Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Bretton Woods system wikipedia , lookup
Foreign direct investment in Iran wikipedia , lookup
Fixed exchange-rate system wikipedia , lookup
Foreign-exchange reserves wikipedia , lookup
International monetary systems wikipedia , lookup
Exchange rate wikipedia , lookup
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. 2 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 3 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. 4 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 5 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. 6 • 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 7 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. 8 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 9 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. 10 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, 11 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 12 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. 13 • 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, 14 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 15 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