Photo courtesy of Times of India
I debated with myself whether Sri Lanka’s present state was a crisis of incompetence or a crisis of arrogance and settled on incompetence. You could have someone arrogant but competent; it’s not perfect but it’ll do. Someone who is modest but incompetent would at least have the modesty to ask for help. But someone who is arrogant and incompetent is objectively worse. Not only do they not know what to do but they also would not ask for help. Hence, I will call it a crisis of incompetence.
How it started
The tax cut proposed in the Viyathmaga-drafted Vistas of Prosperity and Splendor were implemented in late 2019 – “the prevailing tax system has contributed to the collapse of the domestic economy”, it said. I think I do not need to expand on the irony of this, which by the way, the vistas document is full of. Several taxes, PAYE, withholding tax, economic service charge was scrapped, VAT was slashed and several tax holidays were granted. The government’s tax revenue fell by nearly 28%, completely upsetting the path of fiscal consolidation undertaken by the previous government.
In 2016, Sri Lanka had entered into an Extended Fund Facility (EFF) with the International Monetary Fund (IMF) equivalent to $1.5 billion, the purpose of which was to deal with the balance of payments (BOP) pressures (yes, they were not new problems), to unlock other financing and to boost investor confidence. In 2019, following its 6th and final review the IMF decided not to disburse the final tranche of the lending facility due to Sri Lanka’s U-turn away from fiscal consolidation.
By September 2020, the Sri Lankan government decided it would terminate a $1.5 billion Japanese funded light rail system saying that it was not “cost-effective”. One engineer even went so far as to claim the Japanese LRT was useless as it could not carry cargo on top of the carriages.
The ground work for the project had been done by the previous government, and the interest on the loan was a mere 0.1% with a 40 year payment period and a 12 year grace period. Anyone else would have thought we were ripping the Japanese off, not the other way around. To make matters worse for us, the Japanese firm which had been signed on as consultants to the LRT project claimed damages worth Rs 5.8 billion for violating the terms of the agreement.
By December 2020, the US Millennium Challenge Corporation (MCC) decided to discontinue the proposed $480 million grant to Sri Lanka that would have upgraded our urban transport network, land registration and built several rural road links to highways around the country without a cent in loans.
We can’t really blame the US for the cold shoulder after all the fear-mongering spearheaded by Podujana party politicians and their allies. Biology tuition master Tissa Jananayaka even went so far as to conduct a lecture on how the US would take over a 200 km strip of land with an area of 1.2 million acres connecting Colombo and Trincomalee and called it the American Corridor. This same biology teacher also helped lend credence to the now debunked Dr Shafi hoax. Ah, the purveyors of alternate facts in Sri Lanka.
In December 2019, the Central Bank had $7,642 million in its reserves. Reserve adequacy which is measured in months of imports was 4.6 (basically Sri Lanka could fully service its import needs for 4.6 months if everything else was held constant). By December 2020, 9 months after Sri Lanka’s first lockdown, reserves were at $5,665 million, enough for 4.2 months of imports.
Now, at this point, it might have triggered some retrospect in someone arrogant but competent. None of us knew how long the pandemic would really last – it was a “novel” coronavirus after all. In April/May 2020, Sri Lanka’s sovereign ratings were downgraded to B-negative, immediately locking Sri Lanka out of international financial markets. So, raising financing through international sovereign bonds was no longer an option either. It was clear at this point, that Sri Lanka would need IMF support eventually.
But unfortunately, Sri Lanka decided to bank itself on the self-proclaimed Godfather of Russian tourists instead and pilot an ill-fated tourism bubble with Russian and Ukrainian tourists. The purpose of which was to increase forex inflows through tourism. At this point, Covid vaccines had not been rolled out anywhere else in the world (it started on January 2021), let alone in Sri Lanka.
Perhaps the only competence displayed was in the distribution of Covid vaccinations, but even that was not without issue. There were delays in the procurement of the 2nd dose of Astra-Zeneca and of course plenty of flexing connections to get Covid vaccines ahead of others.
How it went
In July 2021, the Central Bank of Sri Lanka settled a $1 billion bond, increasing the fragility of its external liquidity position. Reserves fell to $2,806 million by end July, just 1.8 months of imports. It was soon after in August 2021 that the Delta variant started spreading in Sri Lanka, and experts warned that things would get worse. It would go onto become Sri Lanka’s worst wave of Covid in terms of hospitalizations and deaths.
We were teetering on the edge. By October 2021, Sri Lanka’s reserves had fallen to $2,269 million, just 1.4 months of imports. It was in this month that governor of the Central Bank announced his six month roadmap. How it has been six months since this roadmap was launched and none of the inflows mentioned in the document ever materialized.
In November 2021, reserves fell to $1,588 million, just one month of imports. Despite the impossible nature of Sri Lanka’s economic crisis at this point, the government of Sri Lanka still refused to explore IMF support. The presidential secretary, P.B. Jayasundera, in November said the government will “restructure its loans instead of seeking the assistance of the IMF”, the hardline stance it had maintained throughout until this month.
Soon after Christmas, the Central Bank decided to draw down on a $1.5 billion Chinese-Yuan swap it has agreed to in March 2021 to boost Sri Lanka’s reserve position, at least on the books, to $3,139 million. Reserve adequacy remained bleak, just 1.8 months of imports. Who was the Central Bank trying to fool? I do not know.
Against all expert advice, the government of Sri Lanka opted to settle a $500 million bond in end January 2022, quite literally by selling the family silver, or rather the gold in this case. In early January, the Central bank sold 3.6 tons of 6.69 tons of its gold reserves. I do not know the rate at which the Central Bank sold its gold at, but in January, the market price of gold was $1,825 per ounce.
In early January Goldman Sachs had raised its 12-month gold price forecast to $2,150 per ounce expecting a slowdown in the US economy. By March, gold prices had hit a record $2,050 per ounce following Ukraine-Russia tensions. Goldman Sachs has now raised its 12-month gold price forecast to $2,350. Perhaps if we had competence, we would now not be here wondering what the market value of that 3.6 tons of gold we sold in January would be.
Between January 2020 and December 2022, the Central Bank of Sri Lanka had expanded broad money supply, defined as the sum of currency held by the public and demand deposits held by the public with commercial banks, by Rs. 2,726 billion, a 40% increase since the start of 2020. Ajith Nivard Cabraal, who was then a state minister and currently the governor of the Central Bank boldly claimed, “there is no relationship between money printing and rupee depreciation”.
This is what the Central Bank of Sri Lanka says about broad money supply, “studies have shown that the most appropriate monetary variable to analyze the relationship between the money supply and the general price level is the broad money supply”. Perhaps then, it is not a surprise that inflation is rising so rapidly – I suspect, with the devaluation of the rupee, that March inflation will likely exceed 30%.
At the same time the Central Bank decided to maintain an artificially low interest rate, along with an artificially low managed-float exchange rate. The second lesson I learnt at my monetary economics course during my undergraduate days was that the Central Bank much choose what it wishes to control: the interest rate, the exchange rate or the inflation. It cannot, in any sense, control all three at once because these are often conflicting.
But what we saw over the past two years was, in fact, an attempt to control all three. To keep interest rates low, it was necessary to supply more money but when you supply more money that causes the rupee to depreciate and inflation to increase. Hence, the Central Bank had no choice but to employ moral suasion to maintain an exchange rate that fails to reflect reality.
But the market is no fool. Worker remittances, one of top three sources of foreign exchange into the country, fell by 22% from 2020 to 2021, that’s $1.6 billion lost due to the Central Bank’s exchange rate policy.
In end February reserves were $2,361 million, that is about 1.4 months worth of imports. The rupee devaluation hit like a ton of bricks. The Central Bank floated the rupee earlier this month and today it is being quoted at Rs.300 by some private banks. That is a depreciation of one-third. It will likely stabilize at a lower rate eventually but will have a drastic impact on purchasing power and the cost of living.
The domestic banking sector is also now at risk. In 2020, there was a shift in the foreign-domestic composition of government debt. Instead of borrowing internationally, the government borrowed domestically, shifting the composition to a 40-60 ratio. Domestic commercial bank exposure to government debt increased from 28% of central government debt in 2019 to 43% in 2020. I do not have 2021 and 2022 figures.
How it’s going
The government has finally decided to seek IMF support but it is too little too late. The government, if it was not besieged with incompetence, would have gone to the IMF one and a half years ago. A debt restructuring program will likely take upwards of 11 months (according to Lee Buccheit), depending on how proactive the sovereign debtor is (the current Sri Lankan government is many things but proactive is not a word one would use to describe it). Whatever reforms undertaken will be slow yielding and we have also piled on short term debts like swaps.
If we take away the $1.5 billion Chinese-Yuan facility that definitely cannot be used to service debts, our usable reserves are below $1 billion. But we have a $1 billion bond maturing in end-July 2022. How does the government plan to make this? In the meantime, besides financial aid, the government has not sought humanitarian assistance for food and medicine for inevitable shortages that will occur. It will probably not be proactive about this either and wait until our backs are against the wall.
The $1 billion credit line from India will help but despite import bans on non-essentials our import bill in December 2021 was $2.2 billion due to global inflation and other factors beyond our control. The war raging on in Ukraine will affect global wheat prices shortly. Fuel prices are also higher than it was pre-Covid so even if we buy less, we may still be paying the same total amount. Russia is selling oil on discount but Sri Lanka cannot even afford to buy that.
The disastrous organic agriculture policy has affected domestic food supply and domestic production. Rice yields fell by 20% in six months, the drop in tea production is expected to cause a loss of $425 million. Without an adequate supply of food and fuel, we can also kiss our projected tourism earnings goodbye. On top of that, Russia, which is one of our top tea markets will most likely not be able to buy our tea for the foreseeable future.
Reforms will take time to bear fruit, exports will not double in a year, no matter what Finance Minister Basil Rajapaksa said at his budget speech. Some countries have issued travel advisories about shortages and power cuts, so tourists will be skeptical. Worker remittances may take some time to bounce back from informal channels.
The only option the government has is to cut its expenses drastically and immediately; this means stopping all infrastructure projects, sending everyone except a skeletal staff home, raising taxes to increase revenue and to immediately start seeking humanitarian assistance to meet its food and medical needs because the cost of living will soon be unbearable for many.
Sri Lanka is now in the perfect storm precipitated by this Rajapaksa-led crisis of incompetence. Will we make it out?