Business

The war against the ‘undial’ system

By Shenal Fernando

Over the past few weeks, as Sri Lanka’s foreign exchange liquidity crisis continues unabated, it has become evident that the Central Bank of Sri Lanka (CBSL) will be taking an increasingly aggressive approach  in tackling the burgeoning unofficial ‘undial’ money transfer system in the country.

The CBSL through its conduct has shown that it views the dismantling of the undial system as the panacea to all its troubles and recently took steps to ban importing through Open Account transactions and Documents against Payment/Documents against Acceptance (DA/DP) terms. Thereafter, all imports to the country would be required to be made through a Letter of Credit (LC). 

The new Governor of the CBSL Dr. Nandalal Weerasinghe justified this new policy by claiming that the massive amount of forex flowing through the undial system was funding non-essential imports and that this new policy would have the effect of bringing back such foreign exchange to official channels. 

“In other methods, goods will come through customs but the transactions will be carried outside the banking system through various methods. Using the hawala system, people are making payments from abroad when the import order is made and the transaction will be settled in Sri Lanka in rupees and goods will be cleared through customs. Consequently, the money doesn’t move through the banking system, and as a result, a black market is created outside the banking system,” Dr. Weerasinghe stated. 

He further called on expats and exporters to not to remit money though the undial system and claimed that going forward there would be no such market for it and that the gap between the official exchange rate and unofficial exchange rate would decrease, leading to an increase in liquidity within the banking system. 

Furthermore, over the last week reports emerged of several persons being arrested by the Special Task Force (STF) for attempting to send money through the undial system. Speaking to The Sunday Morning Business Police Spokesman SSP Nihal Thalduwa stated that several persons who had attempted to send foreign currency abroad through the undial system had been arrested by the STF on a tip-off under the Prevention of Money Laundering Act, and had been handed over to the Illegal Assets and Financial Investigations Division under the Deputy Inspector General (DIG) of the Criminal Investigation Department (CID) for further inquiry.   

 

How did we get here?

 

As Sri Lanka’s foreign currency liquidity crisis intensified from mid-2021 onwards, the incumbent Government at the time made sure that the blame for this crisis rested squarely on the shoulders of the country’s burgeoning undial money transfer system, thereby ignoring the role played by the decisions of the then Governor of the CBSL Ajith Nivard Cabraal to fix the exchange rate at Rs. 200-203 for over six months. This significantly aggravated Sri Lanka’s foreign exchange shortage at the time, due to the near collapse of the country’s tourism industry in the face of the Covid-19 pandemic. 

This decision made by the former CBSL Governor disregarding severe criticism by most economists and policy institutions of the country, led to a significant decrease in foreign worker remittances as people moved to the informal money transfer channels such as the undial system, which provided them a significant premium over the fixed exchange rate maintained by the CBSL. Consequently, foreign worker remittances fell by over 61.6% YoY in 2021 to $ 5.5 billion from $ 7.1 billion in 2020 and this trend continued in 2022, as foreign worker remittances were down by 58.1% YoY during the period January to March 2022 at $ 798 million, compared to the equivalent period in 2021 as per CBSL statistics.    

Furthermore, the former CBSL administration in its ill-advised efforts to guard Sri Lanka’s unblemished record of external debt servicing since independence, imposed a mandatary surrender rule on all Licensed Commercial Banks (LCBs) in order to build up the country’s foreign reserves which had fallen from around $ 7.6 billion as of December 2019 to below $ 2 billion as of 2022. 

This mandatory surrender imposed on LCBs required them to mandatorily sell a share of remittances and export proceeds converted by them every week to the CBSL, and this share to be surrendered gradually increased over time and reached a high of 50% on 25 March 2022. This decision by the CBSL further aggravated the foreign exchange shortage in the domestic banking system as the CBSL was continuously sweeping away a significant portion of the foreign exchange received by the banking system in order to meet its foreign debt payments. This mandatory surrender rule was somewhat relaxed by the new Governor of the CBSL Dr. Nandalal Weerasinghe, who reduced the share to be surrendered from 50% to 25%.   

By the time the CBSL accepted defeat and floated the exchange rate on 7 March 2022, the damage had already been done, with trust in the CBSL and the formal banking system being lost and most foreign workers having moved away from formal channels when remitting money and turning to informal channels such as the undial system. Furthermore, in the face of a full-blown foreign exchange liquidity crisis, there were claims that many reputed and large organisations were forced to turn to these informal channels to fund their necessary imports as domestic LCBs proved incapable of doing so. Consequently on 12 April 2022, Sri Lanka went into a selective default with the Finance Ministry announcing a temporary freeze on all foreign debt payments.   

Despite the floating of the exchange rate, Sri Lanka’s liquidity crisis continued to worsen and according to former Governor of the CBSL and well-known economist Dr. Indrajit Coomaraswamy who, speaking at a discussion hosted by the Ceylon Chamber of Commerce on 12 April 2022, stated that the decision to selectively default was made because the official foreign currency reserves of the country had fallen to $ 5 million on 12 March 2022. 

“There was no choice. There are those who say that this was not done in the correct sequence and that the creditors should have been consulted before it was announced. All that is very true. But when the Governor took office, within days he found himself with a situation where reserves on that day (12 April) were down to $ 5 million,” stated Dr. Coomaraswamy. 

Following the floating of the exchange rate, the Sri Lankan Rupee has depreciated by over 79% and currently the selling rate of a US Dollar for Telegraphic Transfer (TT) transaction is around Rs. 365 as per CBSL data. Despite the market reflective exchange rate offered by the CBSL now, the foreign exchange liquidity crisis of the country persists. This was admitted last week by Prime Minister Ranil Wickremesinghe who in his address to the nation on 16 April stated: “In November 2019, our foreign exchange reserves were at $ 7.5 billion. However, today, it is a challenge for the Treasury to find $ 1 million. The Ministry of Finance is finding it difficult to raise $ 5 million required to import gas.” 

Therefore, the continuing foreign exchange liquidity in the country has pushed the authorities to aggressively work towards dismantling the system as the policy measures taken have failed to deter reliance on the undial system   

 

Dismantling the undial system is the panacea for current forex liquidity woes?

 

Speaking to The Sunday Morning Business recently, former Deputy Governor of the CBSL Dr. W.A. Wijewardena questioned the effectiveness of this approach taken by the CBSL to dismantle the undial system. 

He pointed out that the undial money transfer channels were no longer the dominant methods used by the public in transferring foreign exchange and claimed that numerous WhatsApp, Facebook, Messenger, and other informal groups had been created by Sri Lankans to link those who possessed foreign exchange and those who needed foreign exchange. 

Dr. Wijewardena further stated: “The presence of undial/hawala systems in the global payment system predates the creation of the modern formal banking system of a mere 200 years, whereas these undial/hawala systems have been active in the global payment systems as far back as 800 years ago. Therefore, you can’t kill this system which has survived for over 800 years.” 

It should also be acknowledged that the younger generations who are more tech-literate are increasingly utilising crypto coins and tokens to transmit money and this has been further simplified by the introduction of P2P trading by certain crypto platforms. Therefore, as claimed by Dr. Wijewardena, dismantling the undial money transfer system will not have the effect envisaged by regulators due to the plethora of other options available.

 

Difficulty in dismantling the undial system

 

The very nature of the undial system, with its lack of a paper trail for cross-border transactions and its decentralised organisational structure, makes any attempt by the authorities to identify transactions through the undial system a challenging task.

This was recognised by University of Colombo Faculty of Arts Department of Economics Senior Lecturer Dr. Shanuka Senarath who told The Sunday Morning Business that it was not possible to directly monitor transactions through the undial system and claimed that the only way to identify them was through supporting evidence such as checking movement of money in local accounts.

“Part of the undial transaction occurs in Sri Lanka. In that case, whatever the local money transactions between local accounts will be taken into account. You cannot actually trace it though just one transaction. For example, if these transactions occur frequently, then you can actually suspect that they involve the undial system. There is no direct mechanism to observe the undial system.”

Responding to a query by The Sunday Morning Business as to whether existing reporting requirements on LCBs are effective in identifying transactions through the undial system, Advocata Institute Senior Visiting Fellow Dr. Roshan Perera stated that all LCBs were required to report to the Finance Intelligence Unit (FIU) regarding any unusual money movement where the underlying commercial transaction could not be ascertained or where an unusual pattern had been observed, regardless of the value of the transaction.

Prof. Senarath, referring to the recent arrest of persons using the undial system under the Prevention of Money Laundering Act No. 5 of 2006, pointed out the difficulty of imposing a legal liability on a person for the offence of money laundering for merely conducting transactions through the undial system, considering the definition of the offence of money laundering provided in Section 3 of the Act.  

Section 3 of the Prevention of Money Laundering Act provides: “Any person who engages directly or indirectly in any transaction in relation to any property which is derived or realised, directly or indirectly, from any unlawful activity or from the proceeds of any unlawful activity; receives, possesses, conceals, disposes of, or brings into Sri Lanka, transfers out of Sri Lanka, or invests in Sri Lanka, any property which is derived or realised, directly or indirectly, from any unlawful activity or from the proceeds of any unlawful activity, knowing or having reason to believe that such property is derived or realised, directly or indirectly from any unlawful activity, or from the proceeds of any unlawful activity shall be guilty of the offence of money laundering.”

However, a more suitable legal provision to impose a legal liability on a person conducting transactions through the undial system would be Section 4(3) of the Foreign Exchange Act No. 12 of 2017 which provides: “Save as otherwise provided in this Act, no person in or resident in Sri Lanka shall deal in foreign exchange within or outside Sri Lanka, by any act which involves the conversion of Sri Lanka Rupees or assets within Sri Lanka to foreign exchange, otherwise than through an authorised dealer, or to the extent specified in the permit, through a restricted dealer.”

 

Measures to deter reliance on the undial system

 

Dr. Perera stated that she believed that the primary reason for the significant increase in cash flows through the undial system was the ill-advised attempt by the former CBSL Governor to fix the exchange rate. She further pointed out that the increase in cash flows through the undial system over the past year had created a powerful incentive for those engaged in the system to continuously offer higher rates over the official exchange rate to attract people away from the formal channels.

She stated: “Previously, only a very small percentage of transactions went through this undial system. It was only because of this fixed exchange rate that this happened.” However, she claimed that getting the money flowing through unofficial channels to revert back to the official banking system would be quite challenging.

According to Dr. Perera, the public had lost trust in the traditional banking system and that once trust was lost it was difficult to regain it. Therefore, she stated that in order to bring money back to the formal banking system, it was essential that trust be established. She further claimed that it was essential to ensure credibility and to address the misinformation circulating among the public.

She explained that the lack of trust in the Government, together with misinformation circulating regarding the apparent misuse of money remitted through the official banking system due to Government corruption, have had a negative impact on the use of official banking channels to remit money.

Theoretically, when foreign exchange is remitted through the official banking system, it doesn’t end up in the government coffers. Instead, it will enter the domestic foreign exchange market to be used by LCBs for the ordinary functioning of the economy and only 25% will be sold to the CBSL in terms of the current mandatory surrender rules.

“I’ve heard people say that they aren’t going to send money through the formal banking system because of how it will be used by the Government. This is completely wrong, because ultimately you are impacting the whole country by not sending it through the formal banking channels. It’s not like the Government uses all of the money that comes through the official channels and that it’s wasted. This is complete misinformation.”

She further stated that the main deterrent against the undial system would be the risk factor because the undial system was based on trust on third party strangers.

“Once inflows start coming in, then others will, because of the herd instinct. I can say right now what the trigger will be. But I hope it will happen sooner rather than later because we can’t go on like this. We have to get these inflows to come to the official banking system because right now we are surviving hand to mouth and we cannot build reserves like that.”  

Prof. Senarath stated that the callous treatment of foreign workers by the Government had played a significant role in pushing them towards the more lucrative unofficial channels. He pointed out particularly the treatment of foreign workers returning to the country in the early days of the Covid-19 pandemic, with many subjected to callous treatment and forced to undergo quarantine procedures at substandard quarantine facilities. Therefore, he stated that if the Government treated its foreign workers with the appropriate respect they deserved, they would return to the formal banking channels.

Prof. Senarath also highlighted the need to update/develop the existing transaction mechanisms within the formal banking sector, claiming that the failure of the Government to implement an effective mechanism for transactions in the formal banking system due to its incompetence had played a significant role in the surge in adoption of the undial system by the public. Accordingly, he pointed out that high transaction costs in the formal sector compared to no transaction costs in the undial system and tiresome bureaucratic red tape involved in transmitting money through the formal banking channels had played a role in pushing people to turn to the undial system.

“This is 100% the Government’s fault. For example, how much money can you take out of Sri Lanka? There is a limit. How much money can you bring to Sri Lanka? There is a limit. If you want to send money abroad you have to get CBSL permission. Do we have PayPal in this country for even a simple transaction? No. Can we use our credit card to do a foreign transaction? No. So, in this situation no wonder people have turned to other solutions,” he stated.