Sri Lanka Under Liquidity Trap

Sri Lanka has been reeling under a severe economic crisis. The situation of the country is going from bad to worse. Understanding the last financial crisis is necessary to make sense of Sri Lanka’s present predicament. Ever since the subprime mortgage crisis happened in 2008, the global economy has been on a program to purchase immense piles of bonds. The Federal Reserve Bank of America began buying mortgage-backed securities to fight the recession. The Fed started the first round of assets purchase program, so-called quantitative easing, in 2011 at 85 billion dollars a month and 1 trillion dollars in a year in the 17 trillion dollars economy of the United States (U.S). This unconventional monetary policy was meant to push investment and control the deflationary trends in the private economy. These volatile investment flows spilt across the global economies as short term debt in treasury bills and bonds and into the private debentures. That affected the central bank’s monetary policy and even stimulated inflation globally.

Along with massive inflation, Sri Lanka is also facing severe inflation and foreign exchange crisis with falling foreign currency assets and the government’s inability to foot the bill for essential imports. Sri Lanka has seen an enormous capital flight of this short term capital which has triggered a massive selloff in its bond market and currency. The central bank sold dollars in the foreign exchange (forex) market to stabilize the sliding rupee. After the U.S Federal Reserve confirmed plans to trim its security purchase program in January, foreign investors continued to pull out of treasury bonds. The high demand for bond inflows and an ample supply of dollars from the treasury aggravated the shortage. Amidst the panic, importers bought forward dollar contracts with high margin calls.

Sri Lanka’s economy faced challenges of twin deficits, which signals that a country’s expenditure exceeded its revenues, and its domestic goods and services were inadequate. Such economies can be dogged by high debt levels, a heavy reliance on foreign capital inflows, a steady depreciation of their currency, and high-interest rates. Sri Lanka has suffered balance of payments (BOP) crises at regular intervals; it has had 16 arrangements with the International Monetary Fund (IMF). Sri Lanka’s economy has relied on foreign capital borrowings, including private creditors, to finance its balance of payment difficulties. That added extra costs to the debt redemption service to its forex reserves outflows, evidenced by its frequent liquid reserves crises. Despite consecutive fund facilities and regular stand-by credit arrangement programs with the IMF, Sri Lankan Economy failed to improve its worsening BOP crisis.

The Sri Lankan economy opened in 1977. The reform initiative was dictated and supported by the credit arrangements with the IMF. The thrust of the reforms was to liberalize the economy. Much of the growth and flow of investment after the reforms initiated in 1977 came from imports. The foreign capital financed higher investments, which led to a higher external current account deficit. Sri Lanka was already suffering from high inflation levels due to the effects of the war and the increasing government debt.

Forex Crisis

Sri Lanka’s Central Bank has been selling sovereign dollar bonds since 2008 without any plan of how to redeem the debt. It built forex reserves by borrowing foreign debt rather than foreign equity capital or high earnings through export services. This move only exacerbated the foreign debts of the country. The Central Bank has been selling dollars for a long time in the forex market to stabilize the sliding rupee. The dollar demand from foreign investors selling T-bonds in the secondary market and the foreign investors pulling out of treasury bonds to pay the import bills left insufficient forex assets to repay the debt, causing inflation to reach triple digits.

To finance the foreign debt, the government resorted to printing more money. This action violated an essential principle of the quantity theory of money, which states that the price of goods and services must be proportional to the amount of money supply in an economy. This flood of money also led to inflation, and commodity prices increased beyond control. The prices of essential items like food, fuel and medicines have tremendously risen. A kilogram of rice costs 500 Sri Lankan rupees and sugar 300 rupees. The citizens had to stand in queues for hours to get essential commodities. The government deployed military personnel to help in the distribution of essential items. The inflation surged to 22 per cent, and the country’s debt-to-GDP ratio skyrocketed to 120 per cent. These numbers are worrying for the future of Sri Lanka as to whether or not it may be as bleak as the experience of the Weimar Republic hyperinflation crisis. During the crisis, the price of a loaf of bread rose from 250 marks in January 1923 to 200,000 million marks in November 1923 and, more recently, Zimbabwe’s hyperinflation crisis of 2007-08.

The Sri Lankan rupee hit a record low of 330 against the dollar after the Central Bank moved to a flexible rupee exchange rate regime. The Central Bank of Sri Lanka continuously conducted open market operations intervention in the forex market and abandoned the floating exchange rate. The exchange rate regime remained a tightly managed float. The real exchange tended to appreciate, reflecting persistently high domestic inflation relative to its trading partners.

How to address this crisis

The first thing Sri Lanka needs to do is redress its monetary policy because of its mismanagement; the currency’s value rapidly eroded. Moreover, the government’s macroeconomic mismanagement and conscious efforts to conceal the currency’s actual value lead to high inflation and price volatility. It can take years to recover from the economic impacts of inflation. If monetary policy is not redressed appropriately to the conventional standard, it may quickly go on a retreat.

Next, it needs to pay attention to reducing its BOP deficit. Expanding exports requires macroeconomic adjustments to restore the economy’s international competitiveness by depreciating the real exchange rate. Given the massive build-up of foreign-currency-denominated sovereign debt, relying solely on exchange rate depreciation would worsen budgetary woes. Also, given the increased exposure of the economy to global capital markets, adjustments have to be phased in. An abrupt change in the exchange rate could shatter investor confidence, triggering capital outflows, bonds could sell off further, may widen credit spread, and the yields could go up further.

Sri Lanka may also request Rapid Financing Instrument with the IMF. Sri Lanka may ask to reschedule and restructure its foreign debt with the Asian Development Bank, Japan and China, among the other major lenders. Furthermore, it has to seek additional lines of forex credits from its trading partners. The Central Banks worldwide adopted inflationary monetary policies to chase the dollar bonds in the international capital market to access easy global liquidity, which has become the global trend. The case of Sri Lanka offers itself as a cautionary tale to such countries.

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