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Economy

Sri Lanka’s Banks Emerge Victorious with USD 1.49 Billion Reserves Boost

by Press Xpress November 2, 2023
written by Press Xpress November 2, 2023
Sri Lanka's Banks Emerge Victorious with USD 1.49 Billion Reserves Boost
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Sri Lanka’s commercial banks have demonstrated remarkable financial prudence, bolstering their private reserves and successfully clearing foreign loans to the tune of approximately 1.49 billion US dollars as of August 2023. This impressive achievement comes at a time when domestic credit faced a reduction due to declining market interest rates, a fact substantiated by official data.

You can also read: Government Measures and Cash Incentives Boost Remittance Inflows in Bangladesh

Central bank data revealed that the net foreign assets of Sri Lanka’s commercial banks soared to a significant 322 billion rupees, equivalent to about 1.07 billion US dollars, by the close of August 2023. This is a striking turnaround from the negative 153 billion rupees (approximately a negative 424 million US dollars) recorded in December of the previous year.

Raising interest rates sparks remarkable financial turnaround

The turning point can be traced back to April 2023 when the nation made the strategic move of raising interest rates. Since then, commercial banks have effectively repaid or collected a substantial sum of approximately 3.2 billion dollars. This proactive approach has not only strengthened the financial stability of the commercial banking sector but also underscores Sri Lanka’s commitment to meeting its financial obligations.

The backdrop to this impressive feat lies in the challenging financial landscape that Sri Lanka faced. In April 2023, the country defaulted on its financial commitments and initiated official arrears. By June 2023, the official arrears of principal had ballooned to a daunting 3.7 billion US dollars. However, the commercial banks, displaying their financial acumen and resilience, managed to repay loans and build reserves totaling about 2.8 billion during this period.

One of the critical challenges was the necessity for banks to settle foreign credit lines, as counter parties were unwilling to roll over existing contracts. To complicate matters, the government decided to repay dollar-denominated debt in rupees. This strategic move exposed banks to negative net open positions on their dollar deposits, necessitating them to actively collect dollars.

A triumph over traditional economic norms

What’s particularly striking about this achievement is the fact that it was achieved without resorting to printing more money or suppressing interest rates through policy interventions. This is often a hallmark of modern ‘Keynesian’ central banks and ‘economists.’ (Keynesian economics is an economic theory and school of thought that is based on the ideas and work of the British economist John Maynard Keynes.)

This remarkable success story challenges the misconceptions that have persisted since the 1920s when John Maynard Keynes introduced the notion of a ‘transfer problem’ in the context of German payments. Classical economists had long argued that such a problem did not truly exist and that any outflow of funds (without resorting to inflationary measures) would inherently lead to a current account surplus. Sri Lanka’s commercial banks have now reaffirmed this age-old economic wisdom, demonstrating the resilience and resourcefulness that can lead to a path of financial stability and success.

The notion of a “transfer problem” in the context of German payments refers to an economic and financial issue that was widely discussed and debated in the early 20th century, particularly in the aftermath of World War I and the Treaty of Versailles. The term “transfer problem” emerged in discussions about how Germany, after its defeat in the war, would fulfill its reparation payments and settle its international debts.

Sri Lanka displayed a marginal current account surplus in the final quarter of 2022, followed by a substantial 644 million current account surplus in the opening quarter of the next year. It’s important to emphasize that a current account surplus or deficit, in the absence of inflationary open market operations, is a neutral financial indicator. What truly matters is the net balance of the financial and capital accounts, which paints a comprehensive picture of an economy’s health.

Struggle against outdated policies

Analysts had issued warnings well before the island nation faced its debt default, highlighting deep-rooted misconceptions regarding the balance of payments. These misunderstandings, which originated in English-speaking countries in the early 20th century, had only intensified after the conclusion of a civil war. Unfortunately, they had led Sri Lanka down a path of chronic forex shortages, ill-advised policies aimed at “saving foreign exchange,” and stringent economic controls. Consequently, Sri Lanka found itself trailing behind its Asian counterparts, despite having been a close contender to Japan in the days before the central bank’s establishment and the abandonment of a currency board.

The ‘external financing gap’ frequently cited by the International Monetary Fund (IMF) also stems from this same misinterpretation. In reality, such a “gap” is solely based on a given interest rate, and it should not be misinterpreted as an insurmountable financial chasm.

Under an IMF program, the insistence on a positive net international reserve target, effectively a requirement to finance the deficit of a reserve currency country, unequivocally demonstrates that there is no such “gap.” In these circumstances, the central bank efficiently operates with a balance of payments surplus.

Countries with a central bank dedicated to accumulating reserves, without attempting to manipulate interest rates, can thrive without the need for onerous exchange controls. Such nations can effortlessly maintain exchange rates and external stability. Moreover, interest rates in these countries naturally gravitate towards levels reminiscent of Western floating rate economies, fostering financial stability and growth.

In essence, Sri Lanka’s journey highlights the importance of unraveling these age-old misunderstandings and embracing a more pragmatic approach to the balance of payments and financial stability. By doing so, a nation can chart a course toward prosperity and economic resilience, unburdened by the shackles of outdated ideas and misguided policies.

An unnecessary relic of the past in today’s economic landscape

Interest rates in countries that had been historically categorized as ‘third world,’ including those often pejoratively labeled as ‘basket cases’ in Latin America, witnessed a noticeable upward trajectory, especially in the wake of the ‘Second Amendment’ to the International Monetary Fund’s (IMF) Article IV. This amendment, permitting drastic currency devaluations, marked a pivotal turning point, as pointed out by Bellwether, a perceptive economic columnist.

It is worth noting that IMF’s Article I, which not only sanctioned capital controls but also laid the groundwork for the IMF itself, was founded on the same set of misunderstandings. In hindsight, the existence of an IMF seemed unnecessary in the era before the adoption of fixed policy rates, when specie-backed central banks (reminiscent of today’s currency boards or currency-style arrangements in East Asia and the Middle East, as well as clean floating exchange rate systems) possessed the inherent ability to self-correct and navigate economic challenges.

The ‘Second Amendment’ had a profound and, some might argue, adverse impact. By explicitly prohibiting specie anchors, it left central banks without a reliable grounding mechanism. Consequently, the 1980s bore witness to rampant inflation and widespread defaults in countries grappling with precipitous currency depreciations. Bellwether’s astute observation underscores the far-reaching consequences of this shift, which reshaped the global economic landscape.

As we reflect on these historic changes, it becomes evident that reevaluating the tenets of economic policy is essential, in order to chart a more sustainable and equitable path forward. The lessons from this era serve as a stark reminder of the importance of economic stability, thoughtful policymaking, and the perils of hasty transformations in the financial sphere.

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