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Depleting foreign exchange reserves: An evolving crisis in need of solutions?

03 Jul 2021

By Yoshitha Perera The current state of the country’s foreign reserves and its notable decline has become a hot topic, with concerns being raised over many related issues while local banks are reportedly facing difficulties in honouring Letters of Credit (LCs) issued on behalf of importers. Potential funding access challenges Sharing views with The Sunday Morning, economist and Advocata Institute Chief Operating Officer (COO) Dhananath Fernando said that importers may face issues due to insufficient dollars to import their materials.  Taking the apparel sector as an example, he said that per year, Sri Lanka exports $ 4.5 billion worth of exports while importing raw materials worth nearly $ 2-2.5 million. However, Central Bank of Sri Lanka (CBSL) Governor Prof. W.D. Lakshman had mentioned in his statement last week that the bank would rationalise these imports and prioritise the importation of capital goods. “There is a misunderstanding about the problem and the solutions that we are proposing. I think we are having a solvency problem. There are structural issues within the country’s economy, and in the current situation, the authorities are trying to solve it as a liquidity crisis whereas the actual issue is with solvency,” he said. Nevertheless, explaining the structural issues in the Sri Lankan economy, Fernando said that national debt in relation to the gross domestic product (GDP) ratio is high and that the country’s income is not adequate to make payments. “If we collect Rs. 1 of tax, 86 cents of that has to be spent on state sector salaries. So, we have only 14 cents left for other expenses, including the interest payments. That is why I say that there is a fundamental flaw in our products,” he added. Fernando noted that in the present situation, options are limited and the country could borrow money from international counterparts, given Sri Lanka’s credit ratings and intensifying Covid-19 situation in the country. “One solution is depending on the IMF (International Monetary Fund) programme since they can bring credibility to our system. As of now, we have proven enough that as a country, we are not good at managing money. We are not managing our expenses and income in a proper manner,” Fernando emphasised. He clarified that the IMF assurance could bring a credibility factor and that would grow into a point to attract more investors into the country, adding: “This is a different crisis. The numbers and the market don’t reflect the Government’s message, and releasing a statement is not enough to attract investors – we have to propose our plans. There is a credibility problem within the country’s economy.” Speaking to The Sunday Morning, former Central Bank Deputy Governor and senior economist Dr. W.A. Wijewardena said the decline in foreign reserves is a development the country had expected due to two reasons. “The first reason is that the country did not have a good Balance of Payments throughout the period starting from 2013. The second reason is the outbreak of the Covid-19 pandemic in three waves, and it had disrupted the economic activities in the country. All these things have contributed badly to the inflows of foreign exchange to Sri Lanka, and as a result, we are now in a situation where the earnings are not sufficient for us to meet our foreign exchange obligations,” he explained. Dr. Wijewardena said that specifically with respect to maintaining the required importing programme and essential commodities while meeting the obligations, the country has to repay its debt. “What I meant by debt is not only the debt of the central government, but also the debt of the private sector. Therefore, we have to look at it from the point of view of the national external debt. Day by day, foreign exchange reserves are declining and it is a very serious situation,” he added. Adding that the present level of foreign exchange alone is not sufficient to meet the country’s external debt obligations, Dr. Wijewardena said that within a 12-month period, the total debt the country has to repay with interest is about $ 7 billion. He said, however, that usable foreign exchange by the end of May was about $ 3.6 billion. On top of this, the country has to maintain very high import components as well, especially with respect to medicines, raw materials for the apparel industry, wheat flour, etc. which are essential imports to Sri Lanka, he noted. Explaining that the Central Bank and the Government have moved to short-term swap facilities, which is not a sustainable solution, Dr. Wijewaradena said that Sri Lanka will have to necessarily go before the IMF and seek its bailout. “We had two similar occasions in the past where the foreign exchange reserves had fallen to a very critical low level. In 2008, when the country was at war with the LTTE (Liberation Tigers of Tamil Eelam), the foreign assets level had fallen to where we could finance only two months of future imports. At that time, present State Minister Ajith Nivard Cabraal, who was the then Governor, together with former Treasury Secretary Sumith Abeysinghe, went to the IMF and got an extension facility to the country,” he explained. Adding that the country is no longer in a situation to avoid the IMF, Dr. Wijewardena said the people who were handling the matter have not been aware of the actual danger the country is going through today. Meanwhile, speaking at a media briefing recently, Samagi Jana Balawegaya (SJB) MP and economist Dr. Harsha de Silva said that engaging with the IMF will not result in pulling the country into further debt. “By 2025, the country will have to pay more than $ 29 billion in debt. The IMF will certainly not give us the entire $ 29 billion, which is our international debt. They will perhaps provide us with $ 2.5 billion. But the objective of this move is to regain the trust of the international community,” he said. Fitch Ratings, in a special report released on Thursday (1), raised concerns over Sri Lanka’s banks’ exposure to sovereign risk. Fitch said it believes the country’s banks are most susceptible to heightened sovereign risk due to their greater exposure to foreign currency-denominated government securities and, in some cases, weak capital positions. This exposure for Fitch-rated banks stood at around 6.4% of total assets and 78% of total equity at end-2020. Accordingly, for every 10% reduction in the value of foreign currency-denominated government securities, the large banks’ common equity Tier 1 ratios would have dropped by 18-219bp as at end-2020, it said. Fitch expects bank ratings to remain constrained by, and closely linked to, its assessment of the Sri Lanka sovereign, which has a “CCC” Long-Term Local-Currency Issuer Default Rating, due to the strong correlation between the sovereign and bank credit profiles. This, it noted, stems from the banks’ significant direct exposure to the sovereign, largely through their government-security holdings, as well as to the wider domestic economy and local financial markets through their Sri Lanka-centric operations. Import restrictions In the wake of the Covid-19 pandemic, the Government imposed several import restrictions. Even last year, the Ministry of Finance imposed import restrictions on items such as rice, flour, sugar, liquor, and apparel products, as the country faced a foreign exchange crisis.  Speaking to The Sunday Morning, Ceylon Chamber of Commerce (CCC) Chairman – Import Section Delano Dias said there is a definite decline in importation due to the restrictions that were in force. “I can’t quantify the exact amounts, but the substantial decline is there for overall products, pharmaceuticals, and raw materials,” he added. Responding to a query, Ceylon Motor Traders’ Association Chairman Yasendara Amarasinghe said that vehicle imports were banned with effect from March 2020. He added that the recent decline in foreign reserves would mainly affect the importation of motor spare parts, which would cause the maintenance of the vehicles that are already in the country costly. However, even though the CBSL had mentioned recent measures to prevent any such issues in the future, economists and rating agencies predict that there would be potential funding access challenges in the country. Government response Releasing a statement on Monday (28), Prof. Lakshman said that the present foreign currency liquidity in the local market is a short-term situation and the Government is considering various measures to curtail the situation. He said Sri Lanka has introduced measures to rationalise selected non-essential imports due to reduced foreign currency inflows. “Some of these restrictions have been gradually removed, although the CBSL is of the view that there is further space to curtail non-essential and non-urgent imports, with the continued challenges emanating from multiple waves of Covid-19,” he said. Though concerns have been raised by many economic experts, the Central Bank ensured that the trade is not excessively disrupted and the intermediated capital goods imports are given priority. Accordingly, total import values have remained considerably high at a monthly average of $ 1.7 billion during March, April, and May 2021, and the CBSL Governor mentioned that high import values in these months show that importers, particularly of essential goods, have not been overly inconvenienced as published media reports claim. Explaining that the foreign currency liquidity in the domestic market is a temporary situation, Prof. Lakshman said that the CBSL is expecting a control to improve the cash flows in the next few months, and the CBSL will be evaluating the national balance sheet and external macroeconomics conditions in deciding the future policy response. “As an interim solution in managing the mismatch in cash flows, the CBSL has been working closely with the banking sector to ensure that stability in the foreign exchange market is maintained,” he noted. Prof. Lakshman added that after the recent meetings with the banking community, they had mutually agreed to manage their outflows within inflows while giving priority to essential and urgent imports, and discouraging orders of a speculative nature. As per the statement, Sri Lanka’s main priority is to manage debt service obligations and gross official reserves remain at $ 4 billion, without considering the standby swap agreement of approximately $ 1.5 billion with the People’s Bank of China. Clarifying that adequate financing strategies have been lined up to maintain reserves through inflows to the country, Prof. Lakshman noted several non-debt inflows expected within a short period of time to the Government through multilateral and bilateral sources. These include a swap facility of $ 250 million from the Bangladesh Bank expected in July 2021, the SAARC Finance swap facility of $ 400 million from the Reserve Bank of India expected in August 2021, and a special swap facility of $ 1,000 million which has been negotiated with the Indian counterpart. “These are in addition to the receipt of around $ 800 million under the International Monetary Fund (IMF) Special Drawing Rights (SDR) allocation expected in August 2021 and the CBSL purchases of export proceeds and worker remittances from the market, which would help the CBSL to build official reserves through non-debt inflows of around $ 700 million annually in the period ahead,” he further noted. Meanwhile, responding to The Sunday Morning’s query on seeking financial assistance from the IMF, State Minister of Money and Capital Market and State Enterprise Reforms Ajith Nivard Cabraal said the Government is not seeking financial assistance from the IMF. “The IMF is regularly apprised of the Government’s plans for the economy, as is usually done by all member countries. Nevertheless, Sri Lanka will benefit by the IMF’s forthcoming enhancement of SDR to all countries in the sum of $ 650 billion, of which Sri Lanka’s allocation will be about $ 800 million.”


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