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Monday June 27th, 2022

Why Sri Lanka is having power cuts, fuel shortages as forex crisis worsens – Explained

ECONOMYNEXT – Sri Lanka on Wednesday made a 35.3 million US dollar payment to release a 37,500 metric tonne diesel shipment and President Gotabaya Rajapaksa has also asked authorities to give priority for fuel as power cuts became bigger.

Energy Minister Udaya Gammanpila who had earlier warned of four hour power cuts when daily power cuts were denied to the CEB after a coal plant broke down, forex shortages disrupted imports and the utility was running down hydro storage too fast.

Gammanpila has also warned of fuel shortages if the CPC is not allowed a price increase to generate rupees to buy dollars as it can no longer borrow from banks.

Here are some key questions and answers on the fuel crisis in Sri Lanka:

Why is Sri Lanka facing a fuel shortage?

Sri Lanka’s state-run fuel retailer Ceylon Petroleum Corporation (CPC) cannot buy enough dollars in the market at the current 200 to the US dollar rate due to foreign exchange shortages. The shortages come from rupees injected into the banking system to maintain low interest rates which it has pushed up credit and demand for all imports.

Unlike other import bills, which are small, fuel bills are among the biggest, and therefore whenever money is printed to keep rates down, fuel bills stand out as the most difficult to fill. Unlike other importers the CPC also does not pay higher rates to buy dollars at higher rates any longer.

On top of that, the CPC says it is losing 551 million rupees a day due to rising fuel prices in February. Unless prices are increased it cannot find the rupees to buy dollars. In the past losses were covered by tax cuts and loans from state banks.

Now the government is short of tax revenues, especially after a salary increase, and the CPC is indebted to the hilt to state banks from past wrong practices. The CPC owes banks over 3.5 billion dollars.

What is the fuel supply outlook in the near future?

Officials at CPC say five oil tankers are scheduled to arrive in the island this week. However, if the CPC is unable to find dollars, the shortages are likely to continue with delays to clear the oil tankers.

Why doesn’t CPC have a buffer stock?

In the past, CPC has borrowed dollars or used suppliers’ credit to import oil without making immediate payments when money was printed to keep rates down, creating forex shortages. Now suppliers are no longer giving credit to the CPC. As a result, the CPC has to find dollars upfront to pay suppliers when there are forex shortages.

Earlier CPC used to have stocks of 2 to 3 weeks. Now the stocks are down to 5 or 6 days.

Though ships are coming on time as ordered, a delay in unloading triggers shortages across the distribution network leading to stock outs.

Minister Gammanpila has said in April in an Indian credit line may be activated allowing more imports to be made.

Is there an increase in Sri Lanka’s fuel demand?

Yes. According to statements by Energy Ministry officials, daily demand for diesel has risen sharply to about 9000 metric tonnes a day, from an earlier 6,000 a day. The increase is mostly from the power sector with some power plants that used to run on furnace oil also using diesel. The 270 MW West Coast combined cycle plant uses 1,000 MT day.

People are also using generators. Industries and people may also be stocking up and running with full tanks. Petrol use has also increased with more people avoiding public transport due to Covid.

In addition, when economic activity recovers, there is generally an increase in energy use. Electricity demand growth slowed during the Covid pandemic in 2020. Growing exports also increase the demand for power. A recovery in tourism can lead to more energy for transport and electricity use in hotels and restaurants.

Energy sector analysts had warned of power cuts from 2018, when a coal plant was cancelled and later a combined cycle plant was delayed due to capacity shortages not keeping up with economic growth. However without fuel now, existing capacity also cannot be run.

Why does fuel demand increase up to April?

The first quarter is the driest months of the year. Until April showers start and monsoons in May, the CEB has to carefully use stored fuel to generate power and also ramp up fuel based generation.

That is why, as soon as the coal plant broke down, the CEB wanted to have one hour power cuts to save water.

In addition the heat may push up air-condition use and export industries generally work at full tilt in March and early April before the New Year holidays, further boosting energy demand.

That is also why economic analysts said rates should be raised and the currency floated before the dry season set in February.

Will a price hike or price formula reduce fuel demand?

Going by past trends, not much. But as people and companies put money into fuel, they have to cut down on non-oil spending. Or they have to reduce savings which in turn will reduce the resources to give credit to other borrowers and therefore imports. The adjustment comes through a fall in non-oil spending, credit and imports in the total economy as the CPC extracts rupees from customers.

However if new money is injected to the banking system for whatever reason, or salaries of state workers are paid with printed money, the required correction will not happen, even if prices are hiked and dollar demand will continue with unsustainable non-oil imports.

If the CPC is forced to borrow dollars despite having rupees taken from the economy as happened in the past, the correction will also not happen as its rupee deposits in the bank are loaned to other customers to trigger non-oil imports, as happened in 2018 despite the price formula.

What will be the impact on the people due to the current fuel crisis?

Fuel shortages can reduce economic activities by disrupting production and transport.

If the central bank uses reserves to import fuel and maintain the 200 the US dollar peg, under the monetary regime currently in operation, more money is printed to offset the transaction, an activity known as sterilization.

The action prevents the banking system from adjusting to the reserve sale through an increase in interest rates, creating further pressure on the currency.

There has been talk of rationing by Minister Vasudeva Nanayakkara among others. Rationing will further disrupt people’s lives without solving the problem. Rationing or price controls have not solved either inflation or foreign exchange in Sri Lanka in the past.

When will the fuel crisis end?

April rains can reduce the demand for electricity from imported oil. The Indian credit line can help bring fuel for some time and leave the country or CPC with another 500 million dollars in debt just as previous currency crises left it with 3.5 billion US dollars in debt.

Sri Lanka has a large stock of coal which may last up to July. After that, more coal will have to be imported.

Foreign exchange shortages are a monetary phenomenon found only in flawed or soft pegged exchange rate systems, triggered by rupee reserves injected to the banking system to maintain artificially low rates. Forex shortage gets worse as economic activity and credit demand (such as loan-funded losses in fuel or electricity companies) or deficit spending go up. Countries that did not have forex problems during Covid can experience currency pressure when the economy re-opens if rates which were cut during the lockdowns are not allowed to go back up. This is happening to both Pakistan and Bangladesh.

Central banks with floating exchange rate regimes, that do not sterilize interventions after giving reserves for imports (usually because there are not much reserves to give in any case), do not suffer foreign exchange shortages. The UK had also experienced forex shortages (Sterling crises) when the Bank of England operated a flawed pegged regime driven by Keynesian dogma. The Bretton Woods system also collapsed the dollar was floated in 1971 for similar reasons.

Forex shortages can be ended by tightening monetary policy. Raising taxes to reduce the budget deficit and therefore domestic credit will also help. Pegged central banks usually float when they run out of reserves after one or more hikes in the policy rate.

Why does a float help?

When a central bank gives reserves for imports by defending a pegged exchange rate, it triggers a liquidity shortage in the banking system and the rupee monetary base or reserve money shrinks by the rupees paid into the central bank by an importer. The action will push up interbank rates in a hard peg where interventions are unsterilized and interest rates float up. However a soft-pegged central bank will re-inject the lost money back into bans via open market operations to offset the reserve sale (sterilize the intervention) to stop the interest rate from floating up, and pressure the currency.

A float stops the cycle of reserve sales for imports (stops defending the peg at 200) and simultaneously ends the need to re-inject money, which the central bank sucked out from the dollar sale to prevent rates from going up. In addition to imports for consumption, Sri Lanka is also experiencing capital flight and pressure on debt repayments, all of which require higher interest rates to generate savings to meet such payments.

When Sri Lanka’s interventions were unsterilized and interest rates were allowed to be floated, and the hard peg was broken in 1950 to set up a central bank the country had foreign reserves worth 11 months of imports. (Colombo/Feb23/2022)

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