Sri Lanka is in crisis due to debt monetisation,inflation and a currency collapse

Whilst there is a backdrop of bad news at the minute that is general it affects nations which are vulnerable and exposed the most, and sadly these tend to be the poorest. This is certainly in play in Sri Lanka as the International Monetary Fund has pointed out.

Sri Lanka has been hit hard by COVID-19. On the eve of the pandemic, the country was highly vulnerable to external shocks owing to inadequate external buffers and high risks to public debt sustainability, exacerbated by the Easter Sunday terrorist attacks in 2019 and major policy changes including large tax cuts at late 2019.

In itself the tax cuts could have been a masterstroke as they would have been in play for the Covid contraction but we see that the external financing issue was in play as exports were hit.

Real GDP contracted by 3.6 percent in 2020, due to a loss of tourism receipts and necessary lockdown measures.

The IMF points out the fiscal concerns but for these times they are not so bad.

Nonetheless, annual fiscal deficits exceeded 10 percent of GDP in 2020 and 2021, due to the pre-pandemic tax cuts, weak revenue performance in the wake of the pandemic, and expenditure measures to combat the pandemic.

There is a cautionary note in the revenue performamce though although again for these times the debt level is high but then so many are.

Public debt is projected to have risen from 94 percent of GDP in 2019 to 119 percent of GDP in 2021.

Debt Monetisation

The issue with foreign debt soon escalated as Covid hit and tourism receipts plunged.

Sri Lanka lost access to international sovereign bond market at the onset of the pandemic.

So the central bank of Sri Lanka decided to put its faith in Modern Monetary Theory.

Limited availability of external financing for the government has resulted in a large amount of central bank direct financing of the budget.

How much?

As a result, the CBSL’s net credit to the government
increased by 9 percent of GDP between March 2020 and November 2021. Meanwhile, reflecting the large NDF requirements, banks’ claims on the government and SOEs (including holdings of ISBs, Sri Lanka Development Bonds, and treasury securities, as well as loans to SOEs) rose to around 40 percent of total bank assets in 2021. ( Net Domestic Financing)

In itself the central bank financing is not much worse then we have seen elsewhere but the banking sector and state banks make up the numbers here. They have bought state debt like Italian banks do although in this instance they are often state banks.

Money Supply

After reading the above you will not be surprised to read that this soared in response to the interest-rate cuts and deficit financing.

Along with the large-scale central bank budget financing and a notable increase in credit to public corporations, M2 growth reached 22.9 (y-o-y) at end-2020 and 15.1 percent at endNovember 2021……… an eventual
private credit growth recovery from 6½ percent (y-o-y) in December 2020 to 13½ percent in
November 2021, led by mortgage and consumer loans

Ah mortgage and consumer loans! At this point again the story is familiar and seen in many other places.

A False Exchange-Rate

I have put a paragraph title of a false exchange rate because the next bit in the circumstances is really rather extraordinary.

The CBSL has effectively fixed the official
exchange rate at LKR 200-203 per U.S. dollar since April 2021, relying on moral suasion, surrender requirements on the FX received through export proceeds and converted remittances, and direct FX sales to cover essential imports.

Direct FX sales to cover essential imports is a sign of real trouble and the IMF estimated that a change of this size was required.

Parallel market quotes were reported at around 20 percent premium, albeit on a limited scale

Actually it was far worse than that because on the 8th of March this year the CBSL abandoned the fixed exchange-rate and this happened.

The central bank devalued the currency on March 9. It said two days earlier it thought the exchange rate would reach “not more than 230 rupees per US dollar”. But the rupee rapidly fell below that level, and today (March 21), it traded at between 290 and 297 to the dollar. ( centralbanking.com )

Actually the exchange-rate is now 335 Lankan Rupees to a US Dollar which is another 5 higher today. So in fact the overvaluation was in fact above 50%. The currency fall is in spite of the official effort to try and prevent it.

The Monetary Board of the Central Bank of Sri Lanka, at its meeting held on 08 April 2022, decided
to increase the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate
(SLFR) of the Central Bank by 700 basis points to 13.50 per cent and 14.50 per cent, respectively,
effective from the close of business on 08 April 2022.

Apologies to anyone at the Bank of England or ECB reading this as such numbers are well beyond even your imagination. As to Sri Lankan citizens as well as anticipating a wave of inflation they now have much higher interest-rate costs.

Inflation

The problem here is that they let the exchange rate drop just as energy prices were surging anyway following the war in Ukraine.

A surge in global oil and gas prices, combined with a 60 per cent drop in the value of the Sri Lankan rupee since last month, has also led to critical shortages of petrol and cooking gasSri Lanka’s state oil company, which had previously rationed petrol to conserve its limited stock, last week raised prices by a third to SLRs338 ($1.00) a litre. ( Financial Times )

There are all sorts of problems there but in inflation terms that may be high but it is not enough even by a quick maths check. The problem is that inflation is on a bit of a tear already.

NCPI based headline inflation (Y-o-Y) increased to 21.5 per cent in March 2022 from 17.5 per cent in February 2022 due to increases of prices of items in both Food and Non-food categories. Meanwhile, Food inflation (Y-o-Y) and Non-food inflation (Y-o-Y) recorded at 29.5 per cent and 14.5 per cent, respectively, in March 2022. Furthermore, the NCPI measured on an annual average basis, increased to 10.6 per cent in March 2022 from 9.3 per cent in February 2022 ( CBSL)

There are signs of rampant inflation in many places.

MD Paul, secretary of the National Construction Association, said his members would raise their rates by at least 60 per cent owing to the rising costs of supplies. He said a 50kg bag of cement now costs as much as SLRs3,000, compared with less than SLRs1,000 before. ( FT)

Transport too.

Both private and public transport is becoming unaffordable. The Lanka Private Bus Owners‘ Association has received government approval for a 30 per cent fare increase, chair Gemunu Wijeratne said. ( FT )

I did point out that more inflation was on its way.

But Perera, the former electricity board official, said energy and power prices remained deeply distorted. The CEB provides heavily subsidised power but has not been able to pay its creditors for six months.
“Even a 100 per cent increase [in tariffs] would not suffice with the current cost escalations,” Perera said, warning that if authorities increased tariffs now, “you would see riots”. ( FT)

Comment

The situation here is truly grim and I feel sorry for the people of Sri Lanka. There has been mistake after mistake as we see debt monetisation plus an exchange rate that was kept at the wrong level for too long. It is pretty much a textbook example of how not to set a fixed exchange-rate. One signal of that is the decline in foreign exchange reserves.

 gross international reserves (GIR) declined from $7.6 billion at end-2019 to $3.1 billion (1.5 months of imports,
25 percent of ARA metric) at end-20212 and to $2.4 billion at end-January 2022.

Whilst we are considering disasters there was also an enforced switch away from  chemical fertilisers.

, the recovery in 2021Q4 is expected to be
dragged down by a temporary restriction on the use
and importation of chemical fertilizer.

Best of luck replacing them at current prices.

The IMF has been involved here many times and its involvement will create more pain at first. Even worse is that China is involved.

China has provided 730,000 MT of fuel to CPC with a value of 500 million USD from July last year to January 2022. Sri Lanka has already paid only for 7 ships and payments for 12 ships to be made which is 390 million USD: Chinese Ambassador to SL ( @rangaba )

As Britney puts it.

With a taste of your lips, I’m on a ride
You’re toxic, I’m slippin’ under
With a taste of a poison paradise
I’m addicted to you
Don’t you know that you’re toxic?
And I love what you do
Don’t you know that you’re toxic?

Podcast

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