The nation’s external finances are in a perilous state. By the end of the first seven months, foreign reserves had fallen to $ 2.8 billion, the trade deficit widened to $ 4.9 billion, and the balance of payments deficit widened due to net capital outflows and lower remittances recently.
This state of external finances has led international rating agencies to lower country risk to the status of ccc-. The implication of this is that Sri Lanka’s borrowing rate for International Sovereign Bonds (ISBs) has skyrocketed, like Greek bonds of old. They are at exorbitant interest rates of almost 50 percent.
How to solve the problem of insufficient foreign exchange reserves to meet essential import expenditure while the trade deficit widens and the balance of payments deteriorates? How will the country escape the impending external financial catastrophe?
Let’s take a look at the facts first. Foreign exchange reserves have depleted from around US $ 6 billion at the end of 2018 to US $ 4 billion at the end of 2020. After the repayment of foreign debt obligations in March of this year, reserves fell to three billion US dollars at the end of April. 2021. It has been declining since then to $ 2.8 billion in July. Foreign exchange reserves are estimated at around US $ 2.3 billion at present.
The trade balance is a key factor determining external reserves. Despite strict import controls, the trade deficit widened from March to July 2021. By the end of July, the trade deficit had widened to reach $ 4.7 billion. This is a serious drain on weak foreign exchange reserves.
Increase in imports
What is surprising is that despite tight import controls, the trade deficit has widened entirely due to increased imports. Increased spending on fuel, due to rising international oil prices, spending on COVID-related medical imports and critical industry raw materials explain the increase in import spending.
This trend in import spending is expected to continue as there is a strong pent-up demand for imports of essential food products and intermediate goods which will have a negative impact on the trade balance.
The reduction in food and tea production due to the ban on chemical fertilizers, weedkillers, fungicides and insecticides could increase food imports and reduce tea export earnings later this year. Imports of organic fertilizers would increase the import bill.
Increase in exports
In contrast, the country’s exports have increased this year, from US $ 5.5 billion in the first seven months of last year to US $ 5.8 billion in the same period this year. This 24 percent increase in export earnings was due to increased agricultural and industrial exports.
Unfortunately, the increase in exports was not enough to offset the increase in imports. Although export earnings increased in the first seven months, import spending grew at a faster pace, causing the trade deficit to widen to $ 4.9 billion at the end of July 2021. While export earnings increased 23.7%, import expenditure increased accordingly. like 30.7 percent.
The increase in import expenditure concerned consumer goods, intermediate goods and capital goods. Despite import controls in place, import spending from January to July 2021 amounted to $ 11.73 billion, compared to $ 8.97 billion in the first seven months of 2020.
In addition, import controls are not the appropriate policies. They can negatively affect export production through the unavailability of raw materials. They will of course affect the basic needs of life, as has happened before. An increase in exports is the long term solution. The immediate need is a solution to the country’s exhaustion of foreign currency.
Weaknesses in external finances reflect weak economic performance and flawed economic policies. The persistent balance of payments difficulties are a fundamental economic and structural problem that can only be solved through economic reforms.
These were discussed in last Sunday’s column on solving the problem of the country’s external reserves and balance of payments.
What are the means to resolve the current crisis of foreign exchange reserves which is urgent and imperative? The country is on the brink of a precipice when an immediate solution must be found to resolve the foreign exchange shortage.
The three options for avoiding a catastrophe are borrowing in the international capital market by issuing new BSIs, providing financial assistance from friendly countries through various foreign exchange and loan agreements, and seeking IMF help to restructure the debt and get balance of payments support.
The first option of borrowing in the international capital market is not an option due to the high risk rating of the country. Sri Lankan ISBs are said to be negotiable at exorbitant interest rates. Besides the impracticality of such a loan, the crushing burden of escalating debt would be unbearable.
The second option of seeking funding from friendly countries has been tried, has been partially successful, but insufficient. We got currency swaps from India and Bangladesh and a Yuan loan that could be used for Chinese imports. These were helpful in overcoming the difficulties, but insufficient in dealing with the critical shortage of foreign exchange.
The prospect of obtaining adequate foreign aid is grim. A lot of financial assistance was expected from China. The growing financial crisis in China that could trigger a global financial crisis makes such assistance highly unlikely.
A third option
This leaves us with the third option of obtaining balance of payments support and an extended facility from the International Monetary Fund (IMF). This is the only realistic and achievable solution.
The gravity of the situation and the unavailability of another way out of the crisis will force the government to turn to the IMF, as it has done fifteen times.
An IMF facility has several advantages for the country. The funds are low interest and repayable over a long period. The conclusion of an agreement with the IMF strengthens international confidence in the Sri Lankan economy which would improve the country by rating agencies. This and a renewed confidence in the Sri Lankan economy would allow the government to sell ISBs at a lower price, if necessary.
The government has repeatedly stated that it will not ask for assistance from the IMF. This reluctance is due to the conditions that the IMF would impose on the country. These conditions are well known. These are principles of sound economic management and structural reforms essential to the country’s economic stability and growth.
Even if government advisers say they won’t go to the IMF, it will. Otherwise, the consequences are too dire to consider.