Download Exchange Control Liberalization, Measures and Their Economic

Exchange Control Liberalization,
Measures and Their Economic Impact
on the Economy
P. Samarasiri,
Assistant Governor,
Central Bank of Sri Lanka
(The paper circulated for the author’s presentation at the special seminar for Hon.
High Court Judges conducted by the Central Bank in association with The Sri Lanka
Judges Institute on Dec 6, 2008)
Exchange Control Liberalization, Measures and
Their Economic Impact on the Economy
By P. Samarasiri, Assistant Governor, Central Bank of Sri Lanka
(Views stated in this paper are only the views of the author based on his knowledge on this
subject and those views do not represent the views of the Central Bank.)
Overview
This article concludes that exchange control liberalisation is an essential component of
macroeconomic policy for mobilization of foreign resources to finance the domestic
resources gap in order for a country to secure and sustain a high rate of growth. Exchange
control in the conventional version, i.e., controls on specific international transactions and
case-by-case-basis approvals for transactions, is not justifiable in terms of macroeconomic
principles. However, given the macroeconomic risks arising from foreign exchange markets
and the case for regulation and supervision of other financial markets, the authorities should
undertake only prudential regulations and market surveillance to promote international
investor confidence and market discipline. Despite the foreign exchange market risks mostly
due to macroeconomic reasons, the economic benefits of exchange control liberalization by
way of expansion of income, employment opportunities and wealth of countries are very
clear.
The article focuses on understanding of the economics of the exchange control liberalisation
in macroeconomic perspectives and, therefore, the article does not attempt to interpret or
explore the legal background relating to exchange control and liberalisation. The exchange
control is a part of the broad regulatory policy package to intervene in or guide economic
activities and markets in terms of the relevant legal provisions that empower the authorities
to apply such interventions in the public interest. Accordingly, the exchange control and its
liberalisation involve a considerable volume of legal aspects and procedures. However, the
exchange control as well as its liberalization should be applied and evaluated carefully with a
good understanding of the underlying economics because their purpose is to promote the
economic welfare of the general public.
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Foreign exchange market which is the market for currencies is one segment of the financial
markets. Since August 2007, global financial markets have been confronting a financial crisis
which is described by some financial experts as “once-in-a-century-financial tsunami.” The
crisis has evolved from turmoil in the sub-prime mortgage market (rising mortgage loan
default by sub-prime customers) in the US to and across credit markets, stock markets and
banking sector in many countries both developed countries and emerging market economies.
Further, foreign exchange markets in many emerging market economies have started
confronting turbulence due to shortages of foreign exchange as a result of contagion effects
of global financial crisis. Therefore, some countries appear to be looking for or re-imposing
certain measures through market rules and surveillance to preserve foreign exchange/reserves
and to stabilise the foreign exchange markets. In addition, a new wave of reform to banking
and financial market regulatory framework is being discussed. Therefore, this topic on
exchange control is attracting new interests.
Meaning of Foreign Exchange
Foreign exchange generally means foreign currency. Foreign currency may also be
defined to include assets denominated in foreign currencies. Foreign assets that can be used
to serve the functions of a foreign money, i.e., a medium of international payments/exchange,
medium of deferred payments for international transactions and a liquid store of
internationally usable wealth are the foreign exchange. Foreign exchange exists because
countries have to trade goods, services and savings. For example, when a Sri Lankan garment
manufacturer exports garments to a buyer in US, Sri Lankan exporter receives the payment
for his export in US$. Therefore, if the Sri Lankan exporter is to use his US$ income in Sri
Lanka, he has to sell his US$ proceeds in exchange of Sri Lanka Rupees. Similarly, Sri
Lankan importers have to buy currencies of the exporting countries for payments to suppliers
in those countries. Accordingly, any foreign receipts to a country involve supply of foreign
currencies (or foreign exchange) in exchange for domestic currency. On the other hand, any
payments to foreign countries involve purchase (demand for) of foreign currencies by paying
in domestic currency. In addition, certain parties or currency traders undertake dealings
(buying and selling) in foreign currencies seeking various kinds of financial gain. The major
foreign currencies such as US$, Sterling Pounds, Yen and Euro are the foreign exchange
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since international transactions are mainly conducted in such major currencies. If a country is
effectively closed from the rest of the world and it can live on own resources, there will not
be any foreign exchange.
Historical View on Foreign Exchange and Globalisation
Foreign exchange is not a new topic that goes far back to early civilization of human
beings through trade. Specialization in products and trade were part and parcel of evolution
of civilization of people in various countries and societies. In ancient times, the countries
leading the world trade printed/produced metal money which was accepted by trade partner
countries. Roman and Chinese coins that were accepted are the examples for ancient foreign
exchange. In ancient times, trade and foreign exchange were free and international traders
marketed products by traveling from country to country carrying products with them. The
trade along the Silk Road is the most ancient world trade that enjoyed a history of nearly
1,600 years from about 220 AD. The Silk Road of about 7,000 miles long spanned China,
Central Asia, Northern India and Roman Empire. In short it linked China with Europe. Sri
Lanka also was a point on the network connected to the Silk Road. Chinese silk was the main
trade while many other specialized products of the countries located around the Road were
traded en route. Silk was carried westward while wool, gold and silver were carried eastward.
Early stage trade was the barter system (exchange of commodities) and later the coins
minted/printed by the lead countries such as China, Roman and Mongols were used. The
countries or tribes permitted the traders enter the land by charging a tax/tariff for providing
trading facilities. There were no controls on trade or exchange and such tariff was collected
for revenue of the kings or tribal leaders. In some countries or tribes, the king or leader
operated a trading department to facilitate trade between the foreign traders and resident
traders who meet at the country boarder or harbour and supply warehouse service. The
foreign coins were used as the legal tender in many tribes which did not require to print
money. Even at present, there are several countries which use the currency of the major
trade-partner countries as the legal tender. The ancient monetary policy instrument was the
tariff. The higher tariff will increase the money in circulation. The globalization took place
through trade of commodities along the Silk Road. The trade and the Silk Road provided for
globalization of religions, cultures, languages or civilizations. Marco Polo used the Silk Road
in the 13th century on his journey to Cathay.
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Transactions Involving Foreign Exchange
In economics, the transactions involving foreign exchange are defined and recorded
in the balance of payments of a country (BOP). The BOP is the economic presentation of
financial flows (inflows and outflows or receipts and payments) underlying the economic
transactions of a country with the rest of the world during a particular time period, i.e., a
quarter or a year. The BOP which is compiled in terms of double-entry book-keeping
principle is the sum of two transactions accounts, i.e., current account and capital account.
The values of transactions on trade of goods and services, income on factors of production
such as capital and labour and remittances are recorded in the current account (see Annex 1).
Exports, imports, travel, payments of factor income such as wages, interest and profit and
remittances fall within the current account. The capital account includes the transactions on
real and financial assets. Transactions on financial instruments such as stocks, debts, deposits
and ownership of real assets, property and businesses fall within the capital account. A
current account surplus means savings of the country that should be invested in foreign
countries to facilitate those economies. Therefore, current account surplus is the capital
account deficit or capital outflow. On the other hand, current account deficit should be
financed through inflow of foreign savings to the country or capital account surplus. For a
country like Sri Lanka, the current account deficit is the avenue for mobilization of necessary
foreign resources including import of raw materials and investments goods (beyond the
foreign income base) that are not available in Sri Lanka to facilitate economic growth which
is good. Therefore, such mobilization of foreign resources is possible only with foreign
capital inflow. If the country needs to expand investments and economic activities in excess
of the existing level of current account deficit, it should promote foreign capital inflow in
excess of the current account deficit. The sum of the balances in the current account and
capital account is the overall balance of payments of a country. A BOP surplus is the increase
in foreign reserves with the monetary authority whereas a deficit will erode the foreign
reserves because any BOP imbalance has to be financed by the monetary authority.
Exchange Controls
Exchange controls generally mean the regulations imposed on payments and receipts
between residents of the country and residents of foreign countries (non-residents) under the
provisions of certain statutes. Since such payments and receipts are generally involved in
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exchange of domestic currency with foreign currencies or foreign exchange, these regulations
are known as exchange controls. In economic terms, these are the controls on the quantity
(i.e., demand for and supply of foreign exchange) in the foreign exchange market. However,
there are state interventions or controls on the price in the market as well, i.e., exchange rate
or fixing the exchange rates of particular foreign currencies. Therefore, in economic terms,
exchange controls are the regulations on the foreign exchange market, i.e., quantity, price and
the market conduct.
The modern history of exchange controls commenced as controls on foreign exchange
outflows during the World War II as attempts to preserve the foreign exchange resources of
the countries. Sri Lanka introduced exchange controls in 1944. Many countries including
England and India introduced exchange controls during the latter part of 1940s. The current
law for exchange controls, i.e., Exchange Control Act, was enacted on 15th August 1953. In
many countries where the exchange rate system followed the system of pegging the country’s
currency to another foreign currency (fixed exchange rate regime), exchange controls or
controls on demand for and supply of foreign exchange were necessary to manage the market
quantity in order to maintain the exchange rate at the level fixed by the authorities (fixed
price). This was so since the exchange rate was fixed at a low (over-valued) level in view of
welfare reasons, despite the market pressure for a higher exchange rate, leading to excess
demand for foreign exchange at cheaper price. Therefore, the controls were attempted to
reduce the demand for/outflow of foreign exchange and to expand the supply or inflow of
foreign exchange. These controls were mainly on current account transactions since capital
account was under complete control. Some of major controls were as follows.
• Application of two exchange rates, i.e., an official exchange rate and a devalued exchange
rate for non-traditional exports and certain imports (to encourage exports and discourage
imports).
• Release of foreign exchange only for imports under licenses controlled by the Controller of
Imports and Exports.
• Travel allowance in respect of the region comprising Bangladesh, Burma, India, Maldives,
Nepal, Pakistan and Thailand was Rs. 2,000 for adults and Rs. 1,000 per person under 16
years of age, once in two years.
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• Travel allowance in respect of other countries was 500 Sterling for adults and 250 Sterling
per person under 16 years of age, once in four years.
• The four types of allowances in respect of emigration since January 1993 were as follows.
i). Capital transfers, i.e., proceeds from disposal of assets, maximum Rs. 750,000 per
person and Rs. 1 mn per family. Any excess funds should be credited to a blocked
account where only interest can be remitted out.
ii). Exchange allowance of US$ 2,000 per person.
iii). Export of personal effects amounting to Rs. 45,000 per adult.
iv). Export of jewellery amounting to Rs. 150,000 per married female, Rs. 60,000 per
unmarried female, Rs. 30,000 per female under the age of 12 years and Rs. 37,500
per male.
According to basic economic principles, controls on trade and foreign exchange would have
restricted the expansion of the world economic welfare and wealth creation because of
closure of the economies from the rest of the world or restricting the globalization. In
economics, it is the free trade or market mechanism that promotes specialization and
comparative advantages in production or resource utilization which enhances the world
economic welfare. Therefore, many countries have opened or liberalized their economies to
the world by phasing out exchange controls. The countries will be open to the world to the
extent of the free flow of foreign exchange and trade in goods, services and savings. It is
observed that poor countries often resort to exchange controls and those are the countries
(except Malaysia) which continue to maintain exchange controls at present.
The provisions of the Monetary Law Act and the Exchange Control Act together provide the
Central Bank with wide discretionary powers to regulate the country’s foreign exchange
operations and such provisions relate to regulatory policies applicable to both quantity and
price in the foreign exchange market as briefed below.
•
Monetary Law Act (MLA): According to John Exter, the founding Governor of the
Central Bank who managed the Monetary Law Act Drafting assignment in 1949,
Monetary Policy which is the primary duty assigned to the Monetary Board and the
Central Bank is concerned with the conscious control of the supply, availability, cost
and international exchange of money and, prior to establishment of the Central Bank in
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1950, except for exchange control, there has been little or no control of money in Sri
Lanka. In terms of Section 5 of MLA, the Central Bank is the authority responsible for
the administration, supervision and regulation of the monetary, financial and payments
system of Sri Lanka and is charged with the duty of securing, so far as possible by
action authorized by the MLA, the objectives of economic and price stability and
financial system stability with a view to encouraging and promoting the development of
the productive resources of Sri Lanka. Foreign exchange is a key factor contributing to
the objectives of the Central Bank and, therefore, foreign exchange market is a specific
policy area falling within the provisions of the MLA. In terms o several other specific
provisions of the MLA, the Central Bank is authorized to adopt policies relating to
supply and availability of foreign exchange and exchange rate (price) determination
mechanism for the exchange of the Rupee for other currencies to assure its free use for
current international transactions and to maintain among the assets of the Central Bank
an international reserve adequate to meet any foreseeable deficits in the international
balance of payments. Such provisions are in Chapter IV-Part II-International Monetary
Stabilisation, Chapter V-Part I- Operations in Gold and Foreign Exchange and Chapter
V-Part II- Regulation of Foreign Exchange Operations of Commercial Banks.
Therefore, the Central Bank has specific statutory responsibilities in managing the
foreign exchange market in the conduct of the monetary policy in the area of
international monetary stability and stability of external value of the currency.
•
Exchange Control Act: The Exchange Control Act provides for specific controls on
financial transactions between residents and foreign residents. Exchange controls in Sri
Lanka generally imply the regulations issued under this Act. The Governor, Controller
of Exchange, officers of the Exchange Control Department and Hon. Minister of
Finance are the authorities empowered to implement the provisions of the Act. These
provisions contain very broad discretionary powers to grant permissions for transactions
and investigations into any violations. These provisions cover not only granting
permission for transactions, but also amending or revoking the approvals already
granted. The approval granted may be general or special or absolute or conditional. The
Minister also may make such regulations as may be necessary for carrying out the
principles and provisions of the Act.
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Liberalisation Measures
The exchange control liberalisation is a major ingredient of economic liberalisation.
The current version of economic liberalisation commenced in 1970s to mean greater freedom
for the market mechanism in economic activities. The market mechanism means that the
economic activities such as production, consumption, savings and investments are guided
and decided by the price without government intervention. The privatisation of state-run
businesses, removal of state controls on prices and quantities in markets and private property
ownership are some of the key measures of such economic liberalisation. This policy
direction was supported by the evidence on socio-economic cost and inefficiencies in staterun enterprises and state interventions and economic principles of markets. In this model, if
the state wishes to run state enterprises, the state is expected to do so in market environment
without resorting to state powers. In addition, the regulatory role of the state to promote
market discipline and to resolve market problems that may not be warranted for market
solutions is also advocated by policy economists. The regulatory role mainly covered
monetary, fiscal, consumer protection and prudential fronts. Therefore, the market
mechanism or economic liberalization is expected to operate within the broad state policies.
The exchange control liberalization means the permission for the currency to be exchanged
with foreign currencies for economic transactions that promote the economy and economic
welfare of the general public. The exchange control liberalization is the route to link the
domestic economy with the global economy in pursuit of economic benefits advocated by
principles of international economics. Globally, the exchange liberalization has two major
aspects, viz., liberalization of current account known as the current account convertibility of
the currency and liberalization of capital account known as the capital account convertibility
of the currency. This conventional classification is adopted by the policy economists in view
of the distinct features of the two accounts and the underlying concerns.
• Current Account Liberalisation: The current phase of liberalisation of exchange controls
on current account transactions commenced in November 1977 with the declaration of the
open economic policies by the Government and accelerated since 1993. Introduction of the
crawling peg exchange rate system in place of fixed exchange rate/multiple exchange rate
system and relaxation of imports were the fundamental measures to promote the current
account convertibility. At present, foreign exchange transactions in the current account are
free and the authorized dealer banks have been permitted to use their discretion to engage
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in buying and selling foreign exchange in designated currencies with the customers on the
basis of documentary evidence on the need for such transactions. Meanwhile, exchange
rate determination has been gradually entrusted with the market forces by moving to a
managed floating exchange rate system since November 1977 and floating/flexible rate
system since January 2001.
• Capital Account Liberalisation: As in many emerging market economies, the
liberalisation of exchange controls on capital account transactions in Sri Lanka has been
quite slow. At present, foreign capital inflow in equity (foreign direct investments and
company equities) is largely free while deposits in foreign currency are permitted under
specified schemes. The debt capital and other capital transactions fall within the control
where the prior approval is required. Direct investments in businesses under Board of
Investments scheme, investments in shares through share investment external rupee
accounts, foreign currency deposits to be maintained at banks by foreign income earners,
foreign investments in government securities subject to a total cap of 10% of outstanding
government securities, investments in bank deposits not below US$ 10,000 by foreigners
subject to a total cap of 20% of bank deposits, release of blocked account balances as at
July 1, 2008, release of funds in new blocked accounts by $20,000 per annum and all
inclusive of allowance for immigration amounting to $ 150,000 per family are the major
measures of capital account liberalisation. The major challenge facing the economic policy
makers in Sri Lanka is the further capital account liberalization to support the long-term
economic growth in the country.
Capital Account Liberalisation: Concerns and justification
Many people including certain policy-making officials raise concerns on foreign capital
flows due to various reasons. Some of them are,
•
Opportunity for the foreigners to own domestic assets.
•
A part of profit and income on national production outflows to foreign countries.
•
The nation becomes indebted to foreign nations.
•
Unhealthy dependence of the economy on foreign funds.
•
Sudden outflow of foreign capital that can destabilize the economy due to
shortage of funds created by the capital outflow.
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Some people favors long-term foreign investments in certain businesses, but short-term
capital is considered unhealthy and unsustainable because of the potential mobility and
capital repayment problems. Similarly, local investments abroad by the residents are also
disliked mainly due to two concerns.
•
Opportunity for wealthy people to move out their wealth and accumulate wealth
in foreign countries.
•
Outflow of the country’s hard-earned foreign exchange (through exports and
workers’ remittances) to finance investments abroad by the private parties.
Meanwhile, many people conventionally believe that inflow of foreign exchange through
exports of goods and services made out of domestic resource base is good and healthy
whereas imports or payments to foreign countries are bad. It should be noted that that the
countries which generate a trade surplus by increasing exports and discouraging imports in
fact economically assist foreign countries in two ways, i.e., by exporting the best quality
goods and services produced out of domestic resources base for foreigners’ benefits and by
exporting the surplus of foreign exchange (foreign money which does not have tangible real
value) back to acquire foreign financial investments again benefiting the foreigners. Further,
many like to beg foreigners’ mercy through various forms of foreign grants to develop the
country which is an illusion, but not to mobilise foreign resources on economic terms.
These types of views are based on individualistic value judgments rather than economic
realities and principles. Instead, foreign payments and receipts including capital flows should
be looked at in macroeconomic development perspectives in line with following principles.
•
Access to benefits from globalization: A country cannot be developed in a closed
economy model. It has to benefit from foreign countries and competition to generate
comparative advantages. Staying relevant to globalization is a pre-requisite for
sustainable economic development. Globalisation is a process that has been taking place
from the ancient history through various routes such as invasions, colonisations, trade,
migration and information technology which facilitated the people living in
geographically and politically separated areas to get connected and share their
knowledge, inventions and outputs. Therefore, a country has to get into globalization if
it is to develop further. International economic transactions involve trade in goods,
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services, labour, real assets (property) and financial assets which generate inflows and
outflows of resources. A country should promote all such transactions on the basis of
(comparative) advantages when compared with other countries because all such
transactions promote economic activities and resource generation and utilisation.
•
The view that certain transactions are not favourable: It is misunderstanding to say
that certain transactions are favourable or unfavourable. Exports and labour migration
are considered as favourable because of foreign exchange earnings despite the fact that
exports outflow the real resources of high quality at internationally competitive
standard. Although imports are treated as unfavourable because of foreign exchange
outflow, imported goods provide numerous opportunities such as technology, inputs,
competition for quality improvement and low prices prevailing in other countries to
support economic activities. Inflow of labour takes place in the areas requiring expertise
and management know-how. Ownership of property and businesses (foreign direct
investments), stocks, debts and deposits are the transactions on capital or savings.
Foreign capital will promote business, management know-how, financial instruments
and markets and international investor confidence and links. Foreign capital flows are
the mobilization of foreign financial savings to finance economic activities. The
aggregate of financial payments and receipts arising from all these transactions during a
particular period is the balance of payments which can be a deficit or surplus. There is
no economic theory to justify which one out of a deficit or a surplus is favourable or
unfavourable for a country and it depends on the prevailing macroeconomic
circumstances.
•
The need for foreign savings to increase economic growth: The major problem in
many countries like Sri Lanka is the lack of domestic savings mobilization to finance
the investments required for a high rate of economic growth. This is known as
economic circle of poverty, i.e., low income-low savings-low investments-low income…, as explained by development economists. Economic growth in Sri Lanka has been
mostly in the range of 4% and 6% in the past and there is no argument that the eonomic
growth should be increased considerably to raise employment opportunities and
income, to reduce the poverty and to improve the living standard. The country may need
an annual economic growth of 8% - 10% for a sustainable development as being evident
in peer countries. This requires a considerable increase in investments. The investment
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rate during the last ten year period has been in the range of 21% and 25% of GDP,
except for 1999 and 2000 which recorded a high rate of investment around 28% of
GDP. According to estimates, each 1% of economic growth requires an investment rate
of 4% - 5% of GDP. Therefore, to maintain an 8% growth, the economy requires an
investment rate of at least 35% of GDP. However, the national savings rate during the
last ten years has been in the range of 19% and 22% of GDP and this level of savings is
not adequate for financing a major increase in investments in the country. The current
level of savings is very low when compared with the national saving rates of East Asian
Countries (30%-45% of GDP). Therefore, only way out to secure a desired rate of
investments is the attraction of foreign savings through a current account deficit in the
medium term and corresponding liberalization of capital account to generate a capital
account surplus. Accordingly, given the current macroeconomic structure and a national
savings rate of 22% of GDP, to secure an investment rate of 40% of GDP per year
requires a high rate of foreign savings. The maintenance of current account deficit for
the growth requires a same rate of capital account surplus through official and private
capital. Theoretically, this mechanism is same as a businessman living in a particular
area raise/borrow funds from a bank located in another area to finance his business or
his savings-investment gap. If a high rate of investments is not maintained as indicated
above, it will take about 7 years to double the GDP per capita. After introducing
liberalized economic policies beginning 1978, it has taken 4-7 years to double the GDP
per capita in rupee terms and 9-12 years to double the GDP per capita in dollar terms.
During the pre-1978 period, it had taken nearly 13 years to double the GDP per capita
and, therefore, the period taken to double the GDP per capital has considerably declined
after liberalised economic policies. Therefore, further capital account liberalization is
justifiable for faster growth and expansion of employment and income. If Sri Lanka is
restricting capital inflow or current account deficit, it will never be able to achieve and
sustain 8% GDP growth.
•
The benefits of capital mobility:
• facilitating the government and private sector to borrow foreign savings to finance
investments.
• inducing foreign entrepreneurs to undertake investments out of their savings directly
in the country.
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• giving the opportunity for global technology and management know-how.
• promoting good governance practices.
• injecting liquidity to domestic financial markets and develop financial markets
enabling domestic savers to invest in a diversified portfolio.
• making monetary policy more effective through increased interest rate responsiveness
of financial and real sector activities.
• benefiting from globalization to generate comparative advantages not known hitherto.
•
Sectoral imbalance: In an economy open to the world, the national income/product
generation is the sum of contributions of the government, private sector and foreign
sector. In open economy macroeconomics, any resource imbalance in one sector has to
be financed by the other sector. For example, if a country runs a budget deficit to
promote welfare of the general public through state policies such as subsidized prices,
transfer payments and supply of public goods and services, the resources to finance the
deficit have to come from the net savings (savings less investments) of the private
sector or from foreign savings through current account deficit or capital account surplus
from the foreign sector or from both. If the private sector also operates a high
investment rate over savings, the total deficit has to be financed from foreign savings
through a current account deficit. Therefore, if the foreign sector is closed through
exchange controls, a government can serve the public through maintaining a budget
deficit only if the private sector economic activities are curtailed to save resources more
than investments. Since this is not a feasible solution in terms of economic principles,
opening to the foreign sector to run a current account deficit is the source of resource
inflow or foreign savings mobilized to finance the domestic resource gap. The intuition
behind the current account deficit is that a country like Sri Lanka has to import foreign
goods and services to promote economic activities/growth and foreign savings should
be mobilized to finance the current account deficit. Financing the current account deficit
requires foreign capital inflow by way of debts and other types of funds. If the capital
account is not liberalized appropriately, financing has to be made through foreign
capital/borrowing raised by the government. Since the current account has been almost
fully liberalized, capital account liberalization is a pre-requisite for enjoying the
economic benefits of current account liberalisation without a burden to government or
without facing chronic balance of payment difficulties. During the last 10 year period,
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the budget deficit has been in the range of 7%-9% of GDP and the private sector and
foreign sector had to save resources to finance the budget deficit. Therefore, the private
sector had to maintain a net savings rate (savings less investments) ranging from 3%9% of GDP. The balance was financed through the current account deficit ranging from
2%-6% of GDP. Therefore, as long as the country runs a budget deficit and domestic
resource gap, the current account deficit and capital inflows are necessary for managing
the economy for a desired rate of growth. According to the above macroeconomic
principle, what matters is the level of foreign capital/savings inflow and not the quality
or term-structure or types of such foreign funds. The term-structure (short-term or longterm) or the types of capital (foreign direct investments or others) are the matters to
address issues relating to the capital mobility due to various other factors.
•
The sustainability of current account liberalization: Since the current account deficit
has been in increasing trend and it has to increase further to facilitate accelerated
economic growth, the deficit financing has to be through government’s foreign
borrowing or reduction in official foreign assets if the capital account is not liberalized
in order to facilitate the private sector to raise foreign funds to finance their domestic
resource gaps. In most years, 60% to 90% of current account deficit has been funded
through long-term foreign borrowings of the Government. Accordingly, total long term
net foreign borrowing of the Government reported in the balance of payments since
1978 was US$ 9 bn and current foreign borrowing outstanding is about US$ 14 bn. or
44% of GDP. Given the current high level of debt burden of the government (domestic
and foreign) and constraints on official reserves, the current status of current account
liberalization is not sustainable unless capital account is liberalized appropriately.
Otherwise, it may be necessary again to introduce certain measures of current account
controls to manage the current account deficit and such measures would not e
acceptable in terms of current international best practices and comparative advantages
of globalization. Further, such measures may lead to socio-political issues that may be
unfavourable for the economic development, given the country’s heavy dependence on
foreign sector and liberalized environment that has been there during a long period.
•
Current account surplus: If a country runs a current account surplus in the balance of
payment, e.g., China, Japan, Singapore and oil-producing countries, it is a net-savings
exporter indicating a net capital outflow from the country. Such countries also need
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specific measures of capital account liberalization in order to avoid adverse economic
impact of balance of payments surpluses. Through foreign capital inflow, a country can
attract more productive and technologically advanced investments and business
management know-how. For example, even though China runs a huge current account
surplus and a net domestic savings rate, it has been in an open process of a gradual
capital account liberalization to attract foreign capital/investments to promote economic
development. Therefore, even a country with a domestic resource surplus may need
capital account liberalization to have a desired combination of domestic and foreign
investments in the country.
•
Fear of financial crises: Based on ex-post analyses of financial crises of many
countries, the fear of capital account liberalization is the potential financial crises due to
sudden outflow of foreign capital (short-term) in the event of loss of international
investor confidence. It is argued that the foreign capital that will easily flow to countries
is the short-term capital such as stocks, deposits and debentures and such capital has the
potential of sudden outflow due to political, economic or other factors since
international investors always seek to protect their investments by moving them across
the countries looking for safe destinations and better returns. The current globalised
financial markets through modern IT provide ample facilities for cross-boarder capital
flows on-line at a very low cost. Most financial crises have initially occurred as
currency or BOP crises and then spread as banking crises. During the stage of currency
crisis, the demand for foreign exchange will increase at unprecedented rates leading to a
huge depreciation of the country’s currency. Subsequently, the crisis will turn to a
banking crisis through a large scale liquidity crunch and non-performing loans of banks.
The contagious capital outflows will destabilise the economy as a result of a number of
risks such as unprecentedly high depreciation of the currency, erosion of foreign
reserves, liquidity shortages, insolvencies of banks and firms, economic downturn and
fiscal cost of crisis resolution. Imprudent macro-economic policies inclusive of overvalued exchange rates and domestic market controls, weak bank supervision and bad
corporate governance practices found in most crisis-hit countries are blamed for the past
financial crises.
Financial crises are complex events due to multiple causes that could only be analysed
in ex-post literature and there is no methodology to predict financial crises. Crises occur
16
in liberalized countries as well as in less liberalized countries. The current global
financial market turmoil in the developed markets is the worst financial crisis in the
history which was never expected and which will have a huge cost to the global public
for many years to come. A financial crisis could also be seen as a reflection of real
sector problems linked to asset prices. Therefore, prevention of any potential financial
crises of the nature identifiable in the recent literature should be done in a
macroeconomic framework. Otherwise, suppression of dangers of financial crises
through tight capital and financial market controls will only create financial repression
and prevent the opportunities available from global markets for the country’s
development. Therefore, the fear of financial crises should be seen as another source of
inefficiency of financial policymakers/bureaucrats not being able to facilitate the
macroeconomic development due to their concerns on unknown events of crises.
Foreign capital, whether short-term or long-term, will generate income and wealth in
the country. In most emerging market economies, a major input in development of real
estates sector has been the foreign capital. It should be understood that the outflow of
foreign capital from the real sector does not outflow the real property developed
through foreign capital. What outflows is only foreign exchange brought in to finance
the projects. A financial crisis should be seen as a part of macroeconomic outcome and,
therefore, the opportunity for wealth creation through foreign capital should not be
compromised for prevention of unknown financial crises. According to financial
analysts, markets as well as the market regulators are responsible for financial crises.
Specific Areas of Economic Impact
As pointed out above, liberalisation is part and parcel of macroeconomic development
of a country. There is enough justification that a country cannot promote an economic
development at levels sufficient to employ productive resources and upgrade living standards
without resorting to foreign transactions. Openness has been a specific economic policy for
macroeconomic development in many countries such as Singapore and Hong Kong. Since
1977 Sri Lanka has implemented several liberalization measures without which Sri Lanka
could not have achieved the current level of development and living conditions. Recognizing
the current phase of global economic developments, it is necessary that Sri Lanka introduce
further measures for promotion of stable capital mobility for the economic benefit of the Sri
17
Lankan economy. Otherwise, the living standard of the general public will continue to suffer
from low economic growth since domestic resources or savings are not adequate for
generating and maintaining a sufficiently high growth. Some of major areas to assess the
benefits of exchange control liberalization measures since 1977 are as follows.
•
Liberalisation of imports enhanced production and employment opportunities and living
standard. For example, many industries and service activities generating employment
and exports have emerged.
•
Business activities through BOI investments generated income, employment and
exports. The best example is the garment industry where Sri Lanka has become one of
the leading garment exporters in the world. By end of 2007, foreign investments worth
Rs. 363 bn or US$ equivalent of 3 bn have been attracted to 1,976 business projects.
•
Development of construction industry through foreign construction projects and imports
of building materials.
•
Development of stock market through foreign investments which facilitate mobilization
of capital by companies. Nearly 36% of listed shares lodged in trading accounts at the
Central Depository System (CDS) of the Colombo Stock Exchange amounting to a
market value of nearly $ 1.2 bn (Rs. 118 bn or 40% of value of shares at CDS) belong
to foreigners. Further, the no of shares held by foreign investors at CDS has increased
from 3,563 mn as at end of 2007 to 4,404 mn as at end of Nov 2008.
•
The banking sector has mobilized nearly $2 bn of deposits in permitted foreign currency
accounts and foreign borrowing of nearly $1 bn facilitating the funding for domestic
businesses.
•
As a result of promotion of foreign transactions, the Central Bank has been able to
maintain foreign reserves of around $ 3 bn adequate generally for three months of
imports.
Concluding Remarks
Exchange controls are the state regulations on payments and financial transactions
between residents and foreign residents. Economic transactions with the foreign sector and
foreign exchange are part and parcel of macroeconomic development of a country through
the benefits of economic globalization. The openness to the global economy is a specific
macroeconomic economic policy because it is not feasible for a country to be self-sufficient.
18
The foreign exchange market is the market that links domestic markets to global markets and
the most part of exchange controls is on the foreign exchange market involving the market
price (exchange rate) and the market quantity (foreign exchange amount). Therefore, the
higher the level of the exchange controls, the lower will be the level of openness of a country
to the rest of the world and the access to the globalization’s benefits.
Openness and, therefore, exchange control liberalisation, is the avenue for mobilization of
foreign resources to finance the domestic resource gap in order to secure and sustain a
sufficiently high rate of economic growth for income, employment and wealth creation in the
country. This is justifiable in terms of macroeconomic principles and practical evidence from
many emerging market economies. Therefore, the role of exchange control should be looked
at macroeconomic perspective rather than ad hoc controls on various transactions and caseby-basis approvals granted through bureaucratic processes for certain transactions. Such
controls may be justifiable at times to preserve the existing foreign exchange reserves during
a short period, but it is extremely difficult for the authorities to continue with controls on
markets such as foreign exchange in the current world with financial technology and
exchange controls are not justifiable in terms of basic macroeconomic principles. In fact,
exchange controls are generally observed from the countries with poor economic
management. However, as in the case of other financial sector regulations of prudential
nature, the authorities should regulate and supervise foreign exchange market with the view
to promote international investor confidence and market discipline, provided that such
authorities have the necessary resources and knowledge on the evolving markets. Otherwise,
the macroeconomic cost of bureaucratic type of exchange controls will be the continued
inability of the country to benefit from the economic globalization to enhance economic
welfare of the general public.
19
Annex 1
BALANCE OF PAYMENTS 1997 - 2007
US $ Million
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007(a)
Current Account
-393
-226
-563 -1,066
-215
-236
-71
-648
-650 -1,499 -1,369
Trade Balance
-1,225 -1,092 -1,369 -1,798 -1,157 -1,406 -1,539 -2,243 -2,516 -3,370 -3,560
Exports
4,639 4,798 4,610 5,522 4,817 4,699 5,133 5,757 6,347 6,683 7,740
Imports
5,864 5,889 5,979 7,320 5,974 6,106 6,672 8,000 8,863 10,253 11,301
Services
159
145
147
38
204
295
399
419
338
257
239
Receipts
875
914
968
953 1,355 1,268 1,411 1,527 1,540 1,625 1,711
Payments
716
770
820
915 1,151
974 1,012 1,108 1,202 1,368 1,473
Income
-160
-180
-254
-305
-267
-252
-172
-204
-299
-389
-358
Receipts
234
214
167
152
108
75
170
157
35
311
449
Payments
393
394
421
456
375
328
341
360
335
700
807
Goods, Services and Income (net)
-1,225 -1,127 -1,476 -2,064 -1,220 -1,364 -1,312 -2,026 -2,478 -3,503 -3,679
Transfers (net)
832
900
913
998 1006 1,128 1,241 1,380 1,828 2,005 2,311
Private Transfers
788
848
887
974
984 1,097 1,205 1,350 1,736 1,904 2,214
Receipts (c)
922
999 1,056 1,160 1,155 1,287 1,414 1,564 1,968 2,161 2,502
Payments
135
151
169
186
172
190
209
214
233
257
288
Official Transfers (net)
44
52
26
24
22
31
36
30
93
101
97
Capital and Financial Account
602
413
373
443
562
444
722
636 1,224 1,808 2,097
Capital Transfers
87
80
80
50
198
65
74
64
250
291
269
Receipts
91
84
86
56
203
71
81
71
257
299
278
10
Payments
4
5
5
6
5
6
6
7
7
8
Long-term (net)
716
398
435
304
163
326
722
684
798
907 1,251
Direct Investment
430
193
177
176
172
185
201
227
234
451
548
Foreign Direct Investment
129
137
177
173
82
181
171
217
234
451
548
Privatization Proceeds
301
56
–
3
90
5
30
10
0
-Private Long-term
47
2
196
82
-257
-21
-33
18
11
-35
31
Inflows
150
146
361
298
44
115
101
169
197
139
199
Outflows
102
145
165
216
301
136
134
151
186
174
168
Government Long-term
239
203
62
47
249
162
554
439
553
491
672
Inflows
500
490
381
355
575
542
913
771
747
932 1,290
Outflows
262
290
319
308
326
380
359
331
194
441
618
Short-term (net)
-201
-64
-142
88
201
53
-75
-112
176
610
577
Portfolio Investment
13
-24
-13
-45
-11
25
2
11
60
51
101
Private Short-term
-20
8
-10
100
-42
68
19
28
16
-30
20
Commercial Bank Assets
-323
180
-19
-141
183
104
-94
-354
-223
297
-281
Commercial Bank Liabilities
129
-228
-101
174
71
-145
-2
202
323
293
364
Government Short-term
–
–
–
–
–
–
–
–
0
372
Errors and Omissions
-46
-151
-73
101
-127
38
-148
-193
-72
-105
-198
163
37
-263
-522
220
338
502
-205
501
204
531
Overall Balance (change in foreign reserve
Item
Exchange Rate Rs/US$
Ratio to GDP in Percentages
Trade Account
Current Account
Current Account without official transfers
(a) Provisional
58.99
64.59
70.39
75.78
89.36
95.66
-8.1
-2.6
-2.9
-6.9
-1.4
-1.7
-8.7
-3.6
-3.7
-10.8
-6.4
-6.6
-7.4
-1.4
-1.5
-8.5
-1.4
-1.6
96.52 101.19 100.50 103.96 110.62
-8.4
-0.4
-0.6
-11.4
-3.3
-3.4
-10.7
-2.8
-3.2
-11.9
-5.3
-5.7
-11.0
-4.2
-4.5
Source: Central Bank of sri Lanka
20
The author is Mr. P. Samarasiri, an Assistant Governor and the former Director of Bank
Supervision of the Central Bank. He holds a BA (Honours) in Economics from the
University of Colombo and an MA in Economics from University of Kansas, USA, covering
Econometrics, Monetary Economics, International Economics and Macroeconomics as major
subjects. He has nearly 25 year service in the Central Bank. During his career in the Central
Bank, he has received training locally and internationally on subjects connected with macroeconomic and financial sector policies. He has published a number of articles and serves as a
lecturer at the Institute of Bankers of Sri Lanka.
21