balance of payment position of sri lanka
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introduction to balance of payment.bop of sri-lanka.economic condition.TRANSCRIPT
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Balance of payments
Balance of payments (BoP) accounts are an accounting record of all monetary transactions
between a country and the rest of the world. These transactions include payments for the
country's exports and imports of goods, services, financial capital, and financial transfers. The
BoP accounts summarize international transactions for a specific period, usually a year, and are
prepared in a single currency, typically the domestic currency for the country concerned. Sources
of funds for a nation, such as exports or the receipts of loans and investments, are recorded as
positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are
recorded as negative or deficit items.
When all components of the BOP accounts are included they must sum to zero with no overall
surplus or deficit. For example, if a country is importing more than it exports, its trade balance
will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by
funds earned from its foreign investments, by running down central bank reserves or by
receiving loans from other countries.
While the overall BOP accounts will always balance when all types of payments are included,
imbalances are possible on individual elements of the BOP, such as the current account,
the capital account excluding the central bank's reserve account, or the sum of the two.
Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit
nations become increasingly indebted. The term "balance of payments" often refers to this sum: a
country's balance of payments is said to be in surplus (equivalently, the balance of payments is
positive) by a certain amount if sources of funds (such as export goods sold and bonds sold)
exceed uses of funds (such as paying for imported goods and paying for foreign bonds
purchased) by that amount. There is said to be a balance of payments deficit (the balance of
payments is said to be negative) if the former are less than the latter.
Under a fixed exchange rate system, the central bank accommodates those flows by buying up
any net inflow of funds into the country or by providing foreign currency funds to the foreign
exchange market to match any international outflow of funds, thus preventing the funds flows
from affecting the exchange rate between the country's currency and other currencies. Then the
net change per year in the central bank's foreign exchange reserves is sometimes called the
balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include
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a managed float where some changes of exchange rates are allowed, or at the other extreme a
purelyfloating exchange rate (also known as a purely flexible exchange rate). With a pure float
the central bank does not intervene at all to protect or devalue its currency, allowing the rate to
be set by the market, and the central bank's foreign exchange reserves do not change.
Historically there have been different approaches to the question of how or even whether to
eliminate current account or trade imbalances. With record trade imbalances held up as one of
the contributing factors to the financial crisis of 2007–2010, plans to address global imbalances
have been high on the agenda of policy makers since 2009.
A record of all transactions made between one particular country and all other countries during a
specified period of time. BOP compares the dollar difference of the amount of exports and
imports, including all financial exports and imports. A negative balance of payments means that
more money is flowing out of the country than coming in, and vice versa.
Balance of payments may be used as an indicator of economic and political stability. For
example, if a country has a consistently positive BOP, this could mean that there is significant
foreign investment within that country. It may also mean that the country does not export much
of its currency.
This is just another economic indicator of a country's relative value and, along with all other
indicators, should be used with caution. The BOP includes the trade balance, foreign investments
and investments by foreigners.
Composition of the balance of payments sheet
BOP The two principal parts of the BOP accounts are the current account and the capital
account.
The current account shows the net amount a country is earning if it is in surplus, or spending if it
is in deficit. It is the sum of thebalance of trade (net earnings on exports minus payments for
imports), factor income (earnings on foreign investments minus payments made to foreign
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investors) and cash transfers. It is called the current account as it covers transactions in the "here
and now" - those that don't give rise to future claims.
The Capital Account records the net change in ownership of foreign assets. It includes
the reserve account (the foreign exchange market operations of a nation's central bank), along
with loans and investments between the country and the rest of world (but not the future regular
repayments/dividends that the loans and investments yield; those are earnings and will be
recorded in the current account). The term "capital account" is also used in the narrower sense
that excludes central bank foreign exchange market operations: Sometimes the reserve account is
classified as "below the line" and so not reported as part of the capital account.
Expressed with the broader meaning for the capital account, the BOP identity assumes that any
current account surplus will be balanced by a capital account deficit of equal size - or
alternatively a current account deficit will be balanced by a corresponding capital account
surplus:
The balancing item, which may be positive or negative, is simply an amount that accounts
for any statistical errors and assures that the current and capital accounts sum to zero. By the
principles of double entry accounting, an entry in the current account gives rise to an entry in
the capital account, and in aggregate the two accounts automatically balance. A balance isn't
always reflected in reported figures for the current and capital accounts, which might, for
example, report a surplus for both accounts, but when this happens it always means
something has been missed—most commonly, the operations of the country's central bank—
and what has been missed is recorded in the statistical discrepancy term (the balancing item).
An actual balance sheet will typically have numerous sub headings under the principal
divisions. For example, entries under Current account might include:
Trade – buying and selling of goods and services
Exports – a credit entry
Imports – a debit entry
Trade balance – the sum of Exports and Imports
Factor income – repayments and dividends from loans and investments
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Factor earnings – a credit entry
Factor payments – a debit entry
Factor income balance – the sum of earnings and payments.
Especially in older balance sheets, a common division was between visible and invisible
entries. Visible trade recorded imports and exports of physical goods (entries for trade in
physical goods excluding services is now often called the merchandise balance). Invisible
trade would record international buying and selling of services, and sometimes would be
grouped with transfer and factor income as invisible earnings.[1]
The term "balance of payments surplus" (or deficit — a deficit is simply a negative surplus)
refers to the sum of the surpluses in the current account and the narrowly defined capital
account (excluding changes in central bank reserves). Denoting the balance of payments
surplus as BOP surplus, the relevant identity is
[edit]Variations in the use of term "balance of payments"
Economics writer J. Orlin Grabbe warns the term balance of payments can be a source of
misunderstanding due to divergent expectations about what the term denotes. Grabbe
says the term is sometimes misused by people who aren't aware of the accepted meaning,
not only in general conversation but in financial publications and the economic literature.[3]
A common source of confusion arises from whether or not the reserve account entry, part
of the capital account, is included in the BOP accounts. The reserve account records the
activity of the nation's central bank. If it is excluded, the BOP can be in surplus (which
implies the central bank is building up foreign exchange reserves) or in deficit (which
implies the central bank is running down its reserves or borrowing from abroad).[1][3]
The term "balance of payments" is sometimes misused by non-economists to mean just
relatively narrow parts of the BOP such as thetrade deficit,[3] which means excluding
parts of the current account and the entire capital account.
Another cause of confusion is the different naming conventions in use.[4] Before 1973
there was no standard way to break down the BOP sheet, with the separation into
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invisible and visible payments sometimes being the principal divisions. The IMF have
their own standards for BOP accounting which is equivalent to the standard definition
but uses different nomenclature, in particular with respect to the meaning given to the
term capital account.
[edit]The IMF definition
The International Monetary Fund (IMF) use a particular set of definitions for the BOP
accounts, which is also used by the Organisation for Economic Co-operation and
Development (OECD), and the United Nations System of National Accounts (SNA).[5]
The main difference in the IMF's terminology is that it uses the term "financial account"
to capture transactions that would under alternative definitions be recorded in the capital
account. The IMF uses the term capital account to designate a subset of transactions that,
according to other usage, form a small part of the overall capital account.[6] The IMF
separates these transactions out to form an additional top level division of the BOP
accounts. Expressed with the IMF definition, the BOP identity can be written:
The IMF uses the term current account with the same meaning as that used by other
organizations, although it has its own names for its three leading sub-divisions,
which are:
The goods and services account (the overall trade balance)
The primary income account (factor income such as from loans and investments)
The secondary income account (transfer payments)
[edit]Imbalances
While the BOP has to balance overall, surpluses or deficits on its individual elements
can lead to imbalances between countries. In general there is concern over deficits in
the current account. Countries with deficits in their current accounts will build up
increasing debt and/or see increased foreign ownership of their assets. The types of
deficits that typically raise concern are
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A visible trade deficit where a nation is importing more physical goods than it
exports (even if this is balanced by the other components of the current account.)
An overall current account deficit.
A basic deficit which is the current account plus foreign direct investment (but
excluding other elements of the capital account like short terms loans and the
reserve account.)
As discussed in the history section below, the Washington Consensus period saw a
swing of opinion towards the view that there is no need to worry about imbalances.
Opinion swung back in the opposite direction in the wake of financial crisis of 2007–
2009. Mainstream opinion expressed by the leading financial press and economists,
international bodies like the IMF—as well as leaders of surplus and deficit countries
—has returned to the view that large current account imbalances do matter.[9] Some
economists do, however, remain relatively unconcerned about imbalances[10] and
there have been assertions, such as by Michael P. Dooley, David Folkerts-Landau
and Peter Garber, that nations need to avoid temptation to switch to protectionism as
a means to correct imbalances.[11]
[edit]Causes of BOP imbalances
There are conflicting views as to the primary cause of BOP imbalances, with much
attention on the US which currently has by far the biggest deficit. The conventional
view is that current account factors are the primary cause[12] - these include the
exchange rate, the government's fiscal deficit, business competitiveness, and private
behaviour such as the willingness of consumers to go into debt to finance extra
consumption.[13] An alternative view, argued at length in a 2005 paper by Ben
Bernanke, is that the primary driver is the capital account, where a global savings
glut caused by savers in surplus countries, runs ahead of the available investment
opportunities, and is pushed into the US resulting in excess consumption and asset
price inflation.[14]
[edit]Reserve asset
Main article: Reserve currency
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The US dollar has been the leading reserve asset since the end of the gold standard.
In the context of BOP and international monetary systems, the reserve asset is the
currency or other store of value that is primarily used by nations for their foreign
reserves.[15] BOP imbalances tend to manifest as hoards of the reserve asset being
amassed by surplus countries, with deficit countries building debts denominated in
the reserve asset or at least depleting their supply. Under a gold standard, the reserve
asset for all members of the standard is gold. In the Bretton Woods system, either
gold or the U.S. dollar could serve as the reserve asset, though its smooth operation
depended on countries apart from the US choosing to keep most of their holdings in
dollars.
Following the ending of Bretton Woods, there has been no de jure reserve asset, but
the US dollar has remained by far the principal de facto reserve. Global reserves rose
sharply in the first decade of the 21st century, partly as a result of the 1997 Asian
Financial Crisis, where several nations ran out of foreign currency needed for
essential imports and thus had to accept deals on unfavourable terms.
The International Monetary Fund (IMF) estimates that between 2000 to mid-2009,
official reserves rose from $1,900bn to $6,800bn.[16] Global reserves had peaked at
about $7,500bn in mid-2008, then declined by about $430bn as countries without
their own reserve currency used them to shield themselves from the worst effects of
the financial crisis. From Feb 2009 global reserves began increasing again to reach
close to $9,200bn by the end of 2010.[17] [18]
As of 2009 approximately 65% of the world's $6,800bn total is held in U.S. dollars
and approximately 25% in euros. The UK pound,Japanese yen, IMF special drawing
rights (SDRs), and precious metals[19] also play a role. In 2009 Zhou Xiaochuan,
governor of thePeople's Bank of China, proposed a gradual move towards increased
use of SDRs, and also for the national currencies backing SDRs to be expanded to
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include the currencies of all major economies.[20] [21] Dr Zhou's proposal has been
described as one of the most significant ideas expressed in 2009.[22]
While the current central role of the dollar does give the US some advantages such as
lower cost of borrowings, it also contributes to the pressure causing the U.S. to run a
current account deficit, due to the Triffin dilemma. In a November 2009 article
published inForeign Affairs magazine, economist C. Fred Bergsten argued that Dr
Zhou's suggestion or a similar change to the international monetary system would be
in the United States' best interests as well as the rest of the world's.[23] Since 2009
there has been a notable increase in the number of new bilateral agreements which
enable international trades to be transacted using a currency that isn't a traditional
reserve asset, such as the renminbi, as the Settlement currency. [24]
[edit]Balance of payments crisis
Main article: Currency crisis
A BOP crisis, also called a currency crisis, occurs when a nation is unable to pay for
essential imports and/or service its debt repayments. Typically, this is accompanied
by a rapid decline in the value of the affected nation's currency. Crises are generally
preceded by large capital inflows, which are associated at first with rapid economic
growth.[25] However a point is reached where overseas investors become concerned
about the level of debt their inbound capital is generating, and decide to pull out their
funds.[26]The resulting outbound capital flows are associated with a rapid drop in the
value of the affected nation's currency. This causes issues for firms of the affected
nation who have received the inbound investments and loans, as the revenue of those
firms is typically mostly derived domestically but their debts are often denominated
in a reserve currency. Once the nation's government has exhausted its foreign
reserves trying to support the value of the domestic currency, its policy options are
very limited. It can raise its interest rates to try to prevent further declines in the
value of its currency, but while this can help those with debts denominated in foreign
currencies, it generally further depresses the local economy.[25] [27] [28]
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[edit]Balancing mechanisms
One of the three fundamental functions of an international monetary system is to
provide mechanisms to correct imbalances.[29][30]
Broadly speaking, there are three possible methods to correct BOP imbalances,
though in practice a mixture including some degree of at least the first two methods
tends to be used. These methods are adjustments of exchange rates; adjustment of a
nations internal prices along with its levels of demand; and rules based adjustment.[31] Improving productivity and hence competitiveness can also help, as can
increasing the desirability of exports through other means, though it is generally
assumed a nation is always trying to develop and sell its products to the best of its
abilities.
[edit]Rebalancing by changing the exchange rate
An upwards shift in the value of a nation's currency relative to others will make a
nation's exports less competitive and make imports cheaper and so will tend to
correct a current account surplus. It also tends to make investment flows into the
capital account less attractive so will help with a surplus there too. Conversely a
downward shift in the value of a nation's currency makes it more expensive for its
citizens to buy imports and increases the competitiveness of their exports, thus
helping to correct a deficit (though the solution often doesn't have a positive impact
immediately due to the Marshall–Lerner condition).[32]
Exchange rates can be adjusted by government[33] in a rules based or managed
currency regime, and when left to float freely in the market they also tend to change
in the direction that will restore balance. When a country is selling more than it
imports, the demand for its currency will tend to increase as other countries
ultimately[34] need the selling country's currency to make payments for the exports.
The extra demand tends to cause a rise of the currency's price relative to others.
When a country is importing more than it exports, the supply of its own currency on
the international market tends to increase as it tries to exchange it for foreign
currency to pay for its imports, and this extra supply tends to cause the price to fall.
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BOP effects are not the only market influence on exchange rates however, they are
also influenced by differences in national interest rates and by speculation.
[edit]Rebalancing by adjusting internal prices and demand
When exchange rates are fixed by a rigid gold standard,[35] or when imbalances exist
between members of a currency union such as the Eurozone, the standard approach
to correct imbalances is by making changes to the domestic economy. To a large
degree, the change is optional for the surplus country, but compulsory for the deficit
country. In the case of a gold standard, the mechanism is largely automatic. When a
country has a favourable trade balance, as a consequence of selling more than it buys
it will experience a net inflow of gold. The natural effect of this will be to increase
the money supply, which leads to inflation and an increase in prices, which then
tends to make its goods less competitive and so will decrease its trade surplus.
However the nation has the option of taking the gold out of economy (sterilising the
inflationary effect) thus building up a hoard of gold and retaining its favourable
balance of payments. On the other hand, if a country has an adverse BOP it will
experience a net loss of gold, which will automatically have a deflationary effect,
unless it chooses to leave the gold standard. Prices will be reduced, making its
exports more competitive, and thus correcting the imbalance. While the gold
standard is generally considered to have been successful[36] up until 1914, correction
by deflation to the degree required by the large imbalances that arose after WWI
proved painful, with deflationary policies contributing to prolonged unemployment
but not re-establishing balance. Apart from the US most former members had left the
gold standard by the mid 1930s.
A possible method for surplus countries such as Germany to contribute to re-
balancing efforts when exchange rate adjustment is not suitable, is to increase its
level of internal demand (i.e. its spending on goods). While a current account surplus
is commonly understood as the excess of earnings over spending, an alternative
expression is that it is the excess of savings over investment.[37]That is:
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where CA = current account, NS = national savings (private plus government
sector), NI = national investment.
If a nation is earning more than it spends the net effect will be to build up
savings, except to the extent that those savings are being used for investment. If
consumers can be encouraged to spend more instead of saving; or if the
government runs a fiscal deficit to offset private savings; or if the corporate
sector divert more of their profits to investment, then any current account surplus
will tend to be reduced. However in 2009 Germany amended its constitution to
prohibit running a deficit greater than 0.35% of its GDP[38] and calls to reduce its
surplus by increasing demand have not been welcome by officials,[39] adding to
fears that the 2010s will not be an easy decade for the eurozone.[40] In their April
2010 world economic outlook report, the IMF presented a study showing how
with the right choice of policy options governments can transition out of a
sustained current account surplus with no negative effect on growth and with a
positive impact on unemployment.[41]
Rules based rebalancing mechanisms
Nations can agree to fix their exchange rates against each other, and then correct
any imbalances that arise by rules based and negotiated exchange rate changes
and other methods. The Bretton Woods system of fixed but adjustable exchange
rates was an example of a rules based system, though it still relied primarily on
the two traditional mechanisms. John Maynard Keynes, one of the architects of
the Bretton Woods system had wanted additional rules to encourage surplus
countries to share the burden of rebalancing, as he argued that they were in a
stronger position to do so and as he regarded their surpluses as
negative externalities imposed on the global economy.[42] Keynes suggested that
traditional balancing mechanisms should be supplemented by the threat of
confiscation of a portion of excess revenue if the surplus country did not choose
to spend it on additional imports. However his ideas were not accepted by the
Americans at the time. In 2008 and 2009, American economist Paul
Davidson had been promoting his revamped form of Keynes's plan as a possible
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solution to global imbalances which in his opinion would expand growth all
round without the downside risk of other rebalancing methods.
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Govt. mismanaged balance of payments crisis, now remedies more painful
*Central Bank needs to be modest enough to accept criticism *How Cabraal debunked concerns
raised last year
Reiterating what has been said in these pages over the past few days, Dr. Harsha De Silva MP,
economic spokesman for the UNP, said mismanagement of the balance of payments crisis has
resulted in the prescribed remedies being more costlier to the economy.
"In complete contrast to the picture painted by Governor Nivard Cabraal and subsequently
showcased by politicians, the sad reality of the economy of Sri Lanka has been revealed, the
opposition lawmaker said.
"The mismanagement of the problem; particularly ignoring the ballooning trade deficit and
under-pricing energy in an artificially controlled exchange rate and interest rate regime, had no
other possible ending other than the one that is unfolding right before our eyes.
The domino effect of the erroneous decision making by the miserably politicized Central Bank
resulting in a massive depreciation and an unprecedented increase in energy prices will be
widespread and be felt by all. The enormity of the fallout will become clear in the coming days
with people unable to meet their daily requirements resulting in worker agitations for salary
increases which could even spin out of control.
"The government has no one to blame but themselves for this predicament and the public would
now realize the vituperative attacks made on their critics were of bad taste and unprofessional.
Going forward we hope for the sake of the millions of innocent people of this country that
persons knowledgeable in the subject of economics and modest enough to take criticism from
others would be handed over the responsibility to manage this nations complex economy," Dr.
De Silva said.
As highlighted in the pages yesterday, several leading economists in the country were ostracized
for highlighting the structural deficiencies in the country’s balance of payments. Had authorities
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headed the warnings last year, the rupee would not have had to be depreciated as much as it is
today, interest rates would not be so tight and fuel price increases could have been gradual and
less of a shock to the economy.
"The overnight adjustment to fuel prices is pretty significant," a young economist attached to the
Institute of Policy Studies, Anushka Wijesinha told The Island Financial Review.
"While the transport, agriculture and fishery sectors will get government subsidies and the
impact on them will be dampened, the manufacturing sector will feel the full brunt. More
generally, though, Sri Lanka needs to rethink its domestic oil pricing mechanism, and move
towards a market-reflective pricing that follows world Brent crude prices, so we don’t have
sudden hikes like this," he said.
Central Bank Governor Ajith Nivard Cabraal had strongly criticised those economists sounding
off the alarm over the impending balance of payments crisis. Last October, in an article
published in The Island, Cabraal swept aside concerns that a balance of payments crisis was
looming large and that the reserves position was not very comfortable. We reproduce some of his
statements below.
Cabraal framed the following response to the question ‘Aren’t we heading for a balance of
payment crisis?’: "Certainly not! We expected this growth in imports to take place this year as a
result of lower duties, higher fuel prices, greater quantum of intermediate goods imported, and
the overall improvement of per capita incomes of the people. Therefore, the increase in imports
which has resulted in the widening trade deficit has been factored into our estimates.
What is important is for us to have a clear picture in relation to our current account balance, and
the capital and financial account balance which finally leads to the balance of payments.
Although we have a trade deficit, the other inflows have more than adequately compensated for
this shortfall, and therefore we expect the balance of payments to record a comfortable surplus
by the end of the year. On that basis, we see no reason to react to monthly changes in inflows and
outflows. Reacting to daily and monthly changes is what speculators and hedge funds do, but, we
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as a Central Bank need to behave and act differently. We take a long-term view of economic
trends. Our current trends clearly indicate that there will be very definite inflows. That is why we
are confident about our stance."
Around that time, economists had also warned against falling reserves, and this is what Cabraal
had to say:
"Sri Lanka’s international reserves are calculated in exactly the same manner that it is done all
over the world. Whether it is a developed country or a developing country, they all follow the
same basis of reserve computation. Every country has borrowed and non-borrowed reserves. So,
there is no difference from our situation. What is important is to understand is as to how stable
such reserves are. Sometimes, reserves that are built up with FDI or portfolio investments could
be even more vulnerable to quick flight in a difficult situation, than long-term debt capital which
is obtained on a fixed term basis. Very often, sweeping statements and vague generalizations are
made by persons who do not see the long-term trends or the big picture. Managing an economy
is not an exercise which ends at a year end, or at the end of a quarter. On the contrary, it is an
ongoing process. For some people who are only looking at programmes, year-end targets or
theories, the quarter end targets, and numbers may be highly important and relevant, and that
could be their only focus. But, for those who manage economies of countries on a long-term
basis, what is most important is the direction of the economy.
"We cannot de-stabilise a country or an economy just to satisfy some temporary theoretical
concept. I can confidently assert that our reserve consolidation path is a well-balanced and well-
executed process which includes many components which function under different paths. Certain
components may be more visible and more active at certain times. At other times, different
components may be more active. Some theoreticians do not understand this "total" approach and
that is why some of them make such statements. Of course, some others with ulterior agendas
and motives understand this, but try to cause panic in the minds of people by making twisted
statements based on some temporary phenomenon. Once again, I must reiterate that we are
confident of the path we have chartered, and we will diligently follow such path, which we know
will realize the desired long-term results," Cabraal said.
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Nearly four months since this interview was published, the Central Bank has had to reverse all its
policy stances as it became too obvious to ignore that a balance of payments crisis was indeed
looming and that the reserves position was fast deteriorating.
Sri Lanka is heading deeper into balance of payments trouble with the monetary system moving
into an active sterilized intervention phase, leaving behind any opportunity for an interest rate
defence of the peg.
This is no drill
The central bank has given a firm signal that it will not depreciate the currency and take
International Monetary Fund advice to float the rupee.
Rates are also not being allowed to go up and money is being printed to keep rates down via
sterilized interventions, fuelling demand and adding to balance of payments pressure.
As mentioned in the last column, the
developments in the monetary system in
July turned out to be just a dress
rehearsal. Now sustained sterilization of
the balance of payments has begun.
The central bank's T-bill stock rose to 42
billion on September 20 and excess
liquidity was lower than that level at 31.4
billion rupees. Put another way, all the
excess liquidity can be accounted for by
freshly injected rupee reserves.
This money is now being re-absorbed by the newly started repo auctions.
Reserve Outflow
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Central Bank's August forex intervention data is now delayed by over two weeks. It is not
unusual in Sri Lanka for data to be delayed during a balance of payments crisis.
A back-of-the-envelop calculation, working backwards from available domestic asset data can
give some idea of reserve outflows.
Sri Lanka's monetary base expanded
from 413.2 billion rupees in end July to
427.2 billion rupees by September 15. In
the same period excess rupee liquidity in
banks fell to 29.8 billion rupees from
75.3 billion rupees.
The central bank's Treasuries stock
which represents fresh injections of
rupees through direct bill purchases or
reserve appropriations by the state, rose
from 1.7 billion rupees to 33.1 billion rupees in the same period.
The sum of the net fall in excess liquidity and the net increase in domestic assets in the period is
76.9 billion rupees. Adjusted for the expansion in reserve money, the net change is 62.9 billion
rupees.
It points to an approximate reserve outflow of 570 million dollars in six weeks when an average
exchange rate of 110.10 rupees is applied.
Assuming no material change in the monetary base, reserve outflows to September 20 amounts
to about 640 million dollars. If the monetary base contracted it is higher, or vice versa.
When added to the 416 million dollar interventions in July the total comes to about a billion
dollars, over a period of some 10 weeks.
Interest Rates
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Interest rates are at the moment being held back with an expansionary sterilization cycle. Rates
will start to move only when sterilization becomes less than 100 percent.
The monetary authority has started cash auctions and it is for the moment withdrawing excess
liquidity which was pumped by its own actions and keeping overnight rates at 7.08 percent.
There was a story where in response to a question from an LBO reporter the IMF mission chief
advised against an interest rate defence of the peg. But even at the time it was probably an
academic question.
Call market data show that if rates were allowed to move up in June as the system tightened it
may have been possible to save the peg.
Jack
To some observers the central bank's defence of the peg by targeting both the exchange rate and
interest rate seems inexplicable.
But from the point of view of a soft pegged central bank it is not that difficult to explain.
Even the IMF encourages the central bank to collect large amounts of reserves.
After being encouraged to collect reserves, which after all are supposed to be there to be spent
when the need arises, everyone suddenly turns around and advises the central bank not to spend
the money.
There is a pithy Sinhalese saying that captures the situation very clearly: Yuddeta nethi kaduwa
kos kotannader? It means 'If the sword is not available for war, is it being kept around to cut up
jack fruit?'
Unfortunately reserve collections - far above the monetary base - is a scam that only benefit the
governments of reserve currency central banks, principally the US where they are invested.
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It is funny that investors actually draw confidence from looking at large reserves. But large
amounts of reserves actually encourage Central Banks to defend pegs and keep rates down,
leading to predictable consequences.
External Anchor
There is no doubt that a peg is a useful tool. It impersonally acts as an escape valve for periodic
build ups of domestic demand pressure, by dynamically adjusting the money supply to economic
needs via the balance of payments.
It stops inflation to around the level generated by the anchor currency.
It stops rulers from destroying the real value of salaries of working people and lifetime financial
savings of the old and the weak through currency depreciation - which is already being done to a
great extent by the anchor currency central bank that is also printing fiat money.
But all this happens only if the monetary authority is prepared to drop policy rates, like in
Singapore (with limited sterilization) and Hong Kong (no sterilization).
To build a peg that is sustainable we need to change our monetary laws.
A 'float' is similar to what gold exchange standard central banks used to call a 'lifting of gold
convertibility'. Essentially dollar convertibility at a fixed rate is lifted by a float.
What Next?
The next step may be the start of reverse repo auctions. Some foreign banks are still liquid. They
also have limits for local banks. So some amount of excess liquidity can be expected to remain
even if reverse repo auctions start eventually.
If some bond holders quit, foreign banks will take paper into their balance sheets and liquidity
may also gradually diminish. Bond holders however need not panic, as over the longer term, the
peg is likely to brought back to near earlier levels following a float.
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Instead of a reverse repo auction, the central bank could continue to buy Treasuries direct and
sterilize its effect later.
In the past, the market has seen outright rejections of entire Treasuries auctions, when balance of
payments pressures reached crisis territory.
As already mentioned in the last column, higher import taxes could be expected on what
authorities quaintly (some would say in a fascist manner) call 'non-essential' consumer goods as
if they have a divine right to decide for individual citizens what is essential or not.
Though the spot dollar rate is around 110 rupees, in the forward markets rates have moved up.
The three month rate is now about 111.10/15, up about 50 to 60 cents over several weeks.
Waiting Game
Sri Lanka's IMF program is "in abeyance" to use a neutral expression. The mission who left with
an "uncompleted review" expects to continue discussions.
In July the Central Bank had eight billion dollars in reserves. At the rate of 300 to 400 million
dollar losses of reserves a month it will take several months for reserves to deplete to the level of
the monetary base, where it can no longer meet its domestic liabilities in dollars.
In a sterilized intervention phase however, state debt repayments can also become net reserve
losses.
Treasuries acquired by the monetary authority in place of reserve appropriations in the middle of
an expansionary sterilization cycle cannot be sold to the market to dampen domestic demand in
the economy and re-build fresh reserves.
All this can at any time be stopped by a float. Unfortunately until the imbalance is resolved
market participants will stop their normal growth generating activities and instead watch the
BOP.
This is costly for the economy at a time the global outlook is also far from rosy.
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Sri Lanka's balance-of-payments position is highly sensitive to price changes in the world market because it depends in large part upon a few export crops to pay for its imports. Since 1983, sharply rising defense expenditures, a decline in tourism caused by continuing civil violence, and slumping world tea and coconut prices combined to exert pressure on the balance of payments. The deficit has also been partially offset by substantial foreign exchange earnings from tourism and from remittances by Sri Lankans working abroad. The current account deficit has declined each year since 1994 when it stood at $860 million. Export growth in 1999, however, slowed considerably to 2% and earnings from tea exports had declined 40% due to the impact of the Russian economic crises in 1998.
In 2000, exports increased by close to 20% to $5.5 billion, and exports of garments and tea did
very well. Other exports, such as food, rubber products, machinery, and
processed diamond exports, also performed well that year. Sri Lanka floated the rupee in 2001,
and the central bank began employing currency controls. Since then, the controls were relaxed.
In addition, the government imposed an import duty surcharge to stem the flow of imports. The
country's external debt stood at $9.9 billion at the end of 2000, equal to 60% of GDP.
The US Central Intelligence Agency (CIA) reports that in 2001 the purchasing power parity of
Sri Lanka's exports was $4.9 billion while imports totaled $6 billion resulting in a trade deficit of
$1.1 billion.
The International Monetary Fund (IMF) reports that in 2001 Sri Lanka had exports of goods
totaling $4.82 billion and imports totaling $5.38 billion. The services credit totaled $1.37 billion
and debit $1.76 billion. The following table summarizes Sri Lanka's balance of payments as
reported by the IMF for 2001 in millions of US dollars.
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Enhancing confidence in Sri Lankan economy
The government of Sri Lanka introduced a number of bold macroeconomic stabilization
measures in February/March 2012. These were necessary as the country was on a trajectory to a
very destructive balance of payments crisis. It is still too early to determine whether enough has
been done to stabilize the balance of payments, particularly the trade deficit. As the Pathfinder
Foundation has pointed out in several previous articles, the trade deficit doubled last year,
despite a 22% increase in exports. The current account deficit deteriorated from 2.8% of GDP in
2010 to 6.8% in 2011. The overall balance of payments was in deficit to the tune of $1 billion.
The deterioration in the external account led to pressure on the currency and a hemorrhaging of
reserves.
No room for complacency
It is still too early to be confident that the courageous measures introduced by the government
are sufficient to stabilize the country’s external account. This is particularly so, as the risks
associated with global economic performance have become much more elevated. The persistence
of the Euro Zone crisis, the fragility of recovery in the US and the slowdown in China and India
have combined to create an adverse external environment for the exports of a country like Sri
Lanka. The decline in oil prices, following the weakness in the global economy, will have a
positive impact on Sri Lanka’s trade deficit. However, the US sanctions on Iran and the potential
loss of deferred payment terms for our oil imports could well reduce the beneficial impact of the
falling oil prices.
Monitoring performance, a must!
The data for 1Q2012 continues to be worrying. Though there has been a slowdown in import
growth this has been more than offset by the reduction in the rate of expansion of exports. The
upshot has been a worse trade deficit in the first quarter of this year compared with the
corresponding period in 2011. However, it is important to emphasize that the 1Q2012 data would
not have reflected the full effects of the stabilization measures that were introduced in
February/March. A clearer picture will emerge once data for April and May become available. It
is of paramount importance that the authorities monitor the developments in the country’s
external account very carefully to ensure that the desired trajectory of stabilization is attained.
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Failure to do so will inevitably lead to a devastating balance of payments crisis, particularly, as
Sri Lanka is now more exposed to international capital markets and the assessment of its
economy by rating agencies.
“Net” & “Gross” Foreign Reserves
In assessing the health of the country’s external account, it is important to differentiate between
“net” and “gross” foreign reserves. Evidence is emerging that there has been some loss even in
“gross” reserves in recent weeks. In addition, the “net” reserves position continues to be a matter
of concern. It is important to recognize that it is not possible to borrow one’s way out of the
current predicament. Recourse to borrowing (by the Government or Banks) can only postpone
for a short time the inevitability of serious balance of payment pressure. A sustainable external
account can only be achieved by effective stabilization measures that are supported by reforms
that strengthen the growth framework of the economy (see Economic Alert 27).
IMF: Looking beyond SBA
In the prevailing uncertain global and domestic environments, it is reassuring that the Senior
Minister of the International Monetary Cooperation has indicated that the authorities are
considering a follow-on arrangement to the current IMF Stand-by Agreement. The IMF team
currently in the country is in the process of undertaking an assessment in relation to the release of
the final tranche ($500 million) of the existing Stand-by. The negotiation of a successor to the
current arrangement assumes greater significance now that Sri Lanka is exposed to the whims
and fancies of international capital markets which have become extremely risk averse in the
current global environment. At present, foreign holdings of short-term Treasury instruments
exceed $3 billion. In addition, the government has issued Eurobonds worth $3 billion, of which
$500 million needs to be rolled over later this year. The upshot is that over $3.5 billion of foreign
holdings of treasury instruments needs to be rolled-over, during the next 6 months. Priority
would need to be attached, therefore, to maintaining foreign investor confidence.
Vulnerabilities and safeguards
In the same vein, it is also instructive to examine the performance of Foreign Direct Investment
(FDI). Such flows amounted to $220 million in 1Q2012. On a pro rata basis, this falls
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considerably below the level required to attain the $2 billion target set out by the authorities. It
also falls short of the investment path required to meet last year’s FDI figure of $1 billion. One
may conclude that it is currently a major challenge to maintain investor confidence in the Sri
Lankan economy. The risk appetite in international markets is low and the risks associated with
the domestic economy are high. Such a conjuncture of events places an extremely high premium
on maintaining investor confidence. In this connection, it would be in the country’s interest to
maintain an arrangement with the IMF to provide comfort to investors in these difficult times. A
lack of such an arrangement would make Sri Lanka vulnerable not only in terms of accessing
additional resources but there may well be difficulty in preventing the flight from short-term
Treasury instruments (it is worth asking the question whether the recent Bank of Ceylon $500
million bond issue would have been as successful without an IMF arrangement being in place).
The consequences would be severe for the people of the country.
Good politics: Pragmatism not dogma
In assessing the merits of an IMF agreement, it is important to be pragmatic and avoid dogma
and ideology or allow manipulative and rent seeking behavior to set the agenda. It is also
important to recognize that the character of the IMF is evolving as the G20 supersedes the G8 as
the premier forum for international economic decision-making. Large emerging counties like
Brazil, China and India are having an increasing voice in running the institution. It is noteworthy
that China decided to channel its support for Europe through the IMF. One should also remember
that the IMF agreed to release the Stand-by financing in 2009, despite opposition from some
major countries, due to the positive intervention of India.
Even if the authorities determine that additional borrowing from the IMF is not required (even if
the costs would be less than half that demanded by international capital markets) it is possible to
have a IMF Board or Staff monitored arrangement which would provide comfort to investors,
while not adding to Sri Lanka’s external liabilities
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Economy - overview
Sri Lanka continues to experience strong economic growth, driven by large-scale reconstruction and development projects following the end of the 26-year conflict with the LTTE. Sri Lanka is pursuing a combination of government directed policies, private investment, both foreign and domestic, to spur growth in disadvantaged areas, develop small and medium enterprises, and increase agricultural productivity. The government struggles with high debt interest payments, a bloated civil service, and historically high budget deficits. However recent reforms to the tax code have resulted in higher revenue and lower budget deficits in recent years. The 2008-09 global financial crisis and recession exposed Sri Lanka's economic vulnerabilities and nearly caused a balance of payments crisis. Growth slowed to 3.5% in 2009. Economic activity rebounded strongly with the end of the war and an IMF agreement, resulting in two straight years of high growth in 2010 and 2011. Per capita income of $5,600 on a purchasing power parity basis is among the highest in the region.
GDP (purchasing power parity)
$116.2 billion (2011 est.) $107.6 billion (2010 est.) $99.55 billion (2009 est.) note: data are in 2011 US dollars
GDP (official exchange rate)
$58.8 billion (2011 est.)
GDP - real growth rate
8% (2011 est.) 8% (2010 est.) 3.5% (2009 est.)
GDP - per capita (PPP)
$5,600 (2011 est.) $5,300 (2010 est.) $4,900 (2009 est.) note: data are in 2011 US dollars
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GDP - composition by sector
agriculture: 13% industry: 29.6% services: 57.4% (2011 est.)
Population below poverty line
8.9% (2009 est.)
Labor force
8.307 million (2011 est.)
Labor force - by occupation
agriculture: 32.7% industry: 24.2% services: 43.1% (December 2010 est.)
Unemployment rate
4.2% (2011 est.) 4.9% (2010 est.)
Unemployment, youth ages 15-24
total: 21.3% male: 17.1% female: 27.9% (2009)
Household income or consumption by percentage share
lowest 10%: 1.7% highest 10%: 36.8% (2009)
Distribution of family income - Gini index
49 (2009) 46 (1995)
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Investment (gross fixed)
27.3% of GDP (2011 est.)
Budget
revenues: $8.495 billion expenditures: $12.63 billion (2011 est.)
Taxes and other revenues
14.2% of GDP (2011 est.)
Budget surplus (+) or deficit (-)
-7.3% of GDP (2011 est.)
Public debt
78.5% of GDP (2011 est.) 81.9% of GDP (2010 est.) note: covers central government debt, and excludes debt instruments directly owned by government entities other than the treasury (e.g. commercial bank borrowings of a government corporation); the data includes treasury debt held by foreign entities as well as intra-governmental debt; intra-governmental debt consists of treasury borrowings from surpluses in the social funds, such as for retirement; sub-national entities are usually not permitted to sell debt instruments
Inflation rate (consumer prices)
6.9% (2011 est.) 5.9% (2010 est.)
Central bank discount rate
7% (31 December 2011 est.) 7.25% (31 December 2010)
Commercial bank prime lending rate
10.77% (31 December 2011 est.) 9.29% (31 December 2010 est.)
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Stock of money
$2.462 billion (31 December 2008) $2.465 billion (31 December 2007)
Stock of narrow money
$4.136 billion (31 December 2011 est.) $3.579 billion (31 December 2010 est.)
Stock of quasi money
$11.01 billion (31 December 2008) $10.46 billion (31 December 2007)
Stock of broad money
$22.52 billion (31 December 2011 est.) $19.72 billion (31 December 2010 est.)
Stock of domestic credit
$25.67 billion (30 November 2011 est.) $20.39 billion (31 December 2010 est.)
Market value of publicly traded shares
$19.48 billion (31 December 2011) $19.92 billion (31 December 2010) $9.55 billion (31 December 2009)
Agriculture - products
rice, sugarcane, grains, pulses, oilseed, spices, vegetables, fruit, tea, rubber, coconuts; milk, eggs, hides, beef; fish
Industries
processing of rubber, tea, coconuts, tobacco and other agricultural commodities; telecommunications, insurance, banking; tourism, shipping; clothing, textiles; cement, petroleum refining, information technology services, construction
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Industrial production growth rate
10.1% (2011 est.)
Electricity - production
10.71 billion kWh (2010 est.)
Electricity - production by source
fossil fuel: 51.7% hydro: 48.3% nuclear: 0% other: 0% (2001)
Electricity - consumption
9.268 billion kWh (2010 est.)
Electricity - exports
0 kWh (2009 est.)
Electricity - imports
0 kWh (2009 est.)
Oil - production
636.5 bbl/day (2010 est.)
Oil - consumption
92,000 bbl/day (2010 est.)
Oil - exports
0 bbl/day (2009 est.)
Oil - imports
84,730 bbl/day (2009 est.)
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Oil - proved reserves
0 bbl (1 January 2011 est.)
Natural gas - production
0 cu m (2009 est.)
Natural gas - consumption
0 cu m (2009 est.)
Natural gas - exports
0 cu m (2009 est.)
Natural gas - proved reserves
0 cu m (1 January 2011 est.)
Current Account Balance
-$4 billion (2011 est.) -$1.418 billion (2010 est.)
Exports
$10.89 billion (2011 est.) $8.307 billion (2010 est.)
Exports - commodities
textiles and apparel, tea and spices; rubber manufactures; precious stones; coconut products, fish
Exports - partners
US 19.6%, UK 10.4%, Italy 5.1%, India 4.9%, Germany 4.9%, Belgium 4.1% (2009)
Imports
$20.02 billion (2011 est.) $13.45 billion (2010 est.)
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Imports - commodities
petroleum, textiles, machinery and transportation equipment, building materials, mineral products, foodstuffs
Imports - partners
India 19.4%, China 15.1%, Singapore 9.1%, Iran 7%, Japan 4.9% (2009)
Reserves of foreign exchange and gold
$8.4 billion (31 December 2011 est.) $7.197 billion (31 December 2010 est.)
Debt - external
$21.74 billion (31 December 2011 est.) $21.43 billion (31 December 2010 est.)
Stock of direct foreign investment - at home
$NA
Stock of direct foreign investment - abroad
$NA
Exchange rates
Sri Lankan rupees (LKR) per US dollar - 112 (2011 est.) 113.06 (2010 est.) 114.95 (2009) 108.33 (2008) 110.78 (2007)