Cabraalnomics: ‘No default because we have enough forex inflows to pay ISBs’

Monday, 1 March 2021 

Sri Lanka’s external debt problem is not a problem of State Minister Cabraal alone. It is a problem faced by the whole nation. Also, all the governments since independence except the one in power in 1954 and 1955 had contributed to it in a small or big way

Challenging doomsayers

My former colleague and friend with whom I can always discuss policy issues without tears, State Minister Ajith Nivard Cabraal in a statement reported in the press had challenged the ‘doomsayers’ who had been pronouncing from time to time the perilous path which Sri Lanka’s economy was taking toward an ultimate self-destruction (available at: http://www.ft.lk/front-page/Nivard-says-doomsayers-will-be-disappointed-again/44-713622). 

He had confidently said that those doomsayers will be disappointed when the Government would repay in full the International Sovereign Bonds or ISBs amounting to $ 1.5 billion coming up for repayment in July this year. He is correct and Sri Lanka will pay this $ 1.5 billion in July out of the country’s existing foreign reserves.

Multiple doomsayers at work

There had been many doomsayers in the past, but the latest addition to the list has been the Standard Chartered Bank or SCB and the Barclays Bank or BB which had functioned earlier as issue managers of those ISBs now out in the market. Both banks had downgraded Sri Lanka’s ISBs to ‘underweight status’ advising the investors to reduce their exposure to the bonds. The reasons for this bleak investment advice have been clearly articulated by the two banks in the titles they have selected for their respective reports. 

Barclays had said that 

Sri Lanka’s foreign reserves have been ‘drained faster than expected’ raising concerns about the country’s ability to meet its ISB obligations. Standard Chartered had projected Sri Lanka as ‘coming down to the wire’ implying that the ‘final outcome’ cannot be said until the last minute of the event. Both of them have opined that unless Sri Lanka goes for an IMF backed debt restructuring, the things would be critical for the country. Before SCB and BB, there was Citibank, another ex-ISB issue manager, which had issued a report on Sri Lanka warning the Government that ‘denying the problem was not a strategy’. 

The fast-draining foreign exchange reserve of the country had been the contentious issue for all these investment advisors. Citi had even recalculated the country’s available foreign exchange reserves for debt repayment by taking out the short-term foreign liabilities on account of SWAPs, etc. According to them, that net amount was a dismal figure at about $ 2.5 billion. Before these investment advisors, all the three rating agencies, Fitch, Standard and Poor’s, and Moody’s, had downgraded Sri Lanka’s sovereign risks from B category to CCC category. 

Is the market driven by doomsayers?

It is quite clear that the whole international community of worth is seeing a ‘doomsday’ event regarding Sri Lanka’s ability to repay maturing ISBs at least in the near future. International investors who have taken a serious view of the emerging situ have begun to reduce their exposure to Sri Lanka’s ISBs by selling them in the market. As a result, ISBs which had been traded at a premium, that is, above the par value of $ 100, in February 2020 began to lose their glamour and consequently traded at a deep discount, that is, below $ 100. 

However, to its credit, Sri Lanka disappointed doomsayers in October 2020 by fully repaying the maturing ISBs by using its foreign exchange reserves. Reserves fell drastically but Sri Lanka managed to maintain its unblemished credit record in the eyes of external lenders. Now with another set of ISBs maturing in July, suspicion has been cast about the country’s ability, in a greater vigour and rigour, to repay its external debt.

Exuding confidence of success

But this has been hotly denied by the Government. Central Bank Governor Deshamanya Professor W.D. Lakshman even went to the extent of castigating those ‘doomers and gloomers’ as not understanding the alternate economic policy being pursued by the Government. But State Minister Cabraal has been more confident. He had argued that there should not be any fear of Sri Lanka’s defaulting its external debt by taking a different line of argument. In a nutshell, his argument is as follows.

Cabraalnomics: Rely on flows and not on stocks

He says that Sri Lanka’s outstanding ISBs amounting to $ 14 billion is only 16.7% of the total external debt and the balance debtholders accounting for 83.3% have no fear of loan default by the Government. But the actual numbers are different from these percentages. ISBs account for 40% of the Central Government’s external debt portfolio of $ 35 billion and 25% of the total country portfolio of $ 56 billion. However, this discrepancy does not invalidate his argument which is based on ‘flows of foreign exchange inflows’ rather than the ‘stock of foreign assets’ which the alleged doomsayers, according to him, have been using. 

In 2021, Sri Lanka would get a foreign exchange inflow of about $ 32 billion and it would be augmented by about $ 2-3 billion every year thereafter. Given this high foreign exchange inflow, repaying ISBs of $ 1 to 1.5 billion is nothing for the country, he concludes. He had therefore questioned, “Will the authorities be so foolish as to default on a payment of around $ 1 to $ 1.5 billion per annum and risk its entire economy and impeccable credit history?”

A numbers game?

State Minister Cabraal has a point, and it can be illustrated as follows. The debt repayment capacity of a borrower depends on both the annual income he gets which is a flow and the amount of assets he has which is a stock. In the case of a country, the flow relating to foreign exchange is simply the credit side of its balance of payments or BOP. The $ 32 billion he had talked about is the total inflow of foreign exchange to be received by Sri Lanka in 2021 as recorded on the credit side of BOP. When one looks at a commitment of $ 1-1.5 billion against this massive inflow, there is nothing to fear, even though the stock of foreign assets is ‘draining faster than expected’ leaving everyone in ‘suspense until the last minute arrives’. He had, therefore, confidently said that doomsayers who will rely on stock figures will be disappointed.

Support by fans

He has a wide fan base in the social media and his statement was quickly shared by many. Some had even translated it into Sinhala and posted it on their respective social media walls as if it is a fine finding they have made without giving credit to him. Many had liked it, and some had made encouraging comments too. His statement had invigorated some of them so much that they had even suggested to him that he should invite leading doomsayers in the opposition to a public debate. In their view, these numbers will leave all those critics speechless.

Two caveats, one practical and the other theoretical

This is new economics, and it can be safely termed ‘Cabraalnomics’. It is the foundation of the alternate strategy which the present Government is following. Its main features are ‘no to IMF, control prices, interest rates and the exchange rate, no risk in financing the budget through bank funding, not to worry about fast draining foreign reserves, rely on flows rather than stocks, have import substitution, restrict imports to contain the debit side of BOP, and have FDIs in large volumes to augment the credit side of BOP’. 

It has two caveats, though. One is practical and relates to the numbers quoted. The other is theoretical which is concerned with trying to attain what is known as ‘the impossible trinity’. The latter was explained in simple language by my former colleague, Professor Sirimevan Colombage, in a recent article (available at: http://www.ft.lk/columns/Policy-trilemma-poses-formidable-challenges-to-interest-and-exchange-rate-management /4-713226).

Forex outflows also matter

First to numbers. It is true that cash inflows will strengthen a borrower’s capacity to repay his loans. But how much of that cash is available for debt repayment will depend on how much of net cash is available after paying out normal bills. In the case of a country relating to foreign payments, this is determined by the magnitude of the debit side of BOP. That consists of imports, payments for services, factor service payments like interest payments and profit transfers, remittances out and above all, foreign exchange outflows on account of share and debt market transactions. If these are more than the foreign exchange inflows, there is a deficit, and the deficit must be financed by drawing on foreign reserves. In other words, the deficit or surplus in BOP is exactly identical with the decrease or the increase in the net foreign assets of the Central Bank. 

Hence, a country experiencing a deficit in BOP cannot use the foreign exchange inflows to repay debt. In the case of Sri Lanka, this is the normal situation, a deficit in BOP, unless the country borrows a massive amount from abroad. Hence, to rely on foreign exchange inflows to repay any debt is a non-event. In that sense, it is correct for the doomsayers to base their analysis on the foreign asset stock of Sri Lanka to determine its ability to repay foreign loans.

Limited success of import controls

To prevent a foreign exchange outflow on account of imports, Sri Lanka has clamped selective import controls. As a result, imports fell in 2020 sharply by 20% to $ 16 billion. But the trade deficit narrowed only from $ 8 billion in 2019 to $ 6 billion in 2020 due to a fall in exports by 16% to $ 10 billion. Hence, Sri Lanka’s foreign exchange numbers are not that favourable. A further unsalutary development has been that import crunching by $ 4 billion due to import controls has taken place mainly in raw materials and capital goods. This affects the future growth prospects of the country. What it means is that import controls has had only a limited success so far. They have not been able to generate a surplus in the foreign exchange cashflow of the country. 

Debt issue is not only about ISBs

Sri Lanka’s debt problem is not related only to ISBs. In addition to the central government’s foreign debt of $ 35 billion, non-central government sector that includes private entities as well has borrowed $ 21 billion. The total known debt repayment obligations during the next 12-month period are about $ 6.4 billion. In addition to this, there are other short-term obligations and REPOs amounting to $ 2.3 billion. So, the total country obligations during the next 12-month period amount to about $ 8.7 billion. Hence, even if ISBs are paid in July, Sri Lanka has to find foreign exchange to meet all these obligations. 

Some of them could be reissued to alleviate the problem as pronounced by Governor Lakshman at a recent webinar. However, that is a peanut given the total obligations of the country. Hence, even after reissuing the maturing obligations, the main problem still remains unresolved. Foreign cash inflows will not help the country in this regard, since there is a deficit in BOP unless the country goes for massive foreign borrowings in the next 12 months. The foreign reserves at $ 4.8 billion are too little compared to these obligations. Hence, Sri Lanka has a genuine foreign debt problem and as SCB had said in its country report, until the last minute, no one cannot be certain about the final outcome. The issue raised by foreign doomsayers is that they do not see a credible plan by the government to meet these obligations successfully.

The impossible trinity

Now, let us turn to the theoretical caveat. The impossible trinity, also called policy trilemma, is that policymakers cannot fix the exchange rate, have free forex movements, and conduct independent monetary policy at the same time. When translated into laymen’s language, what it means that the Central Bank cannot have a stronger rupee, induce foreign inflows in FDIs, remittances and flows into share and debt markets, and control prices and interest rates. When these policies are set at the corner of a triangle, only two could be attained at a time. Colombage in his article has explained the ramifications as follows: 

How the impossible trinity works

“Given free capital mobility, the CBSL has no choice other than to give up either fixing the interest rates or fixing the exchange rate, in terms of the policy trilemma. Simultaneous suppression of the two rates leads to capital flights, as already evident in the Government securities and stock markets of Sri Lanka. The CBSL is engaged in a lonely battle in restoring economic stability whilst the Government does not seem to make any firm commitment towards reducing its budget deficit, which is the major cause of credit expansion, money supply growth, inflationary pressures, and rupee deterioration. 

Monetary policy autonomy has become important now more than ever, as central banks in many countries are compelled to follow Government directives in a subservient manner to inject liquidity into the market so as to resuscitate the economies adversely affected by the pandemic. Eventual erosion of central bank independence in the backdrop of the pandemic has compelled the CBSL to bear the brunt of macroeconomic rectification. It is reported that an agreement with the International Monetary Fund (IMF) would not be feasible due to the Government’s decision to take a different policy path that includes import restrictions and managed exchange rate”. Thus, CBSL’s A-Team maybe burning the midnight oils to disprove the impossible trinity.

A central bank in a panic mode

But the signs are visible that the Central Bank has failed in resolving the impossible trinity. When it has fixed the exchange rate and interest rates, foreign inflows and prices have flown out of the window. Then, instead of abandoning the impossible policy, it has started making mistake after mistake in the form of micromanagement of the economy. First, it invited Sri Lankan diaspora to send in their dollars into special bank deposits in the country. This did not generate a sufficient inflow. 

Then, it went for a dual exchange rate system by offering a premium of Rs. 2 over the official exchange rate to those Sri Lankans who send in remittances to the country. This is a selective depreciation of the currency the cost of which is to be passed onto the general taxpayers. When enough foreign inflows did not materialise, some awkward steps have been taken by the Bank to scrape the bottom of the pan. 

Accordingly, forward contracts have been suspended for three months, commercial banks have been ordered to sell 10% of their receipts on account of remittances to central bank and exporters to bring in export proceeds within six months and convert 25% of them immediately to Sri Lanka rupees. When inflation could not be controlled, a large number of consumer items were brought under price controls. But none of these commodities are available at the controlled prices in the market, as revealed by the weekly retail prices published by the Central Bank. This policy stance, instead of building confidence in those outside the Central Bank, has confirmed to them that the Bank is now being driven by a panic mode. 

Adding insult to injury

This is certainly an embarrassment to the Monetary Board which is responsible for this policy. To add insult to injury, for the first time in the history of the Bank, a civil society activist has demanded the Governor of the Bank and his economic team to come for a public debate on the policy stance in the spirit of adhering to democratic economic policy governance (available at: http://www.ft.lk/opinion/Intellectual-debate-needed-on-present-external-sector-monetary-management-policies-and-practices/14-713567). What this means is that the Central Bank is being continuously watched by the market and it no longer holds an unchallenged position to fix its policy.

Nation should be ready to take a hit

Sri Lanka’s external debt problem is not a problem of State Minister Cabraal alone. It is a problem faced by the whole nation. Also, all the governments since independence except the one in power in 1954 and 1955 had contributed to it in a small or big way. No point in castigating them now. What should be done today is to find a quick solution for the problem without defaulting the obligations. It requires the whole country to take a hit. The hit comes in the form of making available the necessary foreign exchange for debt repayment by cutting the domestic consumption. We are heading toward that position fast and the present problem is how to manage it without causing social, economic, and political disorder in the system.

Avoid anti-IMF rhetoric

In my view, Cabraalnomics should take note of this and have a backup rescue plan. That may include giving up the anti-IMF rhetoric because circumstances would force Sri Lanka to eat the humble pie eventually. This happened in 2008 during the previous Mahinda Rajapaksa administration and in 2016 during the previous Yahapalana Government.

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com.)