Sri Lanka national debt soars to 84-pct of GDP amid soft-peg collapse, REER targeting

ECONOMYNEXT – Sri Lanka’s central government debt is estimated to have soared to 84 percent of gross domestic product in 2018 from 77.6 percent in 2017, finance ministry data showed, amid deliberate real effective exchange rate targeting and monetary instability that led to a collapse of a soft-exchange rate peg.

A port loan from China had also been consolidated into central government debt for the latest data.

Sri Lanka’s rupee fell from 153 to the US dollar in 2018 as the Central Bank suddenly halted sterilisation auctions (ending mopping up of liquidity from dollar purchases) in February 2018 and actively started printing money in the following weeks, loosening a soft-peg with the US dollar and pushing it to the weak side of convertibility undertakings.

Mercantilist Subsidy

Sri Lanka operates a soft-peg with the US dollar based on multiple convertibility undertakings including a Real Effective Exchange Rate index.

REER targeting is a Mercantilist strategy to give a subsidy to hard goods exporters and inefficient domestic producers, at the expense of an entire society including export workers themselves, violating a fundamental classical economic principle of sound money.

When the currency collapses (against a ‘first world’ reserve currency fiat central bank such as the Fed), hard goods exporters can make profits without increasing productivity by cutting real wages of their own workers at the risk of political unrest. This slashes the living standards of an entire ‘third world’ nation.

In Sri Lanka, because power and water prices are not adjusted every month, unlike in countries like Singapore, exporters get additional benefits at the expense of society at large, when the currency falls.

In 2017, the rupee was deliberately weakened despite the credit system being kept on the strong side of convertibility undertakings with inflows being steadily mopped up. A balance of surplus of over billion US dollars was posted by the Central Bank amid weak domestic credit and a budget deficit of 5.5 percent of GDP.

However, the Central Bank lost control of the peg in 2018 despite a similar budget deficit (before currency depreciation) of 5.3 percent of GDP.





National Debt

A budget document for 2019 estimated the debt-to-GDP ratio to climb to 84 percent by the end of 2018 and may ease to 83 percent by end-2019, after climbing from 77.6 percent of GDP in 2017.

Data up to November 2018 placed foreign currency debt at 83.6 percent of GDP or 32.4 billion US dollars (up from 28.7 billion by end December 2017, with loans taken to finance the Hambantota port also being included in the debt stock).

A sale of a stake in the Hambantota port to China brought in cash, a part of which was used to settle debt, but around 400 million dollars was carried over to 2019, which may obscure data.

Some of the money was also used in Soros-style, cash-generating swaps to artificially bring down rates contributing to a second run on the rupee later in 2018.

Dollar debt taken by several state enterprises are not included in the national debt numbers.

Ceylon Petroleum Corporation has been hit by an 82 billion rupee forex loss, pushing up losses to 104 billion rupees in 2018, outside the budget deficit and depreciation of central government debt.

The national debt falls when the budget deficit is lower than the expansion of nominal GDP (real GDP with inflation) and any currency depreciation.

Sri Lanka’s budget deficit up to November 2018, was given as 721 billion rupees or about 5.3 percent of GDP, with 416,200 rupees (about 2.3 billion US dollars at the November 2018 exchange rate) coming in from new foreign debt.

While interest on loans are an expense on the budget, currency depreciation is not, which has helped some bureaucrats to claim that the destruction of the currency has no negative effects and that forex losses can be matched by increases in inflationary revenue.

Unsound Money

Permanent currency depreciation from soft-pegging – a policy error involving contradictory monetary and exchange rate policies – also leads to chronically high nominal rates, regardless of budget deficits, economic analysts have pointed out, as exchange controls prevent the free capital flows.

Even if the capital account is fully open, foreign savers will either demand high interest rates or an exchange rate guarantee. Sri Lanka has now tightened foreign investor holdings in rupee bonds to reduce the fallout from policy errors.

The value of Sri Lanka’s foreign debt soared 1,334 billion rupees during the 11 months to December 2018 from 4,395 billion rupees (28.7 billion US dollars in December 2017) to 5,729 billion rupees (32.4 billion rupees), or by 1,334 billion rupees, which is greater than the total budget deficit.

Even if foreign debt rose from 28.7 billion to 31 billion US dollars, currency depreciation would have been about 1,060 billion rupees, which is also bigger than the deficit for the year.

There have been calls to reform the Central Bank’s soft-peg since Sri Lanka and its poor in particular have paid a high price in inflation, currency depreciation, exchange controls, and trade restrictions since its creation in 1951 and an obsession with ‘saving foreign exchange’.

In the 1970s, Sri Lanka closed its entire economy when the Bretton-Woods system of soft-pegs collapsed to maintain independent monetary policy (print money) and ‘save foreign exchange’.

The danger from monetary instability is greater now, with foreign debt rapidly climbing up as a share of GDP, due to new debt as well as currency depreciation, which bloats past debt. (Colombo/Mar08/2019 – Update II-SB)

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