Reform of Exchange Controls – Part III: Proposed Foreign Exchange Act, an improvement on many count

Making exchange control a permanent law

In parts one and two of this series (available respectively at: http://www.ft.lk/article/610886/Reform-of-exchange-controls--There-is-a-need--but-do-it-correctly-%E2%80%93-Part-I and http://www.ft.lk/article/612271/Reform-of-exchange-controls-%E2%80%93-Part-II--Bringing-exchange-controls-to-the-permanent-law-book), it was presented that the colonial rulers introduced exchange controls to Sri Lanka in 1939 as a war strategy during the World War II. The objective was to prevent the foreign exchange resources of the colony from falling into the hands of the enemy, namely, the Germans and the Japanese. Thus, exchange controls were expected to be a temporary measure and to be lifted at the end of the war. 

However, they were continued by our colonial rulers till independence in 1948. After independence, the local rulers followed in their colonial rulers footsteps. When the Central Bank was established in 1950, the job of implementing exchange controls was assigned to the new bank. In 1953, Sri Lanka enacted a new Exchange Control Act or ECA bringing exchange controls into the permanent law book of the country.

Absolute powers vested with controller and minister

It was pointed out in the previous part of this series of articles that ECA was a draconian legislation with absolute powers given under the Act to the Controller of Exchange and the Minister of Finance. The violation of ECA was categorised as a criminal offence; thus, violators faced the risk of being sent to jail in addition to paying a fine. 

Further, the wartime exchange controls had been introduced as a war strategy to fight the enemies of the empire. Hence, the introduction of exchange controls as a permanent law was tantamount to treating all Sri Lankans as enemies. 

Nationalisation of private property

Accordingly, though people, say exporters or migrant workers, earned foreign currencies through their labour, they were deprived of the right to use them according to their choice. Hence, it was argued in the previous part that exchange controls, whatever the justification that could be given for their existence, were a nationalisation of private property rights. 

The complication of such an economic treatment was that Sri Lanka offered a one-way flight into the country with a trap door in the form of exchange controls that restricted free out-movements. One can bring in foreign currencies to the country but he cannot take them out since they were considered a national property and not a private property. Hence, all those who had earned foreign currencies had the incentive to keep them out of the sight of exchange control through devious methods. Others who had earned incomes in local currencies had the incentive to have them converted into foreign currencies and sent them out. It resulted in the thriving of an underground business activity which operated outside the long arm of exchange controls.

Treating symptoms

The response of the Sri Lankan authorities was not to treat the ailment at its source. Instead, they chose to address the symptoms. Accordingly, exchange controls were tightened when the problem was most serious. On the other side, they were loosened when it was not so alarming. 

For instance, in mid 1970s, the authorities used the Criminal Justice Commission Law – a special court system that had earlier been used to try the rebels of the 1971 youth insurrection. In this law, the normal evidence laws that were applicable to the regular court system were suspended, while the prosecutors were relieved of the burden of proving the guilt of the accused. That burden was passed onto the latter who now had to prove their innocence. Several large-scale operators in the underground foreign exchange market were sent to jail; yet, the underground foreign currency market continued to thrive outside the Central Bank and its network of authorised dealers. 

Loss of confidence in the economy and its policies

This was surely a problem relating to the confidence of people in the economy and the soundness of its macroeconomic policies. Successive governments had been liberally using the Central Bank’s money printing power to finance stubborn budget deficits. 

The unintended consequence of that strategy was to build permanent inflationary pressures within the economy. Before 1977, there was suppressed inflation that had manifested itself as shortage of goods, long queues and profitable black markets for smuggled goods. After 1977, with the liberalisation of the economy, these manifestations disappeared. But, the suppressed inflation of the earlier era was made open and it put pressure on the exchange rate to depreciate in the market. Hence, the root cause of the shortage of foreign currencies was not that Sri Lankans acting unpatriotic; it was due to the failure of governments to win the trust and confidence of people in the policies they adopted.

Singapore shunned exchange controls 

But neighbouring Singaporean leaders had a policy approach different from what Sri Lanka had pursued in 1960s. As Singapore’s first Finance Minister Goh Keng Swee had revealed later in 1992 when he wrote an article under the title ‘Why A Currency Board?’ to the Silver Jubilee Commemoration Publication of the Currency Board of Singapore titled ‘Prudence at the Helm’, that the country’s old guard leaders had carefully considered the option of introducing exchange controls to tackle the balance of payments problems arising from excessive expenditure programs of the Government. They had concluded, according to Goh that “there was no effective way of exchange control in an open trading economy like ours to deal with inevitable balance of payments troubles.” Hence, they addressed the root cause of the problem by disciplining the budget and putting a stop to Central bank money creation as a way to finance budget deficits. 

Sri Lanka’s lost opportunity

Sri Lanka lost a similar opportunity in 1966 when it disregarded a policy recommendation made by the Indian economist B.R. Shenoy, a professor of economics at Gujarat University in India at that time, that Sri Lanka should remove both exchange and import controls in order to create a situation conducive for investment, trade and private enterprise to take place. 

Shenoy’s recommendations were analysed by this writer in a previous article in this series (available at: http://www.ft.lk/article/432905/The-ignored-B-R--Shenoy-Report-of-1966:-An-instance-of-missed-opportunity-for-Sri-Lanka). Among Shenoy’s recommendations, the most revolutionary proposal was to adopt a completely freely floating exchange rate to address the persistent balance of payments difficulties in the wake of uncertainty about the receipt of donor funding. 

It should be noted that this recommendation was two decades ahead of the subsequent global best practices advocating flexible exchange rates. The strict exchange and import controls have generated a massive black market for foreign exchange, on the one hand, and a thriving smuggling business, on the other. 

The reaction of authorities was to impose more and more penalties on the culprits. Hence, there was a substantial disparity between the official exchange rate and black market rate; the result was the over-invoicing of imports and under-invoicing of exports so that saved foreign exchange could be lucratively sold on the black market. 

Shenoy had termed it as ‘disastrous’ for the country’s balance of payments. Hence, he recommended the abolition of exchange controls, import and export restrictions and advocated for the liberalisation of external trade along with the floating of the rupee.

FEA is an improvement: management rather than controls

The present Foreign Exchange Act or FEA has to be evaluated in this background. The Act in many ways is an improvement of the existing ECA. 

The broad framework of FEA has been to establish the management process of foreign exchange dealings by authorised dealers or restricted dealers appointed by the Central Bank for that purpose. There is no controlling aspect of foreign exchange being brought in the new law. The law is implemented by the Central Bank as the agent of the Government subject to the direction of the Minister who is assigned the subject area coming within the purview of FEA.

Decriminalisation of exchange control violations

The proposed FEA has thus decriminalised exchange control violations and citizens have been freed from its draconian provisions. Instead, the responsibility for implementing the new management system has been cast on the authorised dealers who are subject to neither criminal nor civil proceedings under FEA. Instead, they are disciplined through an administrative process. 

Citizens have been permitted to hold on to foreign exchange

In the current ECA, the holding of foreign exchange by citizens has been laid out in a negative context. In terms of Section 5, no person other than an authorised dealer should hold or deal in foreign exchange. 

However, in the proposed FEA, it has been put in a positive context so that, according to Section 8(1)(b), a person in or resident in, Sri Lanka shall “hold foreign exchange in his possession or in his bank account in Sri Lanka”. They could use it subject to the purposes, limits and terms and conditions prescribed by the Minister. 

Further, Section 5 of FEA stipulates that those who hold foreign exchange in a bank account in Sri Lanka or outside Sri Lanka or those who own a foreign asset could use such foreign exchange for paying for any current or capital transaction of his choice. The requirement to be satisfied is that such foreign exchange should not have been acquired by converting local currency into foreign currency meaning that those who genuinely earn foreign currencies could use them for their own purposes. 

This section has, thus, taken out the present law’s embodiment of nationalising foreign currencies earned by citizens through their normal transactions with foreigners. Accordingly, the proposed amendment has protected citizens’ personal property rights which are not available under the present law. 

Citizens can engage in both current and capital transactions subject to rules

Citizens can engage in both current and capital transactions subject to rules and regulations framed by the Central Bank with the approval of the Minister in charge of FEA. There is no need for them to get the prior approval of the Controller of Exchange for that purpose. The responsibility for implementing these directions and regulations has been vested with commercial banks who are appointed as authorised dealers in foreign exchange under the law. 

For any violation of directions or regulations, citizens are not liable but the authorised dealers who could be punished by the Central Bank with the approval of the Minister in a graduated scale of punishments. Thus, starting with a warning, the Central Bank could discipline their behaviour by imposing more severe punishments later such as restricting their business, imposing fines or cancelling the licence. It is similar to taking disciplinary action against those who have misbehaved within the organisation rather than seeking to punish those outside.

This is a significant improvement when compared with the provisions in the current ECA. According to the current ECA, as outlined in the previous part, the Controller of Exchange has powers to impose fines on violators three times higher than the amount involved. This procedure has been taken out in the proposed FEA.

Automatic appointment of authorised dealers upon receiving a banking licence

Another significant improvement in FEA has been the automatic nature of approving authorised dealers. In the current ECA, giving a banking licence to an institution to do domestic banking business is done by the Monetary Board under the Banking Act. However, appointing that institution as an authorised dealer in foreign exchange is being done by the Minister of Finance under ECA. There had been occasions in the past where these two acts had not happened in tandem with each other to the detriment of the banks concerned. However, in terms of section 4 of FEA, when the Monetary Board grants a licence to a banking institution to function as a commercial bank, the appointment of such bank as an authorised dealer has been made automatic, taking the discretionary powers which the Minister of Finance holds under the present ECA.

Architect of exchange controls being victimised

The architect of exchange controls in independent Sri Lanka, the late N.U. Jayawardena during whose term as Governor of the Central Bank ECA was enacted, himself became the victim of ECA on two occasions. 

On the first occasion that took place in early 1990s, one of the companies in his conglomerate had made some foreign deals without getting the prior approval of the Exchange Controller. An inquiry was held and a thumping fine was imposed on NU by the controller. NU maintained that he was persecuted by the then Governor of the Central Bank who had fallen out with him. 

However, on appeal, the thumping fine imposed by the controller was compounded by the then Minister of Finance to a nominal sum making the whole exchange control a mockery of events. 

Architect being victimised for a second time

He became a victim of his own ECA for a second time in mid 1990s. That was when the Merc Bank, which he set up in mid-1990s, was denied a foreign exchange dealership by the Minister of Finance, though it had had the Central Bank’s sanction to operate as a commercial bank. 

Under ECA, it is the Minister of Finance who has the discretionary authority to approve of authorised dealers in foreign exchange. In the Merc Bank’s case, this approval was not granted by the Minister to enable it to handle foreign exchange transactions. Hence, without a profitable foreign exchange business, Merc Bank soon became bankrupt and had to be sold to another bank which had the foreign exchange dealership. 

NU later confided in this writer that one of the mistakes he made in his professional career was to make ECA a permanent law with draconian powers given to those in the Central Bank and the Ministry of Finance. 

Ministerial powers should be clipped

In these circumstances, the proposed FEA is a welcome development. Yet, it also contains some unsavoury features of the existing ECA. When disciplinary action is taken by the Central Bank against the authorised dealers with the approval of the Minister, if they are aggrieved, they could appeal to a Board of Inquiry for redress. However, that Board of Inquiry is appointed by the Minister himself who has the power to remove them at any time by assigning reasons. 

It not only raises questions about the independence of the adjudication board, but also takes the whole process away from the country’s judicial process. If an administrative tribunal is preferred because the judicial process would take a long time, the appointment of this tribunal should be streamlined in order to maintain its independence. A more suitable process would be to take the power to appoint this tribunal away from the Minister and vest it with the President who should do it with the approval of the Constitutional Council.

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