Part I
Current tensions or chronic shortages of foreign currency in many countries due to disruption of global supply chains caused by the Corona Pandemic are no secret. These tensions are easily seen from continuous depreciation of the currency (or exchange rate), chronic shortage of foreign exchange, difficulties in servicing of foreign debt and investments and continuous decline in the foreign reserve. If these tensions are not resolved early, currency crises are only a matter of time.
Since 1990s, currency crises have hit several countries from time to time. Asian Currency Crisis 1997/98 has been a major one. At present, there are several countries such as Turkey and Lebanon struggling on the verge of crisis. Therefore, present economic policy routine of many countries has been to control currency tensions to prevent currency crises. Currency tensions and currency crises are a side effect of many countries failing to manage in the new round of economic globalization that has taken place through increasing flows of multilateral trade and investments that have created a world of currency trades causing economies to depend on global reserve currencies, mainly the US Dollar.
Structural problem in Economies
The new global economic order has led developing countries to depend on imports for all activities of the economy as imports provide inputs for export industries as well as domestic economic activities in addition to supply of many essential food items. As a result, many countries are compelled to manage with wide deficits on global trade financed by foreign investments attracted through specific policies. As these investments comprise of private funds in developed countries, they come on short-term trade basis looking for quick portfolio gains, given the global competition and geopolitical risks underlying these funds. Therefore, servicing of foreign investments (interest, profit, repayment, etc.) has become the major burden on the economy through its balance of payment (BOP). Almost all currency tensions and crises are risks arising from this servicing profile.
Macroeconomic Dependence on Foreign Currency
The direct dependence is very clear in funding the BOP deficit. However, indirect dependence of country’s financial conditions is evident in the Central Bank balance sheet and inter-bank market liquidity. Due to foreign reserve operations, the balance sheet of the Central Banks is 70-80% on foreign currency. As a result, money printing is directly connected to the changes in the foreign reserve. Second, foreign currency flows directly affect the market liquidity, i.e., inflows raise the liquidity and outflows shrink it. As a result, domestic currency market has got roots to monetary policies of the US and Europe to which such foreign investment flows are linked. Therefore, Central Banks have lost monetary policies required for mobilization of domestic productive resources and operate still as de-facto Currency Boards.
Structural problem of the Government
The global economic front of many countries since 1980s has been the liberalization of trade of goods and services whereas capital trade has been largely controlled. Foreign investments into stock market and government securities markets and private foreign borrowing have been permitted only under specific schemes subject to limits and close scrutiny. Therefore, private foreign investment inflow has not been sufficient and stable to finance the protracted BOP deficits. In this background, exchange rate has to depreciate to clear the deficit over the time.
However, the policy routine has been to suppress the exchange rate depreciation (Over-valued exchange rate) to prevent the cost-pushed inflation on higher costs of imports and the increase in domestic currency cost of government foreign debt service. Such exchange rate control requires supply of foreign exchange to the market from the foreign reserve of the Central Bank. Given the structural BOP deficits and excessive control of private capital flows, the maintenance of the foreign reserve to control the exchange rate at discretionary levels requires mobilization of foreign funds through official/government sources because the Central Bank does not seem to resort to monetary policy measures (Monetary Law Act and Foreign Exchange Act in Sri Lanka) for this purpose.
Therefore, the government acts to finance the BOP deficit of the private sector through the sovereign balance sheet although the exchange rate and reserve management are the statutory duties of Central Banks. This is the reason why BOP has been the structural problem confronted by the fiscal policy/national budget.
Official Funding Sources/Instruments
As Central Banks are the bankers and debt managers of the government, they resort to raise foreign borrowing for the government in order to fund their foreign reserve where Central Banks buy these proceeds and provide domestic currency to governments (printing money). International Sovereign Bonds (ISBs), Currency Swaps and IMF facilities have become routine sources with ambitious targets of the foreign reserve. In the past, the sale of state assets to foreign investors was also pursued, but national issues have suppressed this source at present.
• ISBs have become global routine to source foreign funds to governments through investment banking network in global financial markets. Such debt is raised in the guise of foreign borrowing to fund the public investments while their proceeds are bought by Central Banks for their foreign reserve. This new strategy has caused bilateral debt such as project loans to be gradually phased out.
(The writer is a former Deputy Governor of the CBSL and former Chairman and member of six state Boards. He is the author of nine Economics and Banking books)
To be continued
