Columns - The Sunday Times Economic Analysis

Resolving the balance of payments crisis

Changing Economic Scenarios
By Nimal Sanderatne

Will the corrective measures taken by the government resolve the balance of payments difficulties? This is the vital question in the minds of all concerned with the economy. The Central Bank has always been optimistic and, in fact, was to begin with of the view that there was no real problem. Whether it actually thought so or not will be unknown to us. What we do know is that it was this perspective that delayed remedial measures. As a result, the country lost valuable foreign exchange reserves that were mainly borrowed funds.

The recent measures have established a degree of confidence in the Sri Lankan economy. The continuation of the IMF standby agreement with the infusion of a further US$ 800 million that is expected would boost that confidence. It would be foolish if the Central Bank decides to not take it. This facility is at the very low interest rate of 1.1 percent and with a long period for repayment. Apart from the fact that not taking this low interest facility would mean that the government would have to resort to commercial borrowing at high interest rates, such discontinuance with the IMF would spell disaster in as far as international confidence in the economy is concerned and increase borrowing costs.

Central Bank perspective

The Central Bank optimism was based on expectation of large capital inflows. It expected the large trade deficit to be offset by inflows of worker remittances, increased tourist earnings, large inflows of foreign direct investments and foreign borrowing. With this expectation in mind it considered the balance of payments problem to be of a temporary nature. This was the rationale for defending the rupee at an overvalued exchange rate. This unrealistic expectation led to inaction to address the emerging problem. The exchange rate was kept fairly stable and Central Bank interventions in the market cost billions of dollars resulting in further diminishing of the reserves.

There were several deficiencies in this approach of the Central Bank. It depended on the realisation of its expectations of service earnings, foreign investments and loans to be adequate to offset a record huge trade deficit of nearly US$ 10 billion. It is not that worker remittances, tourist earnings and other service receipts did not increase, but they were able to offset only a part of the gaping trade gap. In 2010, worker remittances that have been an important contributor to the balance of payments financed only a little over half the deficit despite remittances increases by about 25 percent.

This is different to the situation in 2010 when they financed 80 percent of a much lower trade deficit of about US$ 5 billion. As it turned out, the trade deficit in 2011 was nearly US$ 10 billion, twice that of 2010 and too large to be offset by the increased capital inflows. In 2012, too, the adequacy of these receipts depends on the extent of the trade deficit.

Similarly, it is far too unrealistic to expect remittances to finance most of the emerging trade deficit in 2012. The original estimates of the Central Bank were that the deficit would increase to US$ 13 billion this year, about US$ 3 billion more than that of last year. Hopefully, the depreciation of the currency, increases in tariffs and their impacts on decreasing the demand for imports and higher interest costs would be significant in reducing the deficit to about the 2011amount of US$ 10 billion or less.
Much of this expectation is dependent on the oil price.

Oil prices have been very volatile. There was a slight decline in oil prices followed by an increase in prices. The situation in the international oil market is highly unstable and the Sri Lankan situation is particularly uncertain owing to the dependence on Iranian oil for refining.

Fundamental weaknesses in trade

There was a further deficiency in the Central Bank approach to the problem as it did not recognise that the trade imbalance was due to fundamental weakness in the economy and the appreciation of the real effective exchange rate. Part of this problem was due to regional currencies being depreciated thereby increasing the relative exchange rate value of the Sri Lankan rupee that became overvalued relative to its competitors.

This would have affected export competitiveness even though exports grew by 23 percent in 2011. The surge in imports would have also been due to the relative cheapness of imports. Both these factors resulted in the increase in the trade deficit. The inflow of remittances and service receipts could ease the balance of payments, but it does not address the problem of the serious imbalance in the trade balance.

Depleting reserves

The other deficiency of this approach was that it used up valuable foreign exchange reserves defending the rupee. It is estimated that about US$ 2.7 billion was depleted by this defence of the rupee. This is a serious setback to the economy as most of the reserves are borrowed funds. At the end of last year reserves had fallen to US$ 5.7 billion from US$ 8.1 billion in July 2010.

The reserve position is perhaps below US$ 5 billion now. Given the commitments to service the outstanding foreign debt and the repayment of loans, this is an inadequate reserve. Although the Central Bank estimates that the reserves are adequate to finance 3.5 of imports, at current levels of export expenditure it may suffice for only about 2.5 months of imports. This is considered an inadequate reserve.

Therefore it is sensible for the Central Bank to obtain the remaining two tranches of the IMF standby agreement of about US$ 800million. Apart from replenishing the reserves, the continuation of the agreement with the IMF would add foreign confidence in the economy.

This would in turn strengthen confidence in the rupee, reduce foreign borrowing costs and improve prospects for foreign investments. The continuation of the IMF arrangement and policies now in place: the more flexible exchange rate policy, monetary measures and fiscal measures to curb demand for imports, should have a beneficial impact on the trade balance.

International ratings

The international rating agency Fitch has expressed this view. "Fitch believes that recent policy measures are encouraging. Not only do these measures suggest an eventual easing of pressure on the BoP but they may also aid the development of more sustainable economic growth. The authorities' ability to persist with these policy measures would be supportive of the current ratings.

Instead of fuming over the Fitch ratings as unsatisfactory, we should pursue the correct policies to address the serious problem of the balance of payments, especially to contain the trade deficit. It is by taking the appropriate policy measures and improving the external finances that we could improve the ratings. "Conversely," as Fitch observes "policy slippage has the potential to apply negative pressure to the ratings."

Economic hardships

Inherent in these policies are hardships for the people. The fact is that we have been living and investing beyond our means. Further hardships are likely with price increases due to increased tariffs and the depreciation of the currency, as well as measures to correct the fiscal balance. The February consumer price index did not reflect the full impact of the price increases owing to the price rises being in the second half of the month and certain other prices coming down. Consumer prices will continue to rise with increasing inflationary pressures owing to the initial price increases having a spiralling effect, especially through increased transportation costs.

Whether the consumer price index would rise sharply in March and continue its uptrend depends on whether there would be creative statistical accounting. What the index reflects is of academic interest. The real price increases that people have to face is what matters.

In this situation it is important for the government to curtail its extravagant conspicuous spending and set an example that would make it less painful for the people to endure the hardships. In fact the popular view that excessive government spending and waste is responsible for this crisis requires a response. It is a time for frugal government expenditure.

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