An Echelon Media Company
Tuesday May 11th, 2021

Sri Lanka and IMF discuss ‘closer engagement’

ECONOMYNEXT – Sri Lanka and the International Monetary Fund had discussed the possibility of "closer engagement" but there has been no formal request for a program of balance of payments support, an official said.

"We discussed the possibility of closer engagement going forward," IMF mission chief to Sri Lanka Todd Schneider said.

"And it is the budget that forces that discussion to take concrete shape."

Finance Minister Ravi Karunanayake had said several times the Sri Lanka was interested in a program with the IMF and he would ‘love to have an enhanced facility‘ but at terms and conditions acceptable to the administration.

Sri Lanka is still paying back a 2.5 billion US dollar bailout following a balance of payments crisis in 2009, generated by central bank accommodation of a budget deficit amid a civil war and fuel subsidies as well as capital flight.

The program derailed by another BOP crisis in 2011 triggered by central bank accommodated credit taken mostly for electricity subsidies amid a drought that hit hydro power output, and a spike in oil prices.

The actions ultimately triggered a cycle of sterilized forex sales to simultaneously defend a peg and print money to defend interest rates also features in all balance of payments crisis. A float is needed to correct this cycle.

Fiscal Profligacy

The key trigger of the current crisis, analysts say, is a state salary hike, which was mostly financed by domestic credit and a rate cut in April despite rising state and private credit, which led to sterilized forex sales and loss of 30 percent of the reserves up to August 2015.

Schneider denies that Sri Lanka is has an ongoing balance of payments crisis because forex reserves are still above three months of imports, but says the Fund is concerned that the BOP has ‘deteriorated’ over the past year.

Because BOP crises in third world countries are triggered by state spending and the suppression of interest rates, IMF programs are designed to address such issues, analysts say. As a member state, IMF advice is available to any country.

The new administration in its manifesto has also outlined its plans, involving investment zones, state enterprise management, and other ‘development economics’ style plans.

The manifesto has also promised to expand freehold land, which can boost economic freedoms of all people especially poor people living in feudal style tenure on ‘state’ land analysts say.

A few ideas about revenue, such as simplifying taxes and the exchange rate and have been bounced around.

Nothing Concrete

However there is nothing yet to pin an IMF program to.

"The nuts and bolts of macro-economic policy is yet to come out and it is the budget that is going to force that discussion," Schneider said.

"In terms of the issues we deal with, macro-financial issues – a lot of which has to do with fiscal and monetary policy – that clarity is not there yet.

"We discussed with them our ideas based on our cross-country experience and our knowledge of Sri Lanka in broad parameters, and ‘These are some possibilities for you to consider’.

"We are here all the time. We hope to have further discussions with them about what policies are going to be in and we are waiting for the budget."

The IMF is recommending a budget deficit of 5.5 percent of gross domestic product for the next year based on Sri Lanka’s recently upwardly revised GDP.

The deficit this year is expected to be around 5.5 to 5.7 percent of the newly bloated GDP compared to the 4.4 percent promised in the budget on the smaller value in January.

Economic Bazooka

The budget deficit is a starting point of an IMF program. Once the foreign financing component is programmed the pressure the domestic credit system can be identified.

After the non-bank financing the balance has to be financed from the banking system.

Balance of payments trouble and inflation comes from the net cash deficit that is financed by the banking system and accommodated by the Central Bank by Treasury bill purchase (central bank credit). The crisis will continue until the lid can be put on that economic bazooka.

Older IMF programs with Sri Lanka had a performance criteria to bring down the government claims on the Central Bank (net domestic assets backing the reserve money), which automatically generates a balance of payments surplus by curbing credit.

But the same objective can be achieved in a roundabout way by setting minimum targets for foreign reserves (which net foreign assets) and a maximum reserve money target.

A ceiling on domestic borrowings is needed to get the whole process to work, by giving space in the domestic credit system for the Central Bank to sell down some of its domestic asses and rebuild foreign reserves by killing liquidity.

If domestic borrowing are high, a higher interest rate will be needed to transfer money from productive private spending and investment to wasteful state spending like salary hikes, maintenance of ministers and vote-buying subsidies to special interest groups.

When large volumes of money are transferred for non-productive state spending at high rates, economic output can go down or even contract and there may also be defaults in the banking system or mark-to-market losses in bonds.

Due to the sudden rise in state spending and borrowings after the January budget revision as well as the rate cut in April, credit slammed into the balance of payments at high speed, before a lot of bad loans built up, analysts say.

Pro-cyclical Devil’s Brew

Up to June 2014 the budget deficit was financed by excess liquidity (which is the liabilities side of the foreign reserves accumulated by the Central Bank until the third quarter of 2014) and outright money printing since then.

A rate cut in April also worsened imbalances further discouraging savings and promoting credit and private consumption adding to the already loose fiscal policy, which analysts said was a pro-cyclical devil’s brew.

Essentially the new administration has been living off foreign reserves either by appropriating them directly (to repay foreign loans or accommodate capital flight) or by injecting liquidity and losing forex reserves from credit and imports via a pass-through the monetary base.

Meanwhile Schneider says eliminating tax exemptions and raising revenues would be key to maintaining stability and managing debt in the future.

Any increases in tax revenue from the people to finance the state salaries and other recently added wasteful spending and can reduce borrowings and therefore the nominal interest rate needed to avoid large scale monetization, analysts say.

This year the budget deficit was expanded by a 10,000 rupee salary hike, pensions and new subsidies, and a bailout of an illegal Ponzi scheme. Elevated interest rates from medium term bonds will add to the interest bill, especially next year.

Other analysts say Sri Lanka can also look to trimming spending especially on defence in the future, and also by turning around or selling down state enterprises to reduce the burden of the state on the poor.

Sri Lanka and other Latin American and Asian countries get into balance of payments trouble because they have a so-called soft-peg where a country tries to target two anchors, an external anchor via the exchange rate and an internal one – a price index – through policy rates.

Flawed Legacy

The fundamentally flawed dual anchor system is a legacy of the post-World War II Bretton Woods system of failed soft-pegs.

The architect of the unstable dual anchor soft peg was Harry Dexter White, an interventionist US Treasury employee who was subsequently sacked for his links with the Soviet Union.

Though Britain’s John Maynard Keynes favoured a single currency (the Bancor) which would have inflated uniformly, the US wanted to make its money the world reserve currency of a dollar pegged world.

Destroyed by war and with no gold reserves neither Europe nor Britain was able to resist the US plan. Keynes died. At the time Sri Lanka (Ceylon) was part of the so-called ‘Sterling area’ where the rupee was hard pegged through a currency board and the exchange rate could not be broken.

The IMF was set up by crafty interventionists including Dexter who knew that the soft pegs were unstable and countries will need help when the currencies collapsed. No IMF is needed for currency boards.

The US State Department used its post-war clout to break currency boards and the then Sri Lankan finance minister J R Jayewardene succumbed. A US Fed officials then made Sri Lanka’s central bank. The US Treasury and the State Department still call the shots at the IMF.

Sri Lanka has never looked back.

Money printing, state intervention, deficit spending, increasingly draconian exchange controls, trade controls, and eventually high inflation currency depreciation that impoverished the entire nation became a regular feature of post-independent Sri Lanka.

Analysts have called for a currency board to be re-established so that interest rates can float according to credit demand, save the poor from high inflation and currency depreciation and prevent investible capital and people’s savings in pension funds and banks from being destroyed. (Colombo/Aug21/2015)


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