Capital outflows from Sri Lanka on the rise, but remedial policies are yet to come
The party is now over for emerging market economies like Sri Lanka which had greater access to low-cost borrowings in the global capital markets until things turned the other way with the rate hike by the US Fed from near-zero levels in last December, an the expected downturn in the global economy triggered by the economic setback in China. Earlier, there had been an influx of capital flows to emerging economies due to low interest rates in the Western capital markets. The trend is beginning to reverse now as investors relocate their investments in the less volatile US securities offering positive returns. Countries like Sri Lanka, which are grappled with weak macroeconomic fundamentals, are the first victims of the turmoil.
Rising capital outflows
Emerging markets had US$735 billion of net capital outflows in 2015, and another $448 billion of outflows is projected for this year.
Concurrently, Sri Lanka too has been experiencing capital outflows from her bond and stock markets in recent months. There was a net outflow of $1,093.4 million from the government securities market in 2015. Foreign investments in the secondary market of the Colombo stock exchange recorded a net outflow of $32.3 million in 2015. Foreign investors were net sellers of $19 million worth of equities last month.
It is a major challenge to deal with large capital outflows in the case of Sri Lanka, as foreign borrowings are the major source of capital flows, and servicing of such debt results in further foreign exchange outflows, in addition to the capital outflows resulting from the global financial turmoil. Sri Lanka has got caught in the debt trap so much that it impossible to escape from debt-roll over, i.e. getting` fresh loans to repay the earlier ones.
Monetary policy is passive
Given the drastic consequences of capital outflows, it is important that appropriate policy responses are applied to manage capital movements, since insulation of capital flows is not the best option. For this purpose, the monetary policy tools, particularly interest rates and the exchange rate need to be used prudently. Sri Lanka’s experience during the last decade or so, however, does not show such proactive policy response with regard to the exchange rate or interest rates. Both tools seem to have been driven by the motive of fiscal and monetary authorities to avoid increases in the debt service burden of the government that would result from a rise in interest rates or depreciation of the rupee. The Central Bank (CB) avoided exchange rate depreciation by releasing its foreign reserves, largely backed by borrowed funds, to the market. At the same time, the CB kept its policy rates low to prevent rise in market interest rates.
Efforts to maintain both the exchange rate and interest rate targets simultaneously in the context of capital flows cannot be materialised from the viewpoint of the ‘Impossible Trinity’ theorem, as I reiterated in these columns for some time. Both monetary policy measures have led to overheat the economy which resulted in increased imports and depressed exports thus, weakening the balance of payments. The exchange rate has begun to depreciate in recent months. However, it is reported that the CB applies moral suasion to prevent falling the rupee below Rs. 144 per 1 dollar level. Meanwhile, the CB is still reluctant to allow an upward shift of market interest rates despite the excess liquidity in the market overheating the economy. In its Monetary Board meeting held last month it was decided to keep the policy rates, the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) unchanged at 6.00 per cent and 7.50 per cent, respectively.
Recent exchange control relaxation is unjustifiable
In the wake of the financial turmoil, the Finance Minister has further relaxed exchange control regulations pertaining to capital outflows, as per three gazette notifications issued on 29 December 2015. Gazette Notification No. 1947/14 permits persons resident in Sri Lanka who maintain Non-Resident Foreign Currency Accounts (NRFC), Resident Foreign Currency Accounts (RFC), Resident Non-National Foreign Currency Accounts (RNNFC) and Foreign Exchange Earners’ Accounts (FEEA) to make payments out of the balances in such accounts to persons resident outside Sri Lanka for the acquisition of securities permitted in terms of Gazette Notification No.1947/13, and any other assets of capital nature.
This encourages any resident in Sri Lanka to make capital outflows even out of the foreign exchange generated within Sri Lanka for any acquisition of financial or real asset outside the country.
The third Gazette Notification, No.1947/15 stipulates that those who acquired such assets are exempted from the requirement of declaring such assets under Section 6AB of the Exchange Control Act. This not only encourages capital outflows but also provides freedom to maintain and dispose the assets so acquired without accountability necessitated for the Balance of Payments purposes. This decision is tantamount to a further liberalisation of the capital account of the balance of payments which seems unwarranted at this juncture. Consequently, the country is bound to lose a sizeable amount of foreign exchange on top of the capital outflows resulting from the global financial shock.
Evasion of reforms through unconditional loans
Borrowings from foreign capital markets enabled the previous government not only to spend the funds lavishly for various projects irrespective of their rates of returns, but also to avoid drawings from the International Monetary Fund (IMF) which are subject to stringent conditions of structural reforms aimed at rectifying the economic fundamentals. Such arrangements could have arrested the economic disarrays that we face today to a large extent, though they might have been politically unfavourable.
The previous government borrowed $5.5 billion through seven sovereign bonds during 2007-2014. Commercial borrowings obtained from China (EXIM Bank, CIDB, etc) amounted to around $5 billion during 2006-2014. In 2013, commercial banks were allowed to borrow up to $50 million per annum and blue chip companies up to $10 million per annum, for three years. Eventually, the state-owned banks (Bank of Ceylon, NSB, NDB and DFCC) became indirect borrowing sources for the government.
The present government is continuing the same practice of resorting to reform-free commercial loans. In 2015, the government raised $2.15 billion through two sovereign bond issues. In addition, the CB signed a currency swap agreement with the Reserve Bank of India to draw $1.1 billion in 2015. It was reported last month that the Minister of Finance had told Reuters that an unknown Belgian investor has promised to park $ billion in dollar deposits. Also, the Minister is reported to have announced a few days ago that the country has received $1.2 billion from two investors, and therefore, there is no need to obtain assistance from the IMF.
While such borrowings help to ease the balance of payments crisis temporarily, the underlying root causes remain unattended, as the present government too uses the easy way out to evade the pressing structural reforms. Leaving aside the concerns about money laundering, there is danger that such ‘hot money’ can be pulled out from the country at any moment triggering adverse domino effects on the entire economy. Given the current trends, however, any deviation from this imprudent practice cannot be expected in the foreseeable future.
(The writer, an economist, academic and former central banker, can be reached at
sscolom@gmail.com)