Tyranny of the international capital markets
Dr. Indrajit Coomaraswamy, ex-Central Banker and International Civil Servant, did not mince words when he addressed the country’s exporters last week. The veteran economist, having made an assessment of the risks associated with Sri Lanka’s external sector crisis, warned that the country will have to grapple with “the tyranny of international capital markets and global rating agencies if it fails to make a quick fix to its external sector problems”.
Earlier in his address, he diagnosed the cause of the problems as a misalignment of the macroeconomic policies pursued by the country. They were many and closely interconnected with one mistake made in one area leading to another mistake in another area and so forth.
When the local inflation was higher than that in trading partner countries, Sri Lanka started losing its competitiveness but the exchange rate was not permitted to depreciate appropriately to restore the needed balance. When the exchange rate became overvalued in this manner, it boosted imports which now became cheaper.
Then, the Central Bank started to lower the interest rates and promote credit in order to stimulate economic growth. At the same time, the Government too ran a deficit in its revenue account and in the overall balance of the budget, releasing a vast amount of money to the hands of the people.
The cheap money so made available caused imports to rise further. As a result, there was a widened gap between the country’s exports and imports generating an unprecedented trade deficit in 2011. This trade deficit could not be fully financed out of the foreign exchange earned by selling the country’s services to foreigners and tapping the remittances sent by Sri Lankans working abroad.
The result was the building of pressure for the rupee to fall in the market, but the Central Bank tried to support the rupee by selling foreign exchange in the market out of its own reserves. This resulted in a fast decline in the country’s foreign exchange reserves from around $ 8.2 billion six months ago to $ 5.9 billion by the end of 2011. Thus, according to Coomaraswamy, monetary policy, exchange rate policy, budgetary policy and the balance of payments policy were all misaligned.
Rating agencies forewarn impending crises
But why should Sri Lanka be driven to the tyranny of the international capital markets and global rating agencies? This is because, as Coomaraswamy reasoned out, Sri Lanka now has to borrow from the international capital markets to supply itself with dollars since it is no longer eligible to receive concessionary credit from the World Bank or the Asian Development Bank or any other friendly donor on account of it being moved up from the status of a poor country to a lower middle income country a few years ago.
When it was a poor country, it was the ‘darling’ of donors; but now it has to raise its foreign funds from commercial markets and those markets and their guiding gurus, rating agencies, would not look at Sri Lanka kindly if its macroeconomic policies are misaligned.
When Sri Lanka was a recipient of concessionary aid, it was the International Monetary Fund or IMF and the World Bank that dictated terms to the country by asking people to tighten their belts to match the resources available. And those terms were reckoned as harsh, unreasonable and killing by practically everybody: those in power, those in opposition and the general public alike.
But those so-called harsh and killing conditions of IMF and the World Bank are nothing compared to the sudden and more killing dictates of the international capital markets, the oncoming of which are forewarned by global rating agencies by downgrading the credit worthiness of a country.
It happened to the world’s economic superpower USA earlier last year and to many European countries recently. The result? The loss of confidence of investors in those countries and their currencies, an increase in the interest rates and a sharp cut in growth prospects in the coming years. It is a ruthless way of telling people of those countries to tighten their belts and go for very painful austerity measures bringing the happy and comfortable life which they had been enjoying for long to a sudden and crushing halt.
Put the house in order
Coomaraswamy spoke through his global experience as an international civil servant for decades and his assessment of the present conditions in Sri Lanka as an objective economist. His warning was that the country should put its economic house in order by fixing the problems as quickly as possible.
His advice to exporters was that, if it does not happen quickly enough, the exporters should be ready for the worse and start making adjustments to their production plans and strategies now itself to escape unharmed. That would be the only way for them to emerge as winners.
Fix the problems or face rating downgrade
Coomaraswamy’s warning proved to be prophetic. Within 24 hours of his warning the exporters, but no relation to his speech at all, the two leading global rating agencies which the Government of Sri Lanka has mandated to rate Sri Lanka’s credit worthiness issued two warning signals.
Fitch Rating, while praising the Government’s recent policy changes relating to exchange rate flexibility and fuel price hike as salutary, warned of the critical level to which the country’s foreign reserves have fallen and the need for preventing its further erosion. The other agency, Standard and Poor’s, went one step further by downgrading the country’s economic outlook from positive to stable and its long-term local public debt, that is, the creditworthiness of Treasury bills and Treasury bonds, from BB minus to B plus.
However, Sri Lanka’s foreign commercial debt was kept by Standard and Poor’s at its original rating of BB minus meaning that it is still not absolutely default free and it should be viewed by investors as speculative or non-investment grade debt issued by a sovereign country. In the market terminology, bonds rated below BBB minus are known as ‘junk bonds’ or simply ‘junkies’ with a warning attached to them “handle with care”.
Rating disputed only when downgraded
This does not mean that Sri Lanka is unable to borrow from international commercial markets. It could still do so, but the interest it has to pay is a little higher than those countries which are rated above Sri Lanka because of the higher risk of default.
It is also a severe blow for the country’s Central Bank which has a dedicated programme to raise the country’s rating to investment grade, that is, the attainment of a minimum rating of BBB minus, by 2014.
The disappointment of the Central Bank to this unexpectedly delivered blow to its plans was demonstrated by the prompt statement issued by it arguing that the downgrading of the country by Standard and Poor’s is ‘unwarranted’ given all the good things that are happening in the country.
However, Sri Lanka’s Central Bank is not alone in disputing the wisdom of rating agencies when the existing rating is downgraded, but not when it is upgraded. Even the US authorities challenged the rating agencies when they downgraded the US debt last year.
IMF’s rescue of Sri Lanka previously
This is not the first time Sri Lanka has gone through an external sector crisis of this nature. In 2000, after losing a substantial amount of its foreign exchange reserves for preventing possible rupee depreciation, Sri Lanka had to give up the elusive goal and allow the rupee to freely float in the market. In the first half of 2009, a similar situation arose and Sri Lanka had to make very painful adjustments to its policy to fix the problems in the macro economy.
But on both these occasions, IMF was behind Sri Lanka supporting its painful adjustment with funds, issuing encouraging statements and getting Sri Lanka to agree on credible make-quick-fix programmes. It in fact helped the country to win the trust and confidence of both local and foreign investors. In 2000, there were no rating agencies to spread the bad story of Sri Lanka globally. In 2009, there were rating agencies but they muffled their mouths because of the strong helping hand extended by IMF to the country.
Borrowing from commercial sources may prove to be more painful
But now, no IMF and, as Coomaraswamy has warned, the country is totally at the mercy of the international capital markets and their guiding gurus, the rating agencies. IMF is not there, not due to any fault of IMF, but because Sri Lanka could not complete its existing Stand-by-Arrangement or SBA to a logical conclusion by complying with all the agreements which it had agreed with IMF at the time of going for the SBA three years ago. Hence, SBA is hanging in thin air to be rescued by Sri Lanka alone.
Perhaps the authorities would have thought that the dictates of IMF are harsh and they could sideline it by relying on the international capital markets and their gurus, the rating agencies and borrowing from friendly countries under highly commercial terms.
The beauty of international capital markets is that they do not dictate terms at the time of raising funds. They are, like any lender, would treat the borrowers most humanely and would accommodate even the seemingly non-viable projects being implemented by them.
But they are vicious, ferocious and tyrannical when things go wrong. As numerous global episodes have shown, they punish the wrongdoers without mercy so that the borrowing countries do not have even time to sit back and formulate a strategy. East Asia in late 1990s and Europe today are living examples.
Economic history has shown that the countries which had got into trouble with external borrowers had had, ironically, followed a similar pattern. The Columbia University academic Sylvia Nasar, in her 2011 book ‘Grand Pursuit: The Story of Economic Genius,’ has documented the sad story of Egypt in the late 19th century.
Egypt’s lost ‘promise of the world’ in late 19th century
According to Sylvia, Egypt sitting on a very convenient place in the trade route between the East and the West was the ‘promise of the world’ for everything at that time, like the promise which China has made to the rest of the world today. When the American Civil War created a shortage of cotton in Europe, the vital raw material in its textile industry, Egypt with its ability produce the material became the focal point.
Egypt’s ruler, the khedive Ismail Pasha, had in fact grabbed all the land in the country for him and his family and turned it to a giant state run cotton plantation. Then, he had borrowed colossal amounts of money from Britain and France and undertaken massive infrastructure projects, including the construction of the Suez Canal, with that borrowed money.
The results of the khedive Ismail Pasha’s insanely obsessive development thrust have been enumerated beautifully by the Polish writer, Rosa Luxemburg, in a book published in 1913 under the title ‘The Accumulation of Capital’.
Sylvia has quoted from this book as follows: “One loan followed hard on the other, the interest on old loans was defrayed by new loans, and capital borrowed from the British and the French paid for the large orders placed with British and French industrial capital. While the whole of Europe sighed and shrugged its shoulders at Ismail’s crazy economy, European capital was in fact doing business in Egypt on a unique and fantastic scale – an incredible modern version of the biblical legend about the fat kine, which remains unparalleled in capitalist history.”
Egypt’s bankruptcy due to foreign commercial borrowings
Says Sylvia: “Inevitably, the debt piled up to complete Suez, and a host of other grandiose projects proved unsustainable. Within six years, the khedive was bankrupt, forced to sell his 44 percent stake in the canal and obliged to let his government be placed in what was essentially receivership” Receivership meant that like a company Egypt was liquidated and creditors grabbed its valuable assets in payment of its foreign loans. Then, Sylvia notes that “had he invested more cautiously and avoided debt, some historians speculate Egypt might have entered the twentieth century as another, if smaller, Japan.”
So the ‘promise of the world’ has been lost due to unsound economic plans that had not taken into account the tyranny of international capital markets when things go wrong and these capital markets, as they had always done in economic history, had punished the khedive Ismail Pasha and his country harshly. According to Sylvia, Egypt’s solvency was restored under the stewardship of the British banker Evelyn Baring after 1883, but by that time, Egypt had lost both its goal of becoming the ‘promise of the world’ and its sovereignty.
Ceylon’s colonial masters were more prudent
However the wisdom shown by the colonial Ceylon with respect to borrowing from the London Capital Market to construct the country’s railway system has been somewhat different.
According to the Colombo University historian Indrani Munasinghe as she has documented in her 2002 book ‘The Colonial Economy on Track,’ the Secretary of State had not approved of the country’s railway authorities issuing 6% and 4% debentures to a value of 1.4 million Sterling Pounds in the London Capital Market until the Railway authorities came up with a viable plan to repay the loans including the establishment of a sinking fund out of the sales revenue to guarantee such repayments.
Whom to follow: Egypt or colonial masters?
Sri Lanka also faces a similar predicament today. It has to decide whether it should follow Egypt’s khedive Ismail Pasha or its own former colonial masters. In other words, it has to decide whether it should subject itself to the tyranny of international capital markets and their guiding gurus, global rating agencies, by having an uncontrolled and unbridled macroeconomic policy and a borrowing programme or playing it safely by going along with a controlled and bridled programme with IMF.
Given Sri Lanka’s current conditions, both require a fair amount of belt tightening and denying it for political expediency is insanity. Borrowing from the international capital markets and other commercial sources is convenient to policymakers because they have to face the real problem of placing the country under the receivership of foreign lenders as it has happened in Egypt in late 19th century only at the end when things have gone wrong.
They do not have to go along with a sound and prudential economic policy programme right from the beginning. But such a programme would definitely allow policy makers to play it safely and avoid having to shock the economy through ‘cold-turkey policies’ as pointed by this writer previously. IMF offers such a good behaviour programme to policy makers.
Hence, Sri Lanka’s choice today is to go back to IMF’s fold because it is less painful and more rewarding. Probably the Central Bank would have realised this wisdom of late. That may be the reason why it has pointed, as a passing reference, in its recent statement disputing the rating downgrading decision of Standard and Poor’s that, “Meanwhile, the IMF-SBA programme is progressing with plans of completing the 7th review towards the end of March 2012”
But it is important that strong words should be matched with strong deeds for otherwise the Central Bank would be viewed as yet another mendacious public institution by the watchful investors throughout the globe.
(W.A. Wijewardena can be reached at [email protected])