 Is Sri Lanka heading towards a major foreign exchange problem? This is a timely issue. It is also true that the country’s external balance has never recorded a long-term healthy growth basically due to internal problems, but it managed to survive without collapsing.
Now the situation seems even worse in the midst of a global financial and economic crisis. Global crisis is only the immediate cause of the problem, because the foreign exchange problem has much deeper roots in the internal economy.
Global crisis
The global financial crisis is inevitably translating into a global economic crisis in two respects. On the one hand, the downturn of the financial markets all around the world leads to a reduction in output and employment. Within the first three-quarters of the year, many firms operating in the US financial market collapsed or downsized, while the job losses were recorded as high as over 600,000. On the other hand, the credit crunch and the loss of the monetary values of assets around the world lead to a reduction in aggregate demand affecting output. In the modern world, aggregate demand is more credit-based.
Therefore, when there is credit-crunch and when there is loss of income and employment, aggregate demand falls. In response now output should also fall. Therefore, a financial crisis turns to be an economic crisis at the end.
What is more important for the Sri Lankan economy is not the global financial crisis, but it translated into an economic crisis. Sri Lanka does not have an important direct relationship with troubled financial companies abroad in terms of assets-holdings or portfolio investments in global financial markets. Even the amount of foreign assets held by the Central Bank is only about US$3 billion. Even if this is such a small amount according to the world standards, that is all what we have. However, the downturn of the world economy will result in a fall in export demand so that Sri Lanka will experience loss of export demand for our garments, tea, rubber and tourism and the consequent fall in their prices. Import prices will also come down so that the net benefit has to be assessed in terms of change in exchange rate and in domestic inflation. Whether the consumer gets the benefit of the price fall is another matter of concern.
Internal problems
The long-term causes are deep-rooted and they are our own problems than the global ones. We have almost neglected the need for ‘export promotion’ for decades so that it has become an ‘outdated’ topic today. Today we talk more about import substitution than export promotion.
As a result, export growth is sluggish according to the standards of the fast-growing economies in Asia. In terms of cushioning the balance of payments problem, Sri Lanka has been relying more on foreign remittances and government’s foreign borrowings. The fastest growing foreign exchange earning sector for the past few years, growing at about 15% per annum, has been the foreign remittance mainly from the Middle East. It is ashamed to boast about this because it is a sign of poverty and misery at home rather than prosperity. Borrowings are not bad as long as they are put in productive use which will create assets and generate income in the future. The government’s foreign borrowings seem to be well over US$1 billion now. We should not forget that today’s borrowings will turn to be tomorrow’s repayments which would exert further pressure on the balance of payments.
Pressure on Balance of Payments
Now the coming foreign exchange problem is clear. We do not have a long-term steady growth of exports and, as a result we do not have a healthy foreign reserve position. Global crisis has also created a negative impact on foreign exchange earnings, in addition to its impact on foreign exchange outflows, if any. The country’s loan repayments are also due within the next few years. All these account for growing excess demand for foreign exchange. In this situation, there are only two options available. One is the use of foreign reserves that the Central Bank held in order to meet the excess demand in the foreign exchange market. But the country cannot resort to this measure continuously with a trivial amount of just US$3 billion as foreign assets.
It will soon end up with a disastrous exchange rate problem – a forceful and a painful currency depreciation problem.
The second option is to allow exchange depreciation now in order to accommodate excess demand for foreign exchange. If the exchange rate is overvalued, it is better to let it depreciate at a time of falling world prices. This is because it would help to maintain export competitiveness on the one hand, and mitigate the domestic price effects of depreciation on the other hand. But there is another problem.
The country is already running a double-digit rate of inflation for some years largely due to internal problems. As long as these internal problems persist, the country will continue with high inflation even if world market prices fall.
After all it is a good time to think of export promotion as a long-term strategy to achieve a sound balance of payments position. In the long-run, export promotion is better than foreign remittances in the current account and, foreign investment is better than foreign borrowings and aid in the capital and financial account. |
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