasinghe told reporters Tuesday, speaking in Sinhalese.

“Even if there is volatility, our policy to allow the market to work, and if there too much volatility we have the ability to intervene.”

The central bank now had 5.4 billion US dollars to intervene but the central bank allows the market to determine the rates based on requirements, he said.

Related Sri Lanka gross foreign reserves rise to 3.5 year high in April

“I do not think there will be huge volatility, based on the data that is available at the moment,” Governor Weerasinghe said.

Sri Lanka is expecting to conclude debt restructuring which will also lead to a resumption of new aid, he said. The re-structure leads to grace periods, and lower coupons, which will have to be serviced.

Last year Sri Lanka had repaid 2.5 billion US dollars of debt to parties including multilateral lenders, he said.

The central bank has allowed the rupee to appreciate to around 300 to the US dollar so far from 370 in March 2022 after ending an surrender rule where banks were compelled to sell dollars to it for new money.

The central bank has also sold down its Treasury bills against the rupee injected by dollar purchases, triggering balance of payments surplus, amid muted private credit, profits in state enterprise and better budget deficits. (Colombo/May07/2024)

Deflationary policy (net sell downs of central bank-held domestic securities) at a market-appropriate interest rate allows a balance of payments surplus to develop.

The rupee sharply appreciated in March and early April, leading to importer bill delays and heavy reserve collections.

Some pressure came in the latter half of the month largely due to oversold position and the central bank used moral suasion and some dollar sales to keep the exchange rate stable.

Sri Lanka’s private credit is still weak, allowing reserves to be collected and the external sector to be kept stable easily.

The gross reserves also includes fiscal balances from loans. The central bank also has 3.2 billion US dollars in swaps outstanding, which exposes the monetary authority to exchange rate risk and large losses when rates are cut with inflationary open market operations (flexible inflation targeting).

However the central bank is steadily settling other loans, including to the IMF and India, which is improving the net foreign assets position of the monetary authority and net international reserve position overall.

Though China has given a swap, the People’s Bank of China put a rule saying it cannot be used if reserves fell below three months of imports, protecting Sri Lanka from further losses and the effective refinancing of private sector imports at the expense of negative reserves of the monetary authority and exposing the agency to forex losses.

Sri Lanka’s net international reserves improved radically to only a negative 404 million US dollars by end December 2023 from minus 3,229 million dollars in 2022, sharply over-performing the IMF target of a negative 1,592 million dollars, by not cutting rates hastily and boosting confidence.

Despite reserves collections, despite higher real rates, the economy has started to recover strongly amid currency and monetary stability. Steep short term appreciations are also not a sign of stability, analysts say.

Since the end of the war Sri Lanka’s monetary system had tended to unravel as soon as private credit recovered, as rates were cut with inflationary policy (reverse repo injections/standing facilities), leading to missed IMF reserve targets and currency depreciation.

Amid flexible inflation targeting (targeting high levels of inflation without a clean floating rate amid reserve targets), potential output targeting (printing money for growth), Sri Lanka ran into currency crises and output collapses.

Budgets and debt deteriorated after each stabilization episode after flexible inflation targeting/potential output targeting.

Eventually growth fell to levels seen in war time, amid back-to-back IMF programs (based on the same monetary doctrine), and the country defaulted.

At the moment the central bank is providing monetary stability, and interest rates are slightly higher than required to keep the external sector in balance (leading to reserve accumulation) and growth is recovering due to monetary stability provided.

However, allowing steep short term currency appreciation made possible by policy also leads to speculative behaviour (importer cover delays, negative NOPs) as the future value of money is in doubt, analysts say.

Sri Lanka’s external sector has tended to unravel post-war as soon as rates are cut with inflationary policy (reverse repo injections/non-penalty rate standing facilities) as credit demand recovers from the previous currency crisis.

In the past, May has been a month that led to currency pressure after April excess liquidity. (Colombo/May07/2024)

The Fed would continue to sell down mortgage backed securities against liquidity in the banking system by 35 billion dollar a month.

The Federal Reserve targets both inflation and jobs, (indirectly economic activity), but generally ignores money supply developments under Jerome Powell.

Under Powell, where inflation rose to 40-year highs, as projected by classical economists, the concept of ‘excess’ liquidity has also been removed.

“Recent indicators suggest that economic activity has continued to expand at a solid pace,” the Fed said in a statement.

“Job gains have remained strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated.

“In recent months, there has been a lack of further progress toward the Committee’s 2 percent inflation objective.”

The move came as some classical economists warned that inflation would fall and the economy would move into a recession based on money supply developments and past trends.

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Broad money, measured by the Fed itself is shrinking in absolute term, a phenomenon that has been rarely seen in the US. However the Powell Fed no longer watches money supply.

There are increasing reports of US consumer slowdown especially in restaurant sales, which have been generally attributed to inflation. This includes lower end chains like McDonalds.
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Meanwhile US bond yields have also edged up, and some banks are seen to be placing liquidity in the Fed’s standing facility, even as repo volumes come down (cash placed by banks in the Fed against securities).

The Fed created the Great Depression after inventing the policy rate by stealth in the mid 1920, without broader discussion or Congressional approval.

The Fed also printed money in the 1960s for various objectives by inflationary rate cuts driving up consumer prices across the globe, and eventually busted both the both the Bretton Woods system and what remained of the gold standard after the policy rate, critics say.

Sri Lanka’s first trips to the IMF also began as the island failed to follow Fed rate hikes in step and instead printed money (quantity easing) for rural credit re-finance and to sterilize interventions.

Since 1978 in particular, Sri Lanka has tried to run monetary policy without a credible anchor or with conflicting dual anchors.

The full statement is reproduced below

Federal Reserve issues FOMC statement

Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have remained strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated. In recent months, there has been a lack of further progress toward the Committee’s 2 percent inflation objective.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. The Committee judges that the risks to achieving its employment and inflation goals have moved toward better balance over the past year. The economic outlook is uncertain, and the Committee remains highly attentive to inflation risks.

In support of its goals, the Committee decided to maintain the target range for the federal funds rate at 5-1/4 to 5-1/2 percent. In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks.

The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage‑backed securities. Beginning in June, the Committee will slow the pace of decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $60 billion to $25 billion. The Committee will maintain the monthly redemption cap on agency debt and agency mortgage‑backed securities at $35 billion and will reinvest any principal payments in excess of this cap into Treasury securities. The Committee is strongly committed to returning inflation to its 2 percent objective.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals. The Committee’s assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Thomas I. Barkin; Michael S. Barr; Raphael W. Bostic; Michelle W. Bowman; Lisa D. Cook; Mary C. Daly; Philip N. Jefferson; Adriana D. Kugler; Loretta J. Mester; and Christopher J. Waller.

The CCPI Index fell 0.8 percent, to 195.2 points in the month of April after falling 1.9 percent in March.

Sri Lanka’s central bank has been operating largely deflationary policy, since September 2022, except perhaps in December 2023, and also allowed the rupee to appreciate in the balance of payments surplus it created.

Since September 2022, when deflationary policy started to show up in the balance of payments, the index has grown only 3.1 percent over the past 19 months.

The food price index fell 4.6 percent over the past 19 months. (Colombo/Apr30/2024)

The financial account was 1.3 billion dollars in deficit in 2023, subject to errors and omissions of 318 million dollars.

Sri Lanka defaulted on official credit in April 2022 after money printed to keep an artificially low policy rate depleted forex reserves, but the country had to repay multilateral lenders and banks and to repay counterparties.

Though rates were hiked in April 2022, the Reserve Bank of India gave credits to the central bank, leading to more money printing to offset interventions, delaying a correction in the external accounts.

Heavy Outflows

The balance of payments turned positive only in the third quarter of 2022 and monetary stability was restored. A positive overall balance of payments also denotes outflows through the central bank.

According to balance of payments data released by the central bank, other banks (deposit taking corporations) had repaid 1.8 billion dollars to counterparties in 2023 as they were unable to roll-over credit lines, though there was a halt to official payments.

Later banks also built-up foreign deposits (in NOSTRO accounts and elsewhere) when Sri Lanka Development Bonds were repaid in rupees, by curtailing domestic credit.

The central bank also built-up reserves and repaid some loans to Bangladesh and the International Monetary Fund in 2023, after monetary stability was restored.

When outward payments are matched by changes to domestic investments and the financial account is negative, the current account turns positive automatically as long as the central bank does not engage in inflationary open market operations to drive up credit and imports.

However, if money is printed including through outright purchases or term reverse repo operations and they are loaned by banks for domestic investments, forex shortages emerge and no repayments can be made.

Since the rate correction in April 2022, Sri Lanka has repaid debt or collected reserves of about 5 billion dollars based on central bank data.

Related Sri Lanka repays debt or collects reserves of U$5bn via banking system since rate correction

Neo-Mercantilism

Keynesians however believe it is something to do with the external current account, in a regression to classical mercantilism and is not related to inflationism.

The problem figured in discussions between classical economists and Keynes in the 1920 as the Fed’s policy rate infected other countries and the ‘age of inflation’ (and the age of balance of payments deficits) began to emerge.

Classical economists pointed out that Germany was unable to make external repayments (reparations) after World War II because the Reichsbank printed money and created forex shortages while also borrowing abroad driving imports and there was no sudden surge in exports required as claimed by Keynese.

All the German government had to do was to raise money domestically (by taxing or borrowings) to make external payments, which was called the ‘budgetary problem’.

While Keynes agreed that the ‘budgetary problem’ could be solved he was unable to grasp how note issue banks worked and insisted that there was a ‘transfer problem’, which required an export surplus.

Economists including Bertil Ohlin and Jacques Rueff pointed out that there was no “transfer problem” but it was a crisis linked to inflationism of the central bank.

Austrian economic doctrine which helped create the Deutsche Mark and German Economic Miracle after World War II.

German liberal politicians including Ludwig Erhard, closed the inflationist Reichsbank and kept tight hold of money, while the war-winning UK was mired in Sterling crises due to Keynesianism and the policy rate and ended up with 11 IMF programs.

Spread of Inflationist Policy Rate

By the inflationist doctrines were widely taught in UK and US universities, backed up by various mathematical formulae, rejecting economic principles, ultimately leading to the collapse of the US dollar in 1971 and the Great Inflation that followed.

In the 1970s, the Bank of England was the top borrower from the IMF and a top user of central bank swaps, which were also invented by the Fed.

The UK ended exchange controls only after Margarat Thatcher became Prime Minister, who was advised by Austrian economist Friedrich Hayek, among others.

The inflationist beliefs also formed the foundation of the Bretton Woods and the International Monetary Fund, where capital controls were taken as a given.

There was a belief that reserves could be ‘loaned’ to countries with bad central banks which mis-targeted rates to boost growth or for any other purpose such as sterilizing interventions.

However, Sri Lanka’s central bank has maintained monetary stability and also allowed the exchange rate to appreciate giving tangible benefits to the people over 2023 and so far in 2024, even as large external payments were made.

Maintaining exchange rate (and balance of payments) stability, which involves sequencing external payments to domestic investments through a market driven interest rate is a simple matter as long as politicians are willing to bring laws against macro-economists to curtail ‘macro-economic policy’, analysts say.

After debt is restructured in Sri Lanka in 2024, foreign inflows to the government resumes, the financial account could turn positive and the current account into deficit, analysts say.

Estimates of current and financial (and capital account) are approximated totals, subject to errors and omissions, but the balance of payments surplus or deficit, which is linked to developments in the central bank’s balance sheet, is verifiable data. (Colombo/Apri24/2024)

“The rupee strengthen now,” President Wickremesinghe told a member of the public who said fertilizer prices were high, while he was inspecting Sri Lanka’s Pekoe Trail on a tea estate in Pussellawa.

“We will take it to 270. Then you can buy more for the rupee.”

Sri Lanka’s central bank can appreciate the rupee by operating deflationary monetary policy (selling down its securities portfolio to mop up liquidity) and buying dollars at slightly stronger rate through its ad hoc peg (exchange rate policy).

However, over the past few days excess liquidity has started to build up in money markets, which a large portion coming from inflationary operations (term and reverse repo operations).

On Tuesday net excess liquidity was 138 billion rupees, with banks borrowing 19.35 billion rupees from overnight reverse repo auction, 4.85 billion from a standing facility, and another 115 billion rupees through term facilities.

When the excess liquidity is turned into credit, rupee demand can rise.

Analysts have urged the central bank to allow some excess liquidity to remain from dollar purchases and refrain injecting money through domestic operations to over-trading banks to run a more consistent regime.

Sri Lanka’s central bank has busted the rupee from 4.70 to the US dollar since it was created by mis-targeting rates with domestic operations for rural credit, sterilizing interventions after credit picked up or through deliberate inflationary open market operations to print money for growth (macro-economic policy).

Rupee depreciation accelerated after 1978 in Sri Lanka after the country abandoned external anchoring coinciding with the IMF second amendment to its articles and operated a monetary regime without a credible anchor or anchor conflicts. The now familiar Latin America defaults started a few years later.

Sri Lanka’s rupee collapsed from around 130 to 370 levels with potential output targeting (printing money for growth) coming into play from around 2015 and eventually defaulted in 2022.

Sri Lanka’s macro-economists has persuaded president Ranil Wickremesinghe to allow them to create up to 7 percent inflation (a domestic anchor) under a new monetary law which allows implicit printing of money for growth.

Analysts have warned that Sri Lanka does not have a consistent single anchor monetary regime and flexible inflation targeting where the island ran into three currency crises with inflation under 5 percent is yet another deeply flawed operational framework.

However, over the last year the central bank has allowed the exchange rate to appreciate (a strengthening de facto external anchor) and 12-month inflation fell to just 0.9 percent in March as the external anchor overrode the domestic anchor, analysts say.

Before the 1970s parliaments around the world exercised substantial control on central bank operations blocking the ability of economic bureaucrats and other inflationists to expand money supply at will or depreciate currencies.

Before the ‘age of inflation’ and the Fed’s invention of the policy rate in the 1920s parliaments exercised full control over the value money through strict laws including outside the governing law of the central bank (the Bank Charter Act in the UK).

Before the ‘age of inflation’ and the rise of so-called spurious monetary doctrines in the 1920s, depreciation was not allowed in the UK after money was printed except with express permission of the parliament and cabinet, through a Bank Restrictions Act.

The current fashion is to claim that exchange rates are ‘market determined’, critics say, paving the way for to denying the key attributes of money as a store of value and a reliable denominator for future payments to the general public.

Related Sri Lanka rupee expected to reach 280 to US dollar by June: President

Sri Lanka’s central bank bought 700 million dollars from forex markets in March as the rupee appreciated.

Banking sources say there is a build up of delayed importer payments after President Wickremesinghe said last month that the rupee would go to 280 to the US dollar by June. Banks also tend to operate negative open positions when the currency appreciates.

The central bank itself however has not made any such claim with Governor Nandalal Weerasinghe only saying that the exchange rate will no longer be a one way bet.
(Colombo/Apr17/2024)

“When we looked at the last two monetary policy reviews… we had an inflation path a little elevated to what was realized, ” he told reporters following a March 50 basis point rate cut.

“Mainly because our projection factored in the VAT increase in January and some of the short-term food price increases, we have seen in December and January.

But what we have seen the actual inflation realization, is that the impact of VAT has not been that much and also the reduction in electricity prices also has helped, as well as the supply conditions, especially food supplies has been better.

“As a result, inflation outcome has been much lower than we expected.”

Sri Lanka’s central bank has been conducting broadly deflationary policy, except perhaps in December 2024, when a private credit spike appears to have been accommodated by standing facilities on top a seasonal real demand for cash.

The central bank has also allowed the currency to re-appreciate departing inflationist policy generally seen since 1978, analysts say.

“In our projections, we see in the next 12 to 18 months, inflation will remain well below our target range between 4-6. In our expectation it will remain around 4-5 percent in the next 12 to 18 months.

“That is one of the reasons we saw we had some pace to reduce our policy rate.”

The central bank cut its policy corridor 50 basis points to 8.50 and 9.50 percent, and has allowed excess liquidity to build up in money markets from a balance of payments deficit (net dollar purchases) at the current market interest rate structure.

Though money is being injected through various tools allowing some banks to trade without deposits, overall, there is a sell down of its domestic securities holdings.

Sri Lanka has a reserve collecting central bank currently subject to IMF forex reserve targets and domestic asset sell down target (which are essentially complementary), an inflation target of up to 7 percent and an implicit potential output (printing money for growth) target.

The central bank currently providing exceptionally monetary stability not for many years, and cautiously lowering rates, as well as reversing some of the inflation it has created in the past in food prices and energy.

Since September 2022, when deflationary policy started to show up in the balance of payments, the central bank has only created 3.9 percent inflation according to the widely watched Colombo Consumer Price Index.

However, analysts have warned that in the past, deeply flawed operational frameworks involving multiple and contradictory anchors have tended to trip up when private credit recovered when rates are cut claiming inflation is low.

Sri Lanka also does not have a penalty rate for standing facilities, unlike countries with tighter operational frameworks, which are less prone to crises. (Colombo/Apr14/2024)

Sri Lanka has high import duties, and so-called para-tariffs such as the port and airport levey, and ‘export development’ CESS which has pushed up cost of imported raw materials, making it impossible for any firm other than those in Board of Investment zones, which can import inputs tax free, to be export competitive.

“The tax structure to support exports and investment is also being facilitated, particularly with the phasing out of para-tariffs such as PAL and Cess which have in the past added to cost of raw materials and intermediate inputs which undermined Sri Lanka’s competitiveness,” Siriwardana was quoted as saying at presentation at the Finance Ministry on April 08.

“Para-tariffs also contributed to an overall macroeconomic framework that led to an anti-export bias in the economy since they channelled scarce resources into sectors where Sri Lanka has not been globally competitive.”

“The reforms to the tariff structure to support an export-oriented economy will be encapsulated in the National Tariff Policy which is being developed and is expected to be approved by cabinet in the near term.”

So-called para tariffs are to be phased out in stages.

Analysts say import duties ensure that there is no spontaneous export diversification in the country as in East Asia as domestic firms outside of BOI zones never has a hope of being export competitive.

Therefore, firms cannot build up links with foreign buyers or learn about catering to actual customer needs facing real competition.

As a result, domestic producers learn to lobby politicians for import protection in a bid to trap consumers within the country using the coercive power of the state to force them purchase their products.

Increasingly concerns have been raised about building material import taxes, which is driving up construction costs and making factory buildings, hotels and also office space too expensive, also hurting services exports.

It is not known whether excessive housing costs are contributing to a brain drain, but studies have already shown that a house is unaffordable for most wage earners in Sri Lanka due to building material taxes.

When late entrants to the East Asia export boom like Vietnam liberalized trade and gave up import substitution, there were no nationalist private enterprises to block trade liberalization, analysts who have studied the country say.

Most Vietnamese large domestic firms (except for privatized state enterprises like Vinamilk), were set up from the early 1990s, after substantial monetary stability was also provided through 1989 central bank reforms.

Farming liberalization and abandoning self-sufficiency has also ended childhood malnutrition and younger Vietnamese were on average 3.7 percent taller than generation that was boren in self-sufficiency and monetary instability data in 2019 showed.

In Sri Lanka import taxes and controls on maize has made poultry, milk, eggs in general more expensive.

Countries like Singapore also abandoned import substitution in a single day after separation from Malaysia, as monetary stability was also guaranteed with as currency board.

Analysts have warned that the so-called export development CESS which is applied to bulk exports of domestic raw material may have discouraged rubber production in the country during its application. (Colombo/Apr13/2024)

Gross official reserves went up by 431 million US dollars in March as debt was repaid from domestic savings.

A central bank is able to collect reserves when domestic credit is moderated by an appropriate interest rate (reducing domestic investments), and the rupees created by dollar purchases are mopped up by central bank securities sales to commercial banks.

The action constitutes a raising of ‘deposits’ by the central bank (a note-issue bank) from the domestic economy and lending it to the US or other reserve currency nations to finance their deficits.

The sale of central bank held securities to banks to mop up dollar generated liquidity is similar to the issue of ‘passbook’ or a fixed deposit certificate to customers of a commercial bank, the sale of a central bank security by an East Asian central bank or the issue of certificate of deposit by a currency-board-like GCC central bank in the recent past.

The commercial banks then end up holding the security and cannot give loans to customers for investment or other credits, leading to a balance of payments surplus.

The central bank had also allowed the exchange rate to appreciate from around 320 to about 298 amid deflationary policy, offsetting recent rises in tax and oil prices in the inflation index and costs of companies.

When the exchange rate appreciates importers have a tendency to cover their bills late.

Meanwhile exporters are under forced sale requirements, which they have protested.

As the currency appreciates, commercial banks also tend to cut their net open forex positions and run negative NOPs, to prevent losses, leading to further sales of dollars.

Sri Lanka operates a so-called flexible exchange rate, an ad hoc pegging arrangement to collect reserves which is neither a consistent hard peg nor a consistent float, which can lead to large swings in the exchange rate in a credit spike, if dollar sales are not made.

Due to its policy rate and narrow policy corridor, the exchange rate has also collapsed in the past, when interest rates are mis-targeted with inflationary open market operations or outright purchase of bonds to target the yield curve.
Analysts have warned that the required market interest rate is determined by domestic credit made up of the private credit demand, budget deficit, SOE credit and the IMF’s reserve target which is essentially a reserve currency country deficit and not the inflation.

Analysts have warned that ‘flexible’ inflation targeting without a clean float is a fundamentally flawed operational framework, as are ‘flexible’ exchange rates, though stability can be maintained as long as private credit is weak and no attempt is made to target potential output.

Mis-targeting has gained momentum in February of the year in past currency crises, with the combined liquidity releases of provisional advances and central bank profits transfers driving up credit, and sometimes in May when April liquidity injections provide room for excess credit by banks, analysts say. (Colombo/Apr11/2024)

Gross official reserves include both monetary and fiscal reserves of the government, that usually come from loans and grants.

Through gross official reserves are listed as 4.9 billion dollars by March, data shows that by February, the central bank’s net foreign exchange position was a negative 2.2 billion US dollars due to its borrowing.

The central bank bought over 400 million dollars in January and February and also allowed the exchange rate to appreciate amid deflationary policy.

However due to settling official liabilities, reserve numbers did not go up.

The central bank had loans to India, the IMF and it had 3.2 billion dollars in swaps by February 2024, and they are being progressively being settled with reserves collected from deflationary policy or mopping up dollars bought outright from current transactions.

By engaging in swaps with domestic counterparties, the central bank can effectively print money, mis-target rates if the generated rupees are not mopped up, and leave the monetary accounts saddled with a debt in case the money is used for ‘reserves for imports’.

Under a fixed policy rate, using reserves for imports or unwinding of swaps leads to fresh printing of money to mis-target rates, when private credit has picked up, worsening currency crises, analysts say.

However monetary policy so far had been deflationary overall, allowing the balance of payments to be in surplus.

However analysts had warned that under flexible inflation targeting, when rates are cut claiming inflation is low, with the help of inflationary policy (standing lending window or reverse repo operations), when private credit picks up, the balance of payments turns into a deficit and the rupee comes under pressure.

Inflation stops after private credit falls ad monetary stability is restored following rate hikes to end mis-targeting of rates with inflationary policy, and shows up in the price index (which measures 12-month changes) about 12 to 18 months later.

In order to repay debt or collect reserves domestic investments have to be curbed at an appropriate interest rates unrelated to the inflation index. (Colombo/Apr07/2024)

The central bank bought 245.3 million US dollars from banks in January 2024 and 248.5 million in February with only 9 million dollars in sales, data show.

The central bank is operating deflationary monetary policy, mopping up inflows from dollar purchases at an appropriate market interest rate that reduces domestic credit and investments and allows dollars to be collected for external payments.

Despite the 484.8 million dollars being bought over two months, gross official reserves only went up 29 million US dollars from 4,491 million dollars in December to 4,520 million dollars in February.

Gross official reserves also include fiscal balances of the Treasury, which may rise when IMF or other budget support loans are given and fall when loans are repaid.

“There are certain debt service payments,” Governor Weerasinghe explained to reporters earlier this month.

“The government is continuously servicing ADB, World Bank loans as well as the central bank servicing its ACU liabilities.”

Any debt service payments outside an identified perimeter are also going through, which led to a small increase in gross reserves, he said.

Some emergency loans taken after a default was declared are expected to be serviced.

Though the central bank repaying its loans to India and the International Monetary Fund does not increase gross reserves, the payment improves the agency’s net reserve position as dollar liabilities are paid down.

The central bank’s net foreign assets position which was about 4.4 billion US dollars negative in August 2022 was reduced to about a 2.2 billion dollars by February 2024.

Central bank data shows that it had repaid 179 million US dollars to the International Monetary Fund on loans taken during an earlier bailout over 2023, and 350 million dollars in swaps.

Related Sri Lanka repays debt or collects reserves of U$5bn via banking system since rate correction

Commercial Banks have also repaid credit lines or collected dollars over the past year. Central Bank data shows that banks have settled about 1,808 million dollars over the past year. (Colombo/Apr02/2024)

Sri Lanka’s central bank is operating a de facto pegged exchange rate where the agency’s domestic assets are being reduced against dollar purchases (reversing ‘money printing’), triggering a balance of payments surplus, allowing the exchange rate to be appreciated if the agency wishes, analysts have shown.

RELATED: Why is Sri Lanka’s rupee appreciating?

There is however a widespread belief that suspending debt repayments have helped appreciate the rupee, though the financial account turned into a deficit in the last quarter of 2022, just as monetary stability was restored allowing out payments to be made and reserves to be collected.

In the five quarters ending in December 2023, the external financial account was 1.35 billion dollars in deficit, before adjusting for errors and omissions, from an earlier surplus, official data show.

Currency depreciation helps widen exporter margins in countries with monetary instability as there is a delay in wages catching up, triggering social unrest and outmigration and – if energy and water tariffs are not raised regularly – through losses in state utilities.

But if wages are raised and any domestically purchased inputs, including items like domestic transport, do not immediately fall with rupee appreciation, exporter margins may be squeezed.

Sri Lanka electricity prices were cut this year and interest rates are falling.

The central bank had allowed the rupee to appreciate from 360 to the US dollar to 300 now, after a surrender rule imposed on commercial banks to force-sell dollars to the central bank against new rupees while taking dollars out of the interbank forex market, was lifted in March 2023.

However, a surrender rule imposed on exporters to sell to banks by the central bank (which does not create new rupees nor take money away dollars from the forex market), remains in place, constraining the ability to delay or sell dollars as they wish at the best price.

The Exporters Association of Sri Lanka, Joint Apparel Association Forum of Sri Lanka, the National Chamber of Exporters, Tea Exporters Association, Sri Lanka Association of Manufacturers and Exporters of Rubber Products say the rupee appreciation is harming them.

Tea exporters who buy at an auction in rupees, are also squeezed, if the exchange rate changes between the time materials are bought and tea is blended and packaged and finally shipped, unless all dollars are sold forward, analysts say.

The central bank had earlier denied a request to conduct tea auctions in US dollars, using a money monopoly given to economic bureaucrats by legislators.

The central bank had also blocked the exporters’ dollars from being moved from bank to bank.

“Today, we stand united in urging the authorities to address the pressing challenges posed by the appreciation of the Sri Lankan Rupee (LKR) against the US Dollar (USD), further compounded by restrictions on the movement of foreign currency between commercial banks, and the mandatory conversion of export earnings into Sri Lankan Rupees,” the exporter associations said.

The association said the exchange rate, which peaked at over 364 per USD in May 2022, led to increased operational costs, compelling them to adjust their cost base in line with higher inflation experienced in the country.  

“The rapid appreciation of the Rupee, with rates falling below Rs. 300 per USD since March 19th, has placed us in a precarious position, threatening the sustainability of our businesses and the livelihoods of those we employ,” the statement said.

“Despite the appreciation of the Rupee, the cost of living remains high, continuing to level pressure on worker wages.”

The exporters did not say by which percentage wages were raised, but analysts say progressive income taxes imposed by the International Monetary Fund as part of ‘revenue based fiscal consolidation’ where government cost-cutting is abandoned, also force exporters to raise salaries beyond rupee depreciation to maintain staff living standards.

“It is crucial to recognize that the landscape of our foreign exchange reserves has significantly transformed and the continued enforcement of the mandatory conversion policy, considering the current positive reserves, is counterproductive,” the exporters said.

“Persisting with this approach has placed exporters at a market disadvantage and forced them to operate on an unleveled playing field, eroding their competitiveness.

“It further acts as and is viewed as an anti-export policy measure.”

Sri Lanka’s rupee, as well as most other unstable countries, started to depreciate their currencies from 1978 in particular, after the Second Amendment to the IMF’s articles, generating high levels of inflation and social unrest while the best performing East Asian export powerhouses either ran actual currency boards or mostly fixed exchange rates (which some classical economists call exchange rate fixity) providing domestic stability through external anchoring of money.

The full statement is reproduced below:

Urgent Appeal from Sri Lankan Exporters on Rupee Appreciation and Policy Concerns

As a collective body of exporters, we have been at the forefront of sustaining employment and ensuring a steady flow of foreign exchange, even amidst the most severe economic downturns faced by our nation. Our membership covers the majority of merchandise exports, which account for some 13% of Sri Lanka’s GDP. Today, we stand united in urging the authorities to address the pressing challenges posed by the appreciation of the Sri Lankan Rupee (LKR) against the US Dollar (USD), further compounded by restrictions on the movement of foreign currency between commercial banks, and the mandatory conversion of export earnings into Sri Lankan Rupees.

Impact of Rupee Appreciation

The appreciating Rupee has had a multifaceted negative impact on our business.  A stronger Rupee means our goods become more expensive for international buyers, directly affecting our competitiveness in the global market. The exchange rate peaked at over Rs. 364 per USD in May 2022, which led to increased operational costs, compelling us to adjust our cost base in line with higher inflation experienced in the country.  

The rapid appreciation of the Rupee, with rates falling below Rs. 300 per USD since March 19th, has placed us in a precarious position, threatening the sustainability of our businesses and the livelihoods of those we employ. Despite the appreciation of the Rupee, the cost of living remains high, continuing to level pressure on worker wages.

The timing of the Rupee’s appreciation coincides with weak global demand for the majority of our merchandise exports and severe competition from competing countries.  Factors such as global inflation and geopolitical tensions have continued to affect sentiment and purchasing power in the primary markets of our merchandise exports.

Background to the appreciation of the Sri Lankan Rupee

The painful economic stabilization process implemented with significant monetary and fiscal policy measures by way of policy rate, inflation, and tax adjustments; import controls; and debt service suspension, has had the desired impact to constrain economic activity and, in turn, adjust and constrain import demand. At the same time the collective efforts of the Government, export community, tourism industry and remittances have continued to have a positive inflow and enhance foreign reserve positions to more comfortable levels.  

This is in the backdrop of the extraordinary circumstances when the debt servicing by the country remains at a standstill, which is a temporary situation.    

During the height of the crisis, the Central Bank of Sri Lanka implemented a policy for exporters, by Gazette No.2251/42, dated October 28, 2021, to mandatorily convert foreign exchange receipts as a temporary measure. This policy enforced the conversion of all repatriated export proceeds into Rupees within a stipulated timeframe, except for specified exempt payments. The exporters do not have the freedom to plan the conversion as per cash flow needs or choice of bank, often forcing conversion at an overvalued exchange rate, and placing further strain on our export operations.  

Revisiting Policies in a Changed Economic Landscape

It is crucial to recognize that the landscape of our foreign exchange reserves has significantly transformed and the continued enforcement of the mandatory conversion policy, considering the current positive reserves, is counterproductive. Persisting with this approach has placed exporters at a market disadvantage and forced them to operate on an unleveled playing field, eroding their competitiveness. It further acts as and is viewed as an anti-export policy measure.  Export-led recovery needs to be prioritized to ensure the inflow of vital export earnings and to encourage investments in the future.

Call for Policy Reevaluation

In light of these considerations, we urgently request the Central Bank to revisit and repeal the aforementioned Gazette, in alignment with the evolving economic context. This appeal is made with a vision towards fostering an environment that not only enables but actively supports the growth and competitiveness of Sri Lanka’s exports. By addressing these policy concerns, we can lay the groundwork for sustainable economic development, secure employment for our citizens, and ensure the continued prosperity of our nation.

We invite the Government of Sri Lanka to join us in taking decisive action towards these ends. Together, we can chart a course towards a brighter, more resilient future for the Sri Lankan export sector and, by extension, our economy at large.

Signed,

Exporters Association of Sri Lanka Joint Apparel Association Forum of Sri Lanka
National Chamber of Exporters Tea Exporters Association
Sri Lanka Association of Manufacturers and Exporters of Rubber Products

Sri Lanka was expected to meet International Monetary Fund debt restructuring requirements in the second quarter for a review to be passed by the lender’s board, he said.

President Ranil Wickremesinghe has said he expected debt re-structuring to be wrapped up by June–July before any elections are conducted.

Discussions with bondholders and commercial creditors are going on, and advisors are engaging he said.

China has also assured that they will work with other creditors and the IMF to support Sri Lanka’s debt restructuring efforts and economic recovery, he said.

Reforms under an IMF program, and credible economic management and decision-making by President Ranil Wickremesinghe, are bearing fruit, he said.

The rupee appreciation is bringing tangible benefits to consumers, Semasinghe said.

Under post-1978 inflationist dogma in particular, collapsing currencies are generally not encouraged to be re-appreciated under IMF programs, though reserves are collected with deflationary monetary policy, analysts say.

Sri Lanka’s central bank has allowed the rupee to appreciate from 360 levels in March 2023 to around 300 currently. (Colombo/Apr01/2024)

In the December 2023 quarter Sri Lanka recorded a current account surplus of 237 million US dollars.

Revised central bank data show that a current account surplus of 687 million US dollars was recorded in the third quarter, 51 million dollars in the second quarter and 584 million dollars in the first quarter.
 
Sri Lanka started to record a current account surplus from the third quarter of 2022, with monetary stability also being restored around the same time and the overall balance of payments also going into surplus with deflationary monetary policy.

The current account surplus is roughly the mirror image of the financial (and capital) accounts, subject to errors and omissions (a balancing item).

The financial account was about 1.3 billion US dollars in deficit in 2024 before errors and omissions.

Sri Lanka has seen outflows through central bank reserve collections, swap repayments, ACU repayments, IMF loan repayments, and also private bank dollar collections and paying down of credit lines.

Unless monetary stability is restored by ending inflationary open market operations it is not possible to repay debt and even for imports, as forex shortages take place.

To make outward payments using current account flows, domestic investment has to be curtailed at an appropriate interest rate.

To collect monetary reserves or repay central bank debt, deflationary monetary policy has to be operated at an appropriate interest rate, otherwise the exchange rate depreciates as attempts are made to collect monetary reserves.

Unlike forex purchases by other agents, including the government, central bank dollar purchases leads to an expansion in reserve money.

Analysts have warned that if the central bank cuts rates with inflationary open market operations claiming that index inflation is low (flexible inflation targeting) as private credit recovers, the country will miss IMF reserve targets and the balance of payments could turn into deficit again, leading to a currency collapses, a default in re-structured debt and eventual higher interest rates.

Related

Sri Lanka interest rates are dictated by the IMF reserve target, not inflation

Sri Lanka debt crisis trapped in spurious Keynesian ‘transfer problem’ and MMT

Inflationary policy is generally described as the ‘transfer problem’ in post 1920s Keynesianism, or the spurious belief that debt repayments require a trade account (now current) surplus driven by a surge in exports and competitiveness (a price effect rather than an incomes effect).

Sri Lanka’s government has seen inflows with the International Monetary Fund and budget support loans from the Asian Development Bank and World Bank, though loans from some bilateral partners have been suspended. (Colombo/Apr01/2024 – Corrected headline 2023)