Columns - The Sunday Times Economic Analysis

A sudden U turn to Bretton Woods

By the Economist

After a prolonged period of denying that the country’s foreign exchange reserves were inadequate, the government has suddenly turned to the IMF for a stand-by facility of US$ 1.9 billion. For quite sometime now the Central Bank has maintained that the country did not have a serious foreign exchange problem. Besides, its announced strategy to replenish foreign exchange reserves did not include dependence on the IMF. Why this sudden turnaround after an assurance that the country had adequate foreign reserves and that it had a strategy of replenishing the reserves by borrowing from friendly countries? Did this strategy fail?

At least it appears the country’s situation was more serious than diagnosed by those who were in the best position to know. Impliedly, there is now an admission that the country’s economy is in a state of crisis and perhaps moving to an even more serious problem. It is not only that the foreign exchange reserves were inadequate but the balance of payments this year, as analysts expected, would be in serious difficulty. This situation is recognised by the government in its latest statement on why the government is going for an IMF stand-by facility of US$ 1.9 billion.

The three reasons justifying the move to borrow from the IMF are revealing. They indicate the weaknesses of the economy, especially the weakness in the foreign reserve position and the balance of payments that were continuously denied. The Central Bank states that “the intensification of global financial crises in September 2008 has adversely impacted the favourable trends in several economic indicators, particularly those relating to the external sector.” Was it not too long ago that we heard the same sources say that the global recession would have little impact on the Sri Lankan economy? Now the blame for the poor external finance is put on this global recession that we were told would have very little impact on the Sri Lankan economy.

The second justification is quite different. It is the impending end of the war and the massive finances that are required for rehabilitation, reconstruction and resettlement. The Central Bank argues the case eloquently that with the imminent end to the war “ there is an immediate need for a large quantum of external financing in order to continue with the resettlement, rehabilitation and reconstruction work in the Northern Province, and the continued rapid development of the Eastern Province.” In addition, it emphasizes that “this is an essential expenditure, not only to uplift the living standards of the people in the areas affected by the decades-long conflict, but also to successfully implement the government’s efforts to bring a sustainable solution to the conflict.” The argument is made even more persuasive when it goes on to say that the government “has already made substantial progress in restoring normalcy and reviving economic activity in the Eastern Province, and has also just commenced resettlement, rehabilitation and reconstruction in the Northern Province.

This momentum has to be intensified and widened in scope and reach, since the country has to make use of this window of opportunity to bring relief and hope to all who have suffered in this conflict.” The argument is indeed convincing. “The peace and socio-political stability that would be achieved as a consequence of such initiatives would, almost certainly, yield enormous economic and social benefits by way of rapid expansion of the domestic economy, mainly in the agriculture and fisheries sectors, as well as lead to the revival of the tourism industry.”

The third justification for the facility reverts to the impact of the global recession that was denied for quite some time as if Sri Lanka was an island unto itself. The rationale advanced is similar to the first argument with respect to the current global recessionary conditions that are not conducive to the country’s external finances. The Central Bank explains that “the current global financial conditions are not conducive for any country to mobilize the required level of essential external financing, and that Sri Lanka is no exception. Therefore, the availability of an IMF facility for balance of payments support at this time would help to supplement the Government’s efforts to stabilize the external sector performance of the country, and enable the country to face the times ahead with greater confidence and certainty. Such funds would be used to finance the new needs as well as to bridge any gap that may arise due to the global financial crises.”

The Central Bank gives the impression that the IMF was eager to give loans to the country rather than the government wanting the facility badly. The facility is not one the government sought but one that was offered by the IMF. “In response to an offer of the International Monetary Fund (IMF) to support Sri Lanka during the current global financial crisis, the Government of Sri Lanka (GOSL), has sought a Stand-by Arrangement from the IMF, in the range of 300 per cent of Sri Lanka's current quota with the Fund, which amounts to approximately US$ 1,900 million.” The government merely responded to an offer by the IMF rather than asked for it: it was the converse of Oliver Twist’s behaviour.

Despite these claims, there is no certainty that the government will get all what it expects. Even if it does it would be on stringent conditions. These tough conditions would not be with respect to the interest rate or the period of repayment. These would be concessionary. The rate of interest attached to these loans would be low and the repayment period very generous. However the IMF would lay down certain conditions that would have to be fulfilled. These could relate to the exchange rate, expenditure on certain items, overall government expenditure and the fiscal deficit. The conditions could extend further to issues of good governance, the implementation of reforms and the privatization of certain public enterprises. These conditions could be very onerous to the country in terms of its promised political policies and the ideological stance of the government. This conflict could jeopardize the loan facility or at least reduce the quantum of the loan. The loan would of course be given in several trenches. Though the government expects a sizeable amount up front, the actual fact is that it is likely to be given in several trenches each conditional to the government conforming to the laid down conditions.

The borrowing from the IMF to resolve our sorry state of external finances and for the development of the country is a step in the right direction. It is a reversal of the tendency in recent years to borrow from commercial sources that were at much higher costs and on terms that tended to be too short term as to create serious repayment problems. In contrast, lending from the IMF would be on concessionary terms and the debt servicing costs would be far less burdensome.

There is merit in several conditions laid down by the IMF as they are principles of good economic management. These include the curtailment of wasteful government expenditure, reduction of investment in public enterprises that have no chance of becoming economically viable and therefore a burden on the tax payer and a decrease in the large fiscal deficits that cause inflationary pressures. The control of these items is of considerable benefit to the economy. The reforms suggested by the IMF in such areas as education, public administration and public enterprises and subsidies too are for most part beneficial to the economy in the long run. These are generally disliked by governments as they are politically unpopular.

However the IMF does sometimes extend its ‘conditionalities’ to areas of government policy that could be beyond the issues of good economic management. IMF borrowing could entail conditions that are difficult for governments to agree to. For instance will the IMF lay down a condition that the war hostilities should be stopped? The Sri Lankan government will not comply with such a condition nor should it. There are some conditions that are an infringement of national sovereignty and also not necessarily beneficial in the specific context of the country.

In addition to the IMF facility, negotiations are on-going for a line of credit on concessionary terms for reconstruction of the North and East. This loan would also replenish the country’s foreign exchange reserves. However the Bretton Woods twin, the World Bank is also likely to lay down stringent regulations and these may well exceed the issues of macroeconomic policy and overflow into issues related to the war and the constitutional settlement.

While the government’s U turn to the Bretton Woods institutions is a right move in the right direction, it was resorted to in despair rather than hope. The government would no doubt have to meet stringent conditions in fiscal management, monetary policy, external finance and issues of good governance and economic and social policy reforms. Will it agree to such conditions to receive the facility or only be able to obtain a portion of it?

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