Financial Times

Governance & transparency
Back to exchange controls?
By Sunil Karunanayake
State restrictions on foreign exchange - commonly called exchange controls and used essentially by developing countries - have not helped these countries to improve and stabilize their currencies. Exchange controls have a natural tendency to cause economic inefficiencies, significant administrative costs leading to bribery, corruption and parallel markets.

Since 1977 foreign exchange transactions in Sri Lanka have been progressively liberalized by allowing commercial banks to determine the exchange rates with foreign currencies. In 2000 further relaxation was made by widening the spread between Selling and Buying rates as announced daily by the Central Bank. In 2001 the Central Bank further liberalized the process by refraining from announcing the buying/selling rates in advance and provided a mechanism for the commercial bank's weighted average rates prevailing in the market to determine the rate.

Heavy pressure on imports brought about by the increase in petroleum products and the political upheavals within the country has seen a sharp depreciation of the rupee against the US dollar, now said to be around 7% p/a. Instability and the weakening of the currency and it's consequent effects on the economy has naturally prompted some thought on reintroducing exchange controls. It is now reported that the JVP, a constituent party of the ruling coalition, has urged the finance minister to remove the relaxation on repatriation of export proceeds currently available to exporters as a measure to stabilize the rupee.

With the world including China (now a WTO member) moving towards liberalization,7 removing barriers and resorting to free trade, it is said that state control in foreign exchange affects private life and is a decisive advance on the path of totalitarianism and suspension of individual liberty.

Despite all good things said about liberalization tough measures during difficult times are not unusual, In the late nineties when East Asian countries were going through a crisis it was none other than Paul Krugman, a renowned Professor of Economics at MIT and a well known guru on Free Trade, who advised on the reintroduction of exchange controls to these countries whose currencies were depreciating rapidly. This dose of advise however was received with much criticism all round.

Steve Hanke, another US professor of economics, describes exchange controls as nothing more than a ring of fence within which governments can expropriate their subjects' property.

In Sri Lanka we do not have a fully liberalized capital account even though the current account was liberalized in 1994 in compliance of the agreement with IMF on it's Article VIII requirement. Prior to this move exporters were required to account for their full proceeds in Sri Lanka and the Dept. of Exchange Control monitored this exercise through a series of documentary controls. Contrary to expectations the relaxation on the repatriation of export proceeds to Sri Lanka did not result in a massive outflow of funds from Sri Lanka. Even at the present moment it cannot be said that exporters hold on to their proceeds abroad for long periods, as it is economically not feasible to do so owing to the higher financing costs in Sri Lanka. This does not rule out the prospect of a few speculators cashing on the rapid depreciation of the rupee. In 2003 a draft bill on foreign exchange management Act (FEMA) was presented with further provisions for capital account liberalization. However this has not progressed to the final stages as yet.

Historical lessons do not give us confidence that exchange controls could resolve the present rupee crisis. On the other hand, mere rumours of a government considering exchange controls alone adds tension and nervousness to investors resulting in capital flight which may cause more damage to the currency. Worker remittances now a significant foreign exchange earner may well be adversely affected in a controlled regime. It is argued that imposition of exchange controls leads to an instantaneous reduction in wealth and since business is based on sentiment and future expectation, any consideration for the introduction of controls should be dealt with skill and caution. To a small island economy with a high import bill and low savings, foreign investment is essential to create wealth and employment.

Given the present gloomy external outlook aggravated by rising fuel prices Sri Lanka must move forward to build up a strong economy to stand up to external shocks, to protect the stability of the rupee. To quote from the Central bank Report of 2003, "increased inflows through the financial and capital account more than offset the current account deficit bringing in a surplus of the balance of payments for the third consecutive year. Foreign reserves rose to a comfortable level, the real effective exchange rate (REER) improved, external debt declined, as a whole the foreign exchange market further expanded, although some volatility was experienced in this market towards the end owing to uncertain political developments. All these would serve to strengthen the country's resilience to external shocks."

Accelerated development in power generation through hydro/coal power are critical for survival. For the past 10 years governments have been playing politics with coal power plant and the Upper Kotmale hydro project. These costly lapses have added more costs to the import bill. Unaffordable subsidies are misleading in promoting unproductive consumption. Diesel consumed by cars and vans used for travelling is a good example.

Controls are easy to impose but should be the last resort, Fiscal discipline, exports growth, political stability investor confidence and good governance are the key words to build up a strong economy capable of standing up with resilience to unexpected external shocks.

Back to Business