Sri Lanka’s new government: Be warned of the empty treasury and negative foreign reserves

Prince Parakramabahu and the empty treasury

In the middle of the 12th century, Prince Parakramabahu who later became the king of Lanka as Parakramabahu I,

had a disappointing experience when he became the ruler of Dakshina Desha, roughly the present-day Western and North-Western Provinces. According to the second part of the chronicle, Chulavansa, the Prince had asked his Treasurer, equivalent to the Secretary to the Treasury today, whether he had enough resources to wage war with other rulers so that he could become the king of the whole island. The Treasurer had been a very frank official. He had opened the doors of the Treasury and told the prince that it was empty. 

Not discouraged by this frustrating news, Parakramabahu is reported to have started a new economic zone called Antharanga Dhura, in the area extending from the Port at Kalutara. He had got his officials to process export products at that time in this special zone, namely, timber, elephants, ivory, gems, pearls, and spices, and exported to the neighbouring countries from Kalutara Port. It seems that the prince who had learned economics from Kautilya’s Arthashastra, again according to Chulavansa, had generated a surplus in the balance of payments, used that surplus to buy weapons and other military requirements, and brought Lanka under one rule. 

A well-supplied treasury is central to everything

This is a very special situation because according to Kautilya, a king whose treasury is empty is a very weak monarch. Says Kautilya: ‘A king with a depleted treasury eats into the very vitality of the citizens and the country’. He further recommends that ‘All state activities depend first on the treasury. Therefore, a king shall devote his best attention to it’. Having known this, Prince Parakramabahu had taken action to build his treasury as his topmost priority.

Taking country forward

Before fleeing the country as a fugitive, the all-powerful President of Sri Lanka, Gotabaya Rajapaksa, who proclaimed his word was the law, had appointed his Prime Minister Ranil Wickremesinghe, as acting president of the republic. The previous arrangement was for both Gota and Ranil to step down, appoint the Speaker of the Parliament as interim President and form an interim government consisting of all political parties with a given mission for a limited period of about six months. That mission was to convert the chaotic-filled country to normalcy and hold an election to enable the people to elect a government of their choice. That was because there was a generally accepted view in the country that both Gota and Ranil had lost legitimacy and there should be a new government in power that should take Sri Lanka of which all systems have come to a standstill forward. 

New government faces an empty treasury 

At the time of writing this article, Gota has resigned from presidency from abroad, Ranil has been sworn in as Acting President, and the Speaker has announced that Parliament will meet later in this week to elect the new President as provided for in the Constitution. So far, there is no indication who will be the Prime Minister, the head of the government in Parliament. However, the new government faces an empty treasury like the one faced by Parakramabahu. 

But there is a difference. At least, the Treasury in the Dakshina Desha had been only empty, and the prince could start filling it from a zero level. But the treasury which the new government has inherited is not only empty, but also overdrawn. Therefore, the new government should start from a negative position. 

Modern treasuries have financial assets

In the olden times, the treasury of the king was made up of all physical resources of value: gold, jewellery, gems, pearls, grains, oils, other consumption goods, etc. Hence, just by opening the door, one can gauge whether there is any resource within. But in today’s context, there are no such physical resources within the Treasury. The power of the government today is represented by the government’s ability to tax people, print currency, borrow money from the people, financial assets like bank deposits and so on. They are not immediately visible. However, in Sri Lanka’s case, there are two representations that could be gauged as the power of the Treasury. One is the value in the Consolidated Fund created under the Constitution. The other is the country’s net foreign assets maintained by the Central Bank of the country. 

Overdrawn Consolidated Fund

In terms of the Constitution, all cash inflows to the government should be credited to the Consolidated Fund. They are made up of tax incomes, loan proceeds, dividends and interest receipts, grants, and all other receipts. Any debit to this account should be sanctioned by Parliament when it approves the Appropriation Act immediately after the passage of the budget. Those debits should be approved by the Minister of Finance by issuing a warrant sanctioning the payment. As such, credits are equal to the revenue side of the Budget, while debits are equal to its expenditure side. 

Since the revenue is equal to the expenditure, theoretically, the Consolidated Fund should balance itself. However, because of the non-synchronisation of the expenditure flows with that of revenue flows, there should be in practice a small surplus or a deficit at any given time. But over time when the revenue and expenditure flows take place, that temporary deficit or surplus will disappear. If there is a surplus, it can be applied to reduce public debt or transfer back to people as Singapore did recently. But if it is a deficit and it is on the increase year after year, it is a sign of a major fiscal issue in the country. Sri Lanka is in this latter state. 

The overdrawn position of the Consolidated Fund has been on the increase in the last few years. According to the Annual Reports of the Finance Ministry, the Fund was negative at Rs. 304 billion at end-2018. This negative position rose to Rs. 437 billion at end-2019, to Rs. 636 billion at end-2020 and further to a staggering Rs. 990 billion at end-2021. The position since then is not yet known but the heavy borrowings from commercial banks and the Central Bank during the first half of 2022 should have caused the overdrawn balance to shoot up.

 Other overdrawn accounts

But the Treasury’s net overdrawing is not limited only to the Consolidated Fund. It has utilised an overdraft facility amounting to Rs. 798 billion from the two State banks, a provisional advance of Rs. 150 billion from the Central Bank and keeps overdrawn bank accounts amounting to Rs. 82 billion as at end-2021. The total overdrawn level of the Treasury thus adds to Rs. 1,920 billion by end-2021. It is in the interest of the new all-party government to make an accurate assessment of the financial position of the Treasury before it embarks on its mission. The government may choose to postpone the replenishment of the overdrawn financial position of the Treasury. 

It is a strategy of financial expedience that will bring short-term happiness to the government. But in the long run, the problem will snowball creating an insurmountable monster. In the past, all successive governments have exactly done the same. They had enjoyed their profligate behaviour in the present and passed the issue to the next government. That government too had enjoyed their term and fattened the monster. Finally, the nation has suffered, while those in the government are deemed to have robbed the nation’s resources. 

Foreign reserve

Foreign reserves are another indicator of a nation’s strength. In olden times, if the king’s treasury is full of internationally tradeable assets like gold, foreign gold coins, gems, pearls, and diamonds, that king is considered a very rich monarch. That is because they are all real assets with value for the king without obligations to pay another party outside the country. But if the king had borrowed from a foreign source having pledged these assets, the picture changes. Then, he has to part with them when the repayment takes place. In that case, though the treasury is visibly full, its value is diluted because the king has to pay an outside party. This latter position is pretty much applicable to a central bank. It may have foreign reserves, but if those reserves have been built by borrowing from outside sources, there is no value for the country. 

Net foreign reserves are negative 

As Sri Lanka’s Central Bank has borrowed so much from foreign sources recently, its foreign reserves have been turned negative on a net basis. This has been a position which it had had since May 2021. That number in that month amounted to negative $ 175 million. In the subsequent period, this negative number swelled significantly month after month. Accordingly, as at the end of May 2022 the latest month for which data are available, the published data show a negative net position of $ 4 billion. But this number is underreported because it contains the value of a Yuan SWAP facility amounting to $ 1.5 billion as country’s foreign assets. Since, according to the conditions of SWAP, it can be used only when the country’s gross reserves will be sufficient to finance three months of imports or more, it is highly irregular to include its value as foreign reserves of the country. When this is excluded, the net negative position will swell to $ 5.5 billion as at May 2022. In rupee terms, this amounts to Rs. 1,980 billion at the current rates. 

Negative position of the government

Thus, the total negative position of the government due to these two sources amounts to Rs. 3,900 billion. The new government should start working from this deficiency. 

What should the new government do with regard to the economy, while fulfilling its mandate for effecting a system change within six months to facilitate people to elect a government of theirs? It has no medium to long-term mandate. Hence, it should necessarily be immediate and short-term. 

The immediate issue is the replenishment of the resources in the Treasury and acquisition of a comfortable balance of foreign exchange. The first is needed to continue with the government services uninterrupted. The second is needed to ensure a safe inflow of essential imports, namely, fuel, cooking gas, medicines, foods, raw materials for industries. 

Proposed money printing and consequences

The Government does not have sufficient inflows to the Treasury to pay even the salaries of the bloated public service, according to the Prime Minister and Minister of Finance. He, therefore, wants the Central Bank to lend him Rs. 1,000 billion over the next six-month period. Already the Central Bank has accommodated the Government’s funding requirements up to Rs. 2.2 trillion. Though this is a huge expansion of the reserve money base, the Central Bank has been saved on the domestic side by the outflow of funds from the country due to its having a net negative position in foreign reserves. As such, the reserve money base has increased marginally from Rs. 932 billion at end-2019 to Rs. 1,454 billion as at the first week of July 2022. 

Thus, if another Rs. 1,000 billion is granted by the Central Bank, there is no foreign reserves to fly out. Hence, it will remain in entirety within the country causing a secondary money supply increase adding further fuel to the inflationary pressures which is running at present at 70% per annum. At present, Sri Lanka has a galloping inflation – inflation moving from one level to another like a horse gallops – but the degeneration of inflation to a hyperinflation cannot be avoided. It will crush the entire economic system because no one will accept the Sri Lanka rupee. As such, what Ranil should do is to enter into an agreement with the Monetary Board outlining an identified timeline to repay the same to the Bank. For that purpose, he is required to introduce new tax measures to fill the coffers not only to maintain general public services, but also to reverse the original monetary expansion. This should be seriously taken by Ranil because Gota has been accused of inflating the economy to a galloping level, but he will be accused of converting it to hyperinflation level. 

Challenge before the new rulers

Regarding the need for building foreign reserves, the current negotiations with IMF for a bailout package should be vigorously pursued, debt restructuring exercise should be effectively concluded, and bridging financing to survive the rest of the year should be contracted. All these three are conditional on Sri Lanka’s ability to prove to the rest of the world that it has a government of acceptance to all diverse forces. This is more easily said than done. 

Medium to long-term, Sri Lanka should have a road map with clearly identified milestones to deliver the country from the present standstill position to a vibrant growth booster. This will be the responsibility of the new government to be formed after the general elections to be conducted upon the expiry of the term of the interim government put in place at present. 

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)