Sri Lanka growth stalls, per capita GDP drops US$200 in 2019 after monetary instability
ECONOMYNEXT – Sri Lanka’s per-person gross domestic product (GDP) had dropped 227 dollars to 3,852 dollars in 2019 after the latest currency collapses as well as bad economic policies, including trade restrictions and price controls, which expanded to credit markets.
In 2019, on top of recovering from a currency collapse, the economy was also hit by Easter Sunday attacks which hit tourism.
Sri Lanka’s per capita GDP in 2019 was 3,852 dollars which is almost the same as 3,842 dollars reach in 2015.
Sri Lanka’s GDP had grown steadily during the war years despite higher interest rates and expanded in 2009 after the war. From 1994 to 2009 there were only two balance of payments/soft peg crises, and there was also privatization until 2004.
A BOP crisis in 2008/2009 also coincided with the end of an economic bubble fired by the US Federal Reserve which inflated the US dollar and ended with the Great Recession towards the tail-end of Sri Lanka’s 30-year civil war.
Sri Lanka’s economy grew rapidly in US dollar terms after the war.
The post-war period was also helped by Chinese debt-funded projects, which had several years of grace until repayments kicked in.
Many countries including Sri Lanka were able to tap International Sovereign bonds easily, partly helped by quantity easing by the Federal Reserve, which kept dollar interest rates low with a severely damaged banking system in the US.
Under Governor Nivard Cabraal and Deputy Governor W A Wijewardene, fiscal dominance of monetary policy had been resisted to avoid an external meltdown in the latter stages of the war by raising rates to near market levels, as deficits rocketed, though the 2008 crisis still occurred.
Its effects were reduced by allowing the rupee to bounce back from 120 to 113 as private credit fell, allowing growth and domestic consumption to resume. Financial capital was also preserved from depreciation.
However, from 2012 greater monetary instability set in with liquidity injections made to suppress rates when domestic private credit picked up, shortening the growth cycle and driving the credit system towards the balance of payments crises quickly.
In 2011 Sri Lanka also passed an expropriation law, worsening regime uncertainty, in a repeat of a key policy in the immediate post-independence period that made the island lag behind most of Asia.
From around 2011 Sri Lanka’s monetary policy framework also started to deteriorate. The issue of central bank securities which helps build up forex reserves was discontinued, which made it less easy to collect forex reserves by mopping up (sterilizing) inflows.
When the rupee fell in the 2011/2012 crisis it was not allowed to bounce back, amid complaints from Mercantilists that greater exchange rate stability was responsible for low export growth, ending one of the key economic planks that had helped maintain growth and living standards.
It ended relative monetary stability that had provided a foundation for growth despite an overall weak economic policy.
By this time W A Wijewardene who had played a key role in keeping monetary stability during the war years had left the agency.
Economic policy was also deteriorating in other directions.
Without monetary stability as a foundation, even a strong economic framework in other ways would not deliver sustained growth.
“Stability is not everything, but without stability, everything is nothing,” Karl Schiller one time economy Minister of the Federal Republic of Germany once said.
Germany had one of the best central banks and the strongest currencies after the Second World War, until the ECB was set up, whose policy was less prudent than the Bundesbank.
In Sri Lanka however the overall policy framework was also weak and generally tilted towards the state and not private enterprise. The overall economy was also stifled with renewed import duties import substitution which seen during the 1970s.
New loss-making state enterprises were also built including with Chinese loans.
The Sri Lanka Ports Authority, which was built with Japanese funds under carefully developed long term plans backed by the Asian Development Bank was burdened with servicing Hambantota Port loans.
Previously privatized firms like SriLankan Airlines, Shell Gas, and Sri Lanka Insurance went back to state hands through different means, leading to mal-investments, corruption, and losses.
Sri Lankan Airlines started to make unusually large losses, running into over a billion and a half dollars since its re-nationalization.
On expressways built with loans, private buses were not allowed to run which was emblematic of a bias towards SOEs and against the private sector.
Anti-private sector biases would reduce tax revenues to service infrastructure loans in the future.
Most of the foreign infrastructure loans, sovereign bonds and also domestic road loans are now maturing.
After a change of government in 2015, in the same lines as the expropriation law, retrospective taxes were slammed on private companies in more regime uncertainty.
In 2015 state worker salaries and subsidies were ratcheted up and more money printed as private credit recovered.
The currency started to collapse in the second half of 2015 as the soft-peg was floated without first taking out excess liquidity in money markets.
Sri Lanka’s soft-peg has driven the central bank to take the whole country into International Monetary Fund programs 16 times.
Instead of cutting expenses in the classical economic tradition, and privatizing state enterprises that were pushing up debt, the International Monetary Fund came up with a program called ‘revenue-based fiscal consolation’ aimed at taxing the private sector to help maintain a bloated state.
The anti-privatization policy continued.
The administration was unable to get private capital to Colombo port, despite top global shipping lines responding to a call to build a terminal.
It was also unable to privatize SriLankan Airlines for which the Janatha Vimukthi Peramuna, the main backer of loss-making state enterprises did not oppose.
The new administration also set up the National Medical Regulatory Authority to control the price of drugs, instead of fixing the central bank and blocking its domestic operations department from printing money which was the reason for price rises and currency collapses.
Monetary Instability Worsens
Monetary instability sharply deteriorated after 2015, under a so-called flexible inflation targeting, where authorities thought it was possible to target inflation (a domestic anchor) while targeting the exchange rate or soft-peg (an external anchor) to collect forex reserves under an IMF program.
REER targeting meant that the external anchor would be downward driven as the index followed the worst central banks in the basket to the bottom.
Increasing forex reserves (and increasing dollar cover of the monetary base) required a peg where reserve money had be slightly under-supplied compared to the balance of payments, in the way Malaysia, Thailand and China until 2005 had done and Vietnam is doing now.
The administration gave the central bank full independence to ratchet up monetary instability.
There was no fiscal dominance to print money and avoid taxes. On the contrary Mangala Samaraweera, the second finance minister put in place a higher value added tax regime and also market price fuel in politically costly reforms.
Operationally the new monetary regime involved Real Effective Exchange Rate targeting to keep the REER index below 100, which involved depreciating the currency to destroy real wages of export workers, lowering living standards of not only export workers but all workers, making the electorate unhappy.
It is not clear that the cabinet of ministers, which had given de facto central bank independence, had any idea of the consequence of REER targeting.
Currency collapses kill domestic consumption and also real domestic financial capital available for investment and growth, by destroying real financial savings in both banks and pension funds.
The Real Effective Exchange Rate is now 90 by March 2020, over-achieving the target, but growth had fallen to low single digits helped by currency crises which were coming rapidly due to call-money rate targeting-with-excess liquidity.
Capital Flight, Dollar Debt
In the eight-year from 2011 to 2018, three currency crises had occurred, killing credit cycles just as they began.
Unlike the 2011 crisis, foreign investors began to flee under REER targeting as credibility of the peg was weakened. As the understanding of the consequences of the new monetary regime grew among foreign investors, capital flight worsened.
Capital flight from rupee bonds has the same effect on the credit system as the inability to roll over dollar debt.
From 2015 about 450 billion rupees in bonds held by foreign investors had dwindled to about 20 billion by April 2020.
In a tragi-comedy Mercantilists did not blame the lack of credibility of the peg for capital flight, but capital flight was blamed for currency collapse.
Meanwhile, stock market investors had also seen the effects of the monetary and other policies on the economy. Their conversations with policymakers made concerns grow.
REER targeting and general monetary instability also bloated the foreign debt of the central government and also state enterprise, many of which had dollar loans, driving national debt towards 100 percent of GDP.
In the last decade, state enterprises had been encouraged to borrow on their own with state guarantees in a bid to understate the budget deficit.
Among those that borrowed dollar on its own was the Road Development Authority, which had no revenues to speak of, in dollars or other currencies. The policy was not changed after 2015.
In the most severe deterioration of policy, the call money rate was targeted to keep it at the middle of the policy corridor, by helicopter dropping large volumes excess liquidity into money markets and de-stabilizing the peg.
Call-money-rate-targeting with excess liquidity lost the economy and the rupee the protection of a policy corridor. In another deterioration the policy corridor was cut fro 150 to 100 basis points.
Call money rate targeting with excess liquidity was seen in action in April 2018 where 60 billion rupees of excess liquidity was dumped on the credit system in April 2018, to enforce a rate cut.
The 60 billion rupee was over and above a real money demand, leading to currency collapsing from May 2018 onwards just as private credit picked up.
The crisis was also worsened by liquidity generated from rupee/dollar swaps with the central bank.
Speculators who broke pegs in East Asia had also used similar swaps with the central banks to generate liquidity and hit the peg. The offshore swap market was closed to help stop the currency fall in Thailand and others.
Singapore Monetary Authority stopped offshore swap and lending in domestic currency for the same reason. Ironically in Sri Lanka, the counterparty to the rupee generating swas was not a foreign speculator, but the Treasury.
Under call money rate targeting with excess liquidity, reserve money growth was not only out of line with the balance of payments (and the foreign reserve target set under an IMF program) but the central bank lost complete control of reserve money growth.
Under a ceiling policy rate, where just enough liquidity is given to target a policy ate, some control of the expansion of reserve money can be maintained to slow or delay currency crises or limit the loss of forex reserves in defending the currency.
With a wide enough policy corridor, linked to the US Fed, currency collapses can be almost eliminated.
But with excess liquidity pumped into the money markets, Sri Lanka is in the same situation as China had been in the late 1980s (injections made to finance SOEs which was stopped with a new PBOC law), Indonesia during its currency collapse in the East Asian crisis, (where excess liquidity came from bank bailouts) and the State Bank of Vietnam up to 1989 (from SBV re-finance of bank loans).
Vietnam’s GDP jumped from around 30 billion US dollars before the opening up of the country in 1986 (Doi Moi), to 42 billion dollars by 1987.
But currency crises led to a swift collapse of output. By 1989 GDP had collapsed to just 6.3 billion US dollars when a new law was brought to reform the State Bank of Vietnam and cut its re-finance links to state banks. Several of those banks are now listed and strategic stakes sold to foreign banks.
Free trade agreements followed swiftly after central bank reform. As a communist state where private firms had been expropriated, there was no entrenched rent-seeking businesses paying off politicians to put up import duties and exploit the population with import substitution.
When the credibility of the peg is lost, massive output shocks (low or negative growth, consumption killing, lower living standards) are required to correct monetary instability.
In 2020, excess liquidity had jumped 160 billion rupees. The central bank is now not only targeting the call money rates, but the 3, 6, and 12-month rates by printing money.
Dropping a prudential rule set by then-Governor A S Jayewardene the central bank has also got back the powers to print money and target long term bond rates during the tenure of Governor Indrajit Coomaraswamy.
In the 2020 liquidity injections, the rupee fell to 200 to the US dollar and has since been brought back to 190 levels, partly helped by a consumption collapse driven by coronavirus curfews.
In the immediate post war period Sri Lanka’s dollar GDP growth was also helped by the post-2009 quantity easing of the Federal Reserve which reflated the US dollar, with commodities and precious metals rising partway towards levels seen in the 2008 bubble.
The dollar reflation boosted dollar GDP not only in Sri Lanka but also in countries like Vietnam.
Vietnam’s currency also collapsed in 2008 after the SBV tried a ‘stimulus’ misled by Western media glorification of interventions. However in the current crisis, SBV had avoided printing money and kept the peg. Vietnam bond are trading at a premium among foreign investors after March 23.
From September 2014 the Federal Reserve reversed quantity easing pushing down commodity prices including oil.
Fed rate hikes began in 2015.
But Sri Lanka cut rates in 2015 triggering the 2015/2015 crisis where the rupee fell from 131 to 151 to the US dollar. In the 2018 crisis the rupee fell to 182.
Measured in ounces of gold, Sri Lanka’s 2019 per capita GDP of 3,852 dollars is around the same as in 2002, when egged on by Ben Bernanke, the then US Fed Chairman Alan Greenspan started the money of all liquidity bubbles.
In 2002, Sri Lanka per capita GDP was 2.5 ounces of gold, the same as in 2019.
In 2002 Bernanke in a speech to the Before the National Economists Club, Washington, D.C.
November 21, 2002, Bernanke told why the Fed should print money to avoid deflation.
“The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation,” Bernanke said in 2002.
“I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.”
“However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition.
“As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.”
The rest is history. Less than years later as the bubble he fired collapse the Fed had to do the very thing he predicted. (Colombo/May10/2020-sb)