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Sunday January 29th, 2023

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.

Monetary Instability

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.

Weak Policy

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.

Bad Policy

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.


Sri Lanka battered by unceasing ‘regime uncertainty: Bellwether

What went wrong; Sri Lanka’s illiberal economics and unsound money : Bellwether

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.

Read: Maersk, MSC, CMA CGM, top port operators bid for Sri Lanka 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.

Related Sri Lanka’s pharma control Neros fiddling while Colombo burns with falling rupee

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.

Sri Lanka may be heading for a triple anchor, ‘inflation targeting’ oxymoron: Bellwether

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.


Sri Lanka’s path to debt and destruction paved by currency collapse, REER targeting: Bellwethe

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.

Liquidity Shocks

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.


Sri Lanka is recovering, Central Bank threat looms: Bellwether

Sri Lanka’s Weimar Republic factor is inviting dollar sovereign default: Bellwether

Sri Lanka has to reform soft-peg to avoid monetary instability, default: Bellwether

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.

Dollar Inflation

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.

Read: Deflation: Making Sure “It” Doesn’t Happen Here

“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)

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Sri Lanka operators seek higher renewable tariffs, amid exchange rate expectations

ECONOMYNEXT – Sri Lanka’s renewable companies say they need tariff of 40 to 45 rupees a unit to sell power to the Ceylon Electricity Board and the agency owes them tens of billions of rupees for power sold in the past.

The association has strong exchange rate expectations based on the country’s dual anchor conflicting monetary regimes involving flexible inflation targeting with a reserve collecting target.

“In the coming year of course because of the rupee devaluation, I think the solar energy sector might require tariffs closer to RS 40 or RS 45, hydropower will also require tariffs on that scale,” Prabath Wickremasinghe President of the Small hydropower Developers Association told reporters.

“I think right now what they pay us is averaging around RS 15 to RS 20.”

Some of the earlier plants are paid only 9 rupees a unit, he said. The association there is potential to develop around 200 Mega Watts of mini hydros, 700 to 1000MW of ground mounted soar and about 1,000 rooftop solar.

In addition to the rupee collapse, global renewable energy costs are also up, in the wake of higher oil prices in the recent past and energy disruption in Europe.

The US Fed and the ECB have tightened monetary policy and global energy and food commodity price are now easing.

However in a few years the 40 to 45 rupee tariffs will look cheap, Wickremesinghe pointed out, given the country’s monetary policy involving steep depreciation.

From 2012 to 2015 the rupee collapsed from 113 to 131 to the US dollar. From 2015 to 2019 the rupee collapsed from 131 to 182 under flexible inflation targeting cum exchange rate as the first line of defence where the currency is deprecated instead of hiking rates and halting liquidity injections.

From 2020 to 2022 the rupee collapsed from 182 to 360 under output gap targeting (over stimulus) and exchange rate as the first line of defence.

“The tariffs are paid in rupees,” Wickremasinghe said. With the rupee continuing to devalue in other 5 years 40 rupees will look like 20 rupees.”

Sri Lanka has the worst central bank in South Asia after Pakistan. Both central banks started with the rupee at 4.70 to the US dollars, derived from the Reserve Bank of India, which was set up as a private bank like the Bank of England.

India started to run into forex shortages after the RBI was nationalized and interventionist economic bureaucrats started to run the agency. Sri Lanka’s and Pakistan’s central bank were run on discretionary principles by economic bureaucrats from the beginning.

The Central Bank of Sri Lanka was set up with a peg with gold acting as the final restraint on economic bureaucrats, but it started to depreciated steeply from 1980 as the restraint was taken away.

Now under so-called ‘exchange rate as the first line of defence’ whenever the currency comes under pressure due to inflationary policy (liquidity injections to target an artificially low policy rate or Treasuries yields) the currency is depreciated instead of allowing rates to normalize.

Eventually rates also shoot up, as attempts are made to stabilize the currency which collapses from ‘first line of defence’ triggering downgrades along the way.

After the currency collapse, the Ceylon Electricity Board, finances are shattered and it is unable to pay renewable operators.

Unlike the petroleum, which has to stop delivery as it runs out of power, renewable operators continue to deliver as their domestic value added is higher.

However they also have expenses including salaries of staff to pay.

The CEB which is also running higher losses after the central bank printed money and triggered a currency collapse, has not settled renewable producers.

“In the meantime, we have financial issues with the investors and CEB owns more than 45 million rupees in the industry,” Warna Dahanayaka, Secretary of Mini Hydro Association, said at the conference.

“We can’t sustain because we can’t pay the salaries and we can’t sustain also because of the bank loans. Therefore, we are requesting the government to take the appropriate action for this matter.”

Sri Lanka and Pakistan have identical issues in the power sector including large losses, circular debt, subsidies due to depreciating currencies.

In Sri Lanka there is strong support from the economists outside government for inflationary policy and monetary instability.

The country’s exporters, expatriate workers, users of unofficial gross settlement systems, budget deficits and interbank forex dealers in previous crises have been blamed for monetary instability rather than the unworkable impossible trinity regime involving conflicting domestic (inflation target) and external targets (foreign reserves).

The country has no doctrinal foundation in sound money and there is both fear of floating and hard peg phobia among opinion leaders on both sides of the spectrum regardless of whether they are state or private sector like any Latin American country, critics say.


South Asia, Sri Lanka currency crises; only 2-pct know monetary cause: World Bank survey

A World Bank survey last year found that only 2 percent of ‘experts’ surveyed by the agency knew that external monetary instability was generated by the central bank. Most blamed trade in severe knee jerk reaction. (Colombo/Jan29/2023)

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Sri Lanka top chamber less pessimistic on 2023 GDP contraction

ECONOMYNEXT – Sri Lanka’s top business chamber said it was expecting an economic contraction of up to 2 percent in 2023, which is much lower than projected by international agencies.

“The forecast of 2023 is quite negative in terms of the international forecasters,” Shiran Fernando Chief Economist of Ceylon Chamber of Commerce told a business forum in Colombo.

“Our view is that there will be some level of contraction, may be zero to two percent. But I think as the year progresses in particular the second half, we will see consumption picking up.”

The World Bank is projecting a 4.2 percent contraction in 2023.

In 2022 Sri Lanka’s economy is expected to contract around 8 to 9 percent with gross domestic product shrinking 7.1 percent up to September.

Most businesses have seen a consumption hit, but not as much as indicated, Fernando said.

“Consumption is not falling as much as GDP in sense and we are seeing much more resilient consumer,” he said.

Sri Lanka’s economy usually starts to recover around 15 to 20 months after each currency crisis triggered by the island’s soft-pegged central bank in its oft repeated action of mis-targeting rates through aggressive open market operation or rejecting real bids at Treasuries auctions. (Colombo/Jan28/2023)

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Acuity Knowledge Partners with Sri Lanka office to be bought by Permira

ECONOMYNEXT – Permira, an investment fund with operations in Europe, US and Asia is buying a majority stake in Acuity Knowledge Partners, which has a 500 seat center in Sri Lanka for a undisclosed sum.

Equistone Partners Europe, from which Permira is buying the stake will remain a minority investor, the statement said.

In 2019, Equistone backed a management buyout of Acuity from Moody’s Corporation.

Acuity Knowledge Partners says it serves a global client base of over 500 financial services firms, including banks, asset managers, advisory firms, private equity houses and consultants.

“Despite the current challenges for the financial services sector, we have experienced continued growth and a strong demand for our solutions and services,” Robert King, CEO of Acuity Knowledge Partners, said.

“Given the significant demand within the financial services sector for value-added research and analytics, and the need for operational efficiency, with Permira’s deep experience in tech-enabled services and its global network, I am confident the business will continue to flourish.”

London headquartered Acuity has offices in the UK, USA, India, Sri Lanka, Costa Rica, China and Dubai, UAE.

Equistone was advised on the transaction by Rothschild & Co and DC Advisory, and Latham & Watkins acted as legal counsel. Robert W. Baird Limited served as financial advisers to Permira, and Clifford Chance is acting as legal counsel.

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