Photo courtesy of Hindustan Times
There is much confusion as to the causes of a balance of payments crisis. To clear up the misunderstanding requires defining the problem clearly and disentangling several issues.
To begin with, there were two distinct crises that occurred.
- The government debt crisis – the government’s inability to rollover its foreign debt.
- The foreign exchange crisis – insufficient supply of foreign exchange to meet the demand.
The two are connected in the sense that the government was unable to service its foreign debt but the cause of the government’s debt problem is quite distinct from the causes that lead to a scarcity of foreign exchange. To add to the confusion is the myth that the cause of the problems was trade mis-invoicing (under or over invoicing of exports/imports).
Trade mis-invoicing is not a new phenomenon, it has occurred in Sri Lanka for decades. While there may be other concerns about the practice, it does not cause a foreign exchange crisis.
Untangling this misunderstanding requires understanding the relationship between international trade flows and the overall levels of consumption and savings in the economy which are what ultimately determine the net trade flows. International trade flows, whether formal or informal, do not cause a foreign exchange crisis. The foreign exchange crisis is a monetary problem and cannot be addressed by attempting to control trade flows, whether formal or informal.
Trade mis-invoicing in the private sector is not directly connected to the government’s inability to rollover its debt. Private sector earnings and savings are distinct from the government’s revenues and savings.
The government never had the revenues to service its debt, either local or foreign. The way it handled debt repayments was to raise new debt to repay old debt. Under the Yahapalanya government, a medium term debt management strategy was put in place to increase government revenue and gradually reduce overall debt over a period of time but in the short-term it was still necessary to keep rolling over the maturing debt.
The crisis was precipitated when the government lost the ability to rollover its foreign debt when investor confidence was lost. This occurred after the large tax cuts of December 2019 which raised doubts in investor’s minds about the government’s ability to repay. The rating agencies started to downgrade the foreign debt in stages as the government’s fiscal position worsened and the IMF programme that was in place at the time was abandoned. The government repaid foreign debt for a while by using the foreign reserves but these ran out by January 2022.
Restoring investor confidence requires demonstrating that the government has put the public finances in order – i.e. that it is able to raise sufficient revenue to service its debt. As the government carries little credibility overseas, especially after the capricious policies of the recent past, the IMF programme is necessary to lend credibility to this exercise.
A foreign exchange crisis involves the flow of international money. To understand the causes of such a crisis it must be treated as a monetary phenomenon requiring the application of the tools and concepts of monetary theory.
This explainer attempts to clear up the misconceptions in a simple manner by summarising and simplifying some complex, counterintuitive and subtle concepts.
What is the exchange rate?
An exchange rate is a relative price of one currency expressed in terms of another currency. If the purchasing power of the rupee falls then it will be reflected in rising domestic prices and an increase in exchange ratio with other currencies (a weaker currency) – it will take more rupees to buy goods. The reverse will happen if the purchasing power of the rupee increases, it will be reflectedin falling domestic prices and a decline in the exchange ratio with foreign currencies (a stronger currency).
Rising domestic prices and a declining exchange rate are both symptoms of the fall in the value (or purchasing power) of money. The value of money; its purchasing power, depends on the demand for and supply of money. It is important to understand that inflation and currency volatility are not problems, they are only symptoms; the actual problem is a change in the value of money.
Demand for money is determined by the level of economic activity – as the economy grows, the volume of transactions grows and the demand for money increases. The supply of money is determined by the central bank. An increase in its supply above demand causes its value to fall. This becomes evident in increasing prices and the currency weakening in the foreign exchange market.
What is the foreign exchange crisis?
Although commonly referred to as a balance of payments problem, it is better defined as a foreign exchange problem. The problem arises when there is a demand for foreign currency that is in excess of the supply; there is a shortage of foreign currency. What causes this shortage?
The demand for foreign currency is determined by the overall levels of demand or consumption in the economy. The demand for foreign goods and services is a subset of the overall level of demand or consumption in the economy. If the government intervenes and sets an artificially low interest rate (to boost growth) by increasing the supply of money, the newly minted money fuels the demand for goods and services both domestic and foreign. As the demand for imports increases due to the artificial credit stimulus created, the demand for foreign exchanges increases and, at the prevailing rate of exchange, a shortage results.
What determines the level of consumption?
Consumption is determined by the level of income. For the most part, people cannot consume in excess of income. If some individuals consume in excess of income, they must finance this through borrowing. The financial sector mediates between savers and borrowers; banks lend out the savings of others, so the excess consumption of one group is financed by the savings of others so as a whole, there is no excess.
Then how does overconsumption arise?
This happens if the Central Bank creates new money. When new money is created, the supply of money increases relative to demand and leads to a fall in the the price of money – i.e. interest rates. When the new money enters the banking system it is lent out for investment and consumption. The artificially low rate of interest attracts borrowers but what is lent out is not only the actual savings of others but also the newly created money of the Central Bank. This leads to investment and consumption above the level of income. This is the source of excessive demand for local as well as imported goods and services which then translates to higher demand for foreign exchange.
If the exchange rate is floating the increased demand for foreign exchange will bring pressure on the exchange rate to increase (a local currency depreciation). If the exchange rate increases, it leads to higher import prices which then causes a contraction in demand for imports. The pressure on the exchange rate eases and the currency stabilises. If the exchange rate is not allowed to adjust (by holding it fixed) and money creation continues, then the demand for foreign exchange continues and a shortage of foreign exchange develops. This can then lead to creation of informal (black) markets for foreign exchange where the true value of the currencies are better reflected.
Sri Lanka’s current crisis
The current crisis is a combination of a foreign exchange crisis and a public debt crisis. The causes of the foreign exchange crisis have been dealt with in the preceding sections. The foreign exchange crisis is a familiar one, occurring at regular intervals.
Several foreign exchange crises have followed since the formation of the Central Bank in 1950; which aimed to “establish monetary conditions in Ceylon that may make possible, as never before, the fuller use of the nation’s human and material resources and a rising standard of comfort for all” (Report on the Establishment of a Central Bank for Ceylon).
The idea was that the Central Bank could create money which enables economic growth and investments in production to occur much faster. Mises (1998) sums up the fallacy of this belief “inspired by the superstition that omnipotent governments can create wealth out of little scraps of paper”. The impact of money creation is evident in the exchange rate of the rupee which stood at Rs.4.77 to the US dollar in 1948 and is around Rs.325 today.
The debt crisis is a new one; Sri Lanka has never defaulted on its debts before. As long as the debt was domestic the government could simply print more money and repay the debt (at the cost of higher inflation and exchange rate). With foreign debt this is not possible as the government cannot print foreign currency.
The best way to think about public debt is to consider it as postponed taxation. The government wants to spend money but instead of raising this money through taxes it borrows the money. Governments prefer not to raise taxes as it is politically challenging, citizens will start to question why taxes are being raised and what benefits they receive. After some time, if the benefits that were promised when taxes were raised by the government do not materialise further questions can arise.
Those in power, especially those who court public popularity are tempted to look for simpler ways to fund spending and debt is an attractive solution; governments can spend now and worry about repayment later. For the public, few questions arise when the government borrows they feel no immediate impact from this and depending on how the money is spent, may even see some benefit from it (such as more government jobs or highways).
Sri Lanka’s elections are said to be periodic auctions of non-existent resources. Over decades politicians have resorted to debt and the printing press to conjure resources to try and meet the popular but unrealistic promises.
Part of the recent debt and money printing has gone towards white elephant projects but a sizable portion has gone towards the growing salary and pensions bills of the public sector, which has doubled in size (to 1.5 million) over the last two decades. There has been no corresponding increase in the quality of public services; what citizens are paying for is the patronage network that ensures the re-election of corrupt politicians. Another sizable portion has gone towards energy subsidies (electricity and fuel) which are used to garner public support.
As long as a government maintains its credibility with financial institutions it is always possible to roll over debt. Governments raise new debt to repay the old debt and the public feels no impact.
When debt accumulates, so does the interest, so governments borrow again, not only to repay the principal amounts due but also to repay accumulated interest. If managed poorly, the amounts accumulating can snowball until a point is reached when the debt levels get to a point where the lenders begin to worry about getting repaid. This affects the credibility of the government, and it is no longer able to borrow any more. The foreign debt crisis arose not because of a shortage of foreign exchange but because the government lost its credibility and could not continue rolling over its maturing foreign debt.
When lenders stopped refinancing a government’s debt it was then confronted with the problem it has postponed and may even have forgotten – how to repay the debt. As we said before, debt is merely postponed taxation. The government should have been raising taxes gradually over the years to repay the debt it was taking but for convenience it chose not to. So, after decades of unbridled indulgence it is now forced to raise substantial tax revenues in a short space of time.
The citizens face a heavy double blow, an “inflation tax” where their savings and incomes are worth much less due to debasement of the currency as well as increased government taxes to make up for decades of fiscal indiscipline.
What makes up the balance of payments?
The balance of payments is purely an accounting exercise that summarises the economic transactions of an economy with the rest of the world. These transactions include exports and imports of goods and services along with transfer payments (like foreign aid).
It is simply an accounting exercise; the trade flows that are recorded in the balance of payments are a subset – they are the result of the overall levels of demand or consumption in the economy. The trade flows are not directly connected to either the foreign exchange crisis or the debt crisis but for the sake of completeness it is worth examining how trade flows arise.
By definition, the balance of payments must always balance – what a country buys or gives away to the rest of the world must equal what it sells or receives – that is the exchange nature of trade. People, whether trading locally or overseas, will not give up something without receiving something of comparable value in return. For a country, the total value of what it gives to the rest of the world will be matched by the value of what it receives.
This is recorded on the two sides of the balance of payments account:
- The current account
- The combined capital and financial account
The current account balance represents the net transactions with the rest of the world while the capital account balance represents net changes in ownership of foreign assets. The current account is always offset by the capital and financial account so that the sum of these accounts – the balance of payments – is zero. The capital account is what finances the current account.
An export of goods (current account) either increases the claim on other countries or reduces the debt (capital account) while an import of goods does the opposite.
Any import must be paid for. If a country is buying more goods and services from the rest of the world than it is selling, it must finance the difference. A net deficit in trade (a current account deficit) must be paid for by a surplus in the capital/financing account – i.e. funds received from overseas, either as foreign investment to Sri Lanka or foreign borrowing.
Saving, a national accounts concept, is simply income (output) not consumed. In simple terms, a current account deficit implies that domestic residents are consuming more than they are producing. Since income arises from production, a current account deficit is analogous to an excess of spending over incomes by domestic residents. The shortfall between income and spending of domestic residents is made up through borrowing from abroad (financial inflows); in these circumstances residents are accumulating net external liabilities.
Persistent current account deficits mean that a country is consistently spending more than its income by accumulating more and more net external liabilities. On the other hand, a current account surplus implies that domestic residents are spending less than their incomes (financial outflows) and accumulating net external assets.
However s surplus or deficit in the current account does not tell us much, what is more important is the actual economic activity behind these numbers. For example, a current account deficit implies a capital account surplus. If this consisted of foreign savings being invested domestically in productive enterprises it is a positive sign of economic health. However, a capital account surplus made up of foreigners buying Sri Lankan International Sovereign Bonds (ISB’s) to finance government deficits to fund public sector salaries, SOE losses or white elephant projects is a negative sign of economic health.
The country’s net position in the current account (that is whether it is in surplus or deficit) is determined by the flow of investments, savings and consumption. In Sri Lanka, private sector savings have always been positive (37.2% of GDP in 2022) but the public sector has negative savings; government spending exceeds government revenue (the budget is in deficit, by 6.4% of GDP in 2022).
Over the past year there has been a surplus in the trade and services account which has allowed the Central bank to accumulate foreign reserves. The surplus in the trade and service account arose because the government reduced its dis-saving by increasing taxes and raising fuel prices.
Corrective measures since March 2022
The currency was allowed to depreciate in March/April2022 and the Central Bank curtailed money printing – stopped increasing the supply of money from April 2022. As the supply of new money was curtailed, interest rates rose, leading to a reduction in demand (consumption and investment). With the source of excess consumption closed, shortages of foreign exchange started to ease. With the rupee trading at realistic rates money flowed back from the informal market to the formal market. Now, there is no shortage of foreign currency and the rupee is reasonably stable.
On the fiscal side, the government started to address the budget deficit – the public dis-saving. Taxes were increased and the prices of energy (fuel, gas, electricity) were raised. As these measures took effect demand contracted and the shortages of goods (and the rationing of electricity through power cuts) eased.
Higher interest rates and taxes have curtailed economy wide consumption and promoted savings which is evident in the change in the balance of payments statistics. As the level of dis-saving contracted, the current account balance improved; the balance of trade in goods and services is now in surplus and the Central Bank is able to collect foreign reserves.
The theory outlined earlier fits the facts of experience.
As long as the Central Bank maintains a consistent monetary and exchange rate policy, the rupee will remain stable and there will be no recurrence of a foreign exchange crisis. There is danger in the run up to the election that political pressure will be brought to bear on the Central Bank to lower interest rates (by increasing the supply of money; interest rates move inversely with the supply of money) which will promote consumption and disincentive savings. This will bring the exchange rate under new pressure. There are already signs of this happening. If attempts are made to “hold” the exchange rate, while the money supply increases it will eventually result in the erosion of reserves and another foreign exchange crisis will occur.
There is no need to seek explanations in the trade flows, formal or informal. The trade flows are only an end result, not a cause. The previous government tried to address currency shortages by controlling trade flows through import restrictions but failed. Even earlier attempts to address shortages in foreign exchange based on controlling trade flow; limiting imports (and stimulating domestic production) from the 1960’s failed. The IMF programmes of 1965,1966, 1968, 1969, 1971 and 1974 are a testament to this. Sri Lanka suffered acute foreign exchange shortages even at the height of the closed economy.
The Central Bank noted in 1960:
“Yet, in the monetary field the year 1960 was one of crisis. As in the years immediately preceding, Ceylon’s total outlay on consumption and investment exceeded her National product. In the Process, her external reserves continued to fall rapidly. By 1960, the decline in external reserves had gone so far that corrective measures became imperative…It would be misleading, however, to view the year 1960 in isolation. It belongs essentially to a phase which commenced some years earlier. The chief feature of this phase was a succession of markedly expansionist budgets which led to a swelling of the domestic demand for goods and services. In the absence of a comparable increase in domestic production, this additional demand was largely met through higher imports. The availability of sizeable external reserves made these imports possible”
And in 1974:
“Sri Lanka’s balance of payments has traditionally been in deficit as the country has consistently spent in excess of its income. Although the 1974 outturn conforms to this pattern, the size of the deficit and the fact that its rapid deterioration came after four years of steady improvement are significant features. The foreign credits which have been made available to finance deficits in the balance of payments have been an important means of drafting external resources for development.”
And in 1975:
“For more than a decade the acute shortage of foreign exchange has acted as a serious setback to the country’s development efforts. Sri Lanka’s foreign exchange difficulties emerged for the first time in the late fifties”