Sri Lanka’s economy is reeling from a foreign currency crisis during pandemic economic turmoil. A long-standing dependence on imports has finally caught up to drain foreign exchange reserves, already strained by large debt repayments in the absence of US $ 5 billion in tourism and influx of sovereign bonds.
Despite the apocalyptic predictions of some economists for debt restructuring, Sri Lanka has several options and combinations of strategies to consider to bridge the gap. Sri Lanka seeking to restructure its debt would tarnish its impeccable credit record since independence and damage its mark in foreign capital markets.
Rating agencies downgraded Sri Lanka to a CCC country rating for the first time after the pandemic, in an effort to refuse to borrow in international capital markets to fund maturing debt. Downgrades and concerns over the valuation of the rupee prompted foreign investors to withdraw from the rupee stock and treasury bond markets to record net capital outflows of around US $ 1 billion, Rs. 149 billion in 2020 and Rs. 42 billion until August 2021, to further exacerbate the currency crisis in Sri Lanka.
The government has responded to the pandemic crisis with stimulus of low taxes, low interest rates and the impression of liquidity like many central banks around the world exploiting weak demand which is helping to contain the ‘inflation.
It is commendable that the Central Bank led by former governor Professor WD Lakshman was able to limit the drain on foreign exchange reserves in 2020 and 2021, while honoring all debt commitments (see chart). Over $ 2 billion in foreign exchange reserves were offered to importers in 2011/12 and again in 2015/16 in futile attempts to control the exchange rate. The chart reveals a net purchase of dollars recently, to reveal an encouraging trend to protect valuable foreign currency reserves.
Today, exports have rebounded to reach US $ 1 billion per month. Despite import and banking restrictions, and a slowdown in demand, the trade deficit widened to over $ 600 million in June and July. The import bill of US $ 11.7 billion until July 2021 exceeded the import invoices by US $ 11.3 billion during the same period in 2019, without any import restrictions. An alarming trend indeed.
If importers anticipate a depreciation of the rupee, they will naturally accelerate import stocks at the prevailing exchange rate. A dollar that is perceived as cheap also results in the importation of low value-added products such as gas stoves and kettles, simply because it is cheaper to import than to manufacture locally. The recent trend of import expansion seems to reflect an elastic movement of the demand curve of import volumes over the price of
But Sri Lanka is not alone in facing a currency crisis and downgrades.
Downgrading crisis in Africa
Hippolyte Fofack, economist and director of the African Import-Export Bank, writes in an article “Downgrading Africa’s Development” republished in Ceylon Today (August 11, 2021), that 56% of the ratings of African countries have been downgraded by the rating agencies. international rating, while the global average was 31.8 percent, 28 percent in Asia and just 9 percent in Europe over the last year. The average is 62.5% if you include Kenya and Mauritius decommissioned in early 2020, “which could trigger disproportionately negative ‘cliff edge effects’.”
“The downgrades of African rulers are underpinned by several factors, but two are particularly relevant to the region. The first is the institutional instinct of rating agencies to preserve their reputation capital. The second concerns what are called “collection premiums” or overinflated risks. Higher premiums will increase borrowing costs and reduce demand for African public assets. The ripple effects of downgrades were felt strongly across Africa as the abrupt tightening of financial conditions at the onset of the COVID 19 crisis resulted in sudden stops and reversals in capital flows. ”
Net outflows from South Africa’s foreign portfolio of bonds and stocks exceeded US $ 9.7 billion in 2020 and undermine the government’s ability to honor its commitments to external creditors. Although oil prices have since recovered above pre-crisis levels, an improvement in Gabon’s credit rating appears far from imminent ”.
The article further states that “at the onset of the COVID-19 crisis, the European Securities and Markets Authority therefore warned rating agencies against worsening the slowdown through rapid downgrades.”
In other words, there is a lot to question the “opinions” of rating agencies which seem to “break” national economies and keep them dependent on funding agencies.
Managing the forex crisis
New central bank governor Nivard Cabraal in an interview with Bloomberg TV said he hoped to “print money and asset purchases” to tighten the money supply. The new governor has the honor of obtaining Sri Lanka’s first credit rating from BB- to issue Sri Lanka’s first sovereign bond in 2007. Under the “can-do” administration of the time, he cultivated a dialogue with the financial markets of Hong Kong with “road shows” to reinforce the confidence of the foreign investors.
Today, the new governor is going through an equally difficult crisis, to provide solutions to the impending currency shortage. But the challenges are not insurmountable. Governor has options to consider in 2022, as he unveils roadmap for recovery
Among them, the ideal solution would be to procure term loans of two to three billion dollars in 2022 and 2023 with maturities exceeding short-term “bundled” repayments. While it would be ideal to avoid future debts, one could imagine that the priority today would be to stay afloat and manage the economic crisis triggered by the pandemic until the income from tourism and FDI returns. .
In terms of foreign investment, the opportunity to generate inflows of dollars through the sale of underutilized or mature public assets to foreign investors and the CSE list of public enterprises to attract foreign capital can be considered. The joint venture agreement with US-based New Fortress Energy is one such FDI deal that will also help align future energy infrastructure with our natural offshore environment.
Blackrock has already invested US $ 60 billion in assets in India and plans an additional US $ 40 billion. Unfortunately, foreign investment has been politicized as undesirable in Sri Lanka, despite its major success in the telecommunications, ports and tourism sectors.
The Port City project has already met with initial success with commitments for the majority of its plots in the Marina District. Port City and Colombo Financial Center provide a unique platform to attract foreign capital with the establishment of new legal structures.
Rising yields on treasury bills and attractive valuations of the CSE provide opportunities to bring speculative foreign investment back into the rupee capital markets. However, in order to attract short-term foreign capital into rupee assets, Sri Lanka needs to restore confidence in the stability of the rupee.
Benefits of a competitively valued currency
While working capital loans for oil imports would provide relief, the most lasting solution, which includes short-term difficulties, would be a strategy to generate a current account surplus on the balance of payments (BoP). , that is, cash flows in foreign currencies. positive in trade in goods and services. Sri Lanka has been living well beyond its means for many decades to run inflated trade deficits. An obvious tool to achieve this is a competitively valued currency that will discourage imports and promote investment, exports and domestic production.
The current strong rupee policy runs counter to the government’s goal of promoting local production. If the rupee is overvalued, it performs the function of a subsidy to any consumer to purchase an imported product versus a local substitute. Imports of motor vehicles and fuel have benefited from the subsidized cost of dollar imports to generate trade deficits of $ 8 billion to $ 10 billion per year over a decade.
Fortunately for Sri Lanka today, many export sectors such as IT, seafood and clothing are growing rapidly. Most exporting economies such as Japan, Korea and China have become rich from trade surpluses to build up strong foreign exchange reserves. Sri Lanka could use a sustainable monetary policy to build up reserves, allowing the rupee to find a market value in the current economic context. It would be better to depreciate the currency than to continue with debilitating banking restrictions.
However, managing the budget deficit and inflation can be difficult during a period of currency depreciation. Yet inflationary pressures remain low globally due to the economic downturn, while increasing budget deficits are common during the pandemic. India’s budget deficit reached 13.7% in 2020 and is expected to reach 10.8% in 2021. India’s debt-to-GDP ratio fell from 70% to 90% during the period of pandemic crisis, although that foreign exchange reserves hit a record $ 642 billion. Forcing the exchange rate as a tool to control inflation and budget deficits is usually a short-lived tactic.
The upcoming budget proposal is expected to reflect fiscal consolidation with increased tax revenue, while GDP growth is expected to exceed 5% in 2021. A competitively valued currency would help gain the confidence of foreign funding agencies. If the government comes to an agreement with the IMF that does not involve debt restructuring, it will help regain the confidence of foreign investors.
The performance of the Colombo Stock Exchange is the 7th best performing stock exchange in the world until August 2021, with an increase in turnover testifying to local confidence in the economic revival of Lanka’s vibrant private sector. The new SEC law will improve investor confidence and market integrity.
Sri Lanka awaits a crucial budget proposal in November 2021 that will determine our economic fate.
(The author is the CEO of Ceylon Asset Management)