A Sudden Stop Or A Balance Of Payments Crisis
By Dr. Arujuna Sivananthan
The consensus view is that Sri Lanka is in the midst of a Balance of Payment (BOP) crisis. It usually follows a period of large capital inflows and rapid economic growth. However, due to conflicting policy responses or policy slippage including irresponsible credit creation, an economy finds itself in a position where it struggles to pay for imports and service its foreign currency liabilities. Sri Lanka is fast approaching this point and the consequences of inaction should be apparent to everyone.
A BOP crisis can morph into a set of circumstances which is now referred to as a Sudden Stop and has been the subject of extensive academic research following the ‘Tequila’ and Asian economic crises during the mid and late nineties respectively.
A Sudden Stop is an economic phenomenon, and, is described as the sudden slowdown of private capital inflows into emerging market economies with an ensuing abrupt reversal of large current account deficits (CAD) into smaller deficits or surpluses. Economies also experience sharp contractions in output; and, credit to and spending by the private sector. There is also a real deprecation in the value of the local currency. Its start is defined to be when the annual change in capital flows drops one standard deviation below the mean.
A series of papers by Professor Guillermo Calvo of Columbia University and other academics study this feature and also conclude that such crisis can arise even in situations where the CAD is fully funded by foreign direct investment and fiscal prudence; a condition which the rating agency Fitch highlights in its latest report as eluding Sri Lanka. Sudden Stops and BOP crises have similar impacts in terms of devaluations of the domestic currency followed by periods of contracting output; however, the former is characterised by a deeper economic downturn.
A small domestic production base of tradable goods relative to their level of consumption, and the dollarisation of domestic debt increase the probability of a Sudden Stop. Unfortunately for Sri Lanka, both of these conditions are axiomatic with almost all its external liabilities consisting of sovereign debt. Loose fiscal policy is also a contributory factor. In Sri Lanka’s case the fiscal deficit seems stuck at 8 percent of national income and will not move unless we see a retrenchment in defence spending which takes up a fifth of government disbursements.
However, by securing long term funding through its foreign currency bond issues and opening up a higher proportion of its rupee bond market to foreign investors, Sri Lanka’s policy makers have sought to somewhat mitigate these risks.
Sudden stops can be followed a V-shaped recovery as evinced by the rapid increase in output following the Asian crises and an improving BOP without any new credit. A necessary condition for this is a large tradable goods production base. Unfortunately, with Sri Lanka, this condition is not satisfied. The ability to restructure short term foreign currency liabilities and assistance from multilateral organisations are also crucial.
Mitigating effects of a Sudden Stop are determined by the central bank’s reaction function including acting as a lender of last resort by releasing foreign exchange reserves in an effective manner. The conclusions of Calvo et al are that usual monetary policy rules can result in the excessive volatility of exchange rates, and, therefore, need to be supplemented by intervention in the foreign exchange market including pegging the exchange rate and controls on the capital account. That is, to impose restrictions on outward bound remittances.
Despite some remedial action by its policy makers, the inherent structural weakness of Sri Lanka’s economy does not lend itself to a V-shaped recovery from a BOP crisis or a Sudden Stop. This includes a small tradable goods production base. However, its biggest limitation in dealing with both lies in the fact that almost all of its external borrowings consist of sovereign debt. A situation which gives rise to its inability to service this will afflict not only its taxpayers and consumers, but, also materially increase the costs of all sectors doing business with the outside world. Unfortunately for Sri Lanka, it has already exhausted the obvious recourse to such situations, which is to seek a bailout from multilateral organisations.
Sri Lanka’s policy makers need to use every tool in their inventory to avert such a crisis; because, unfortunately, their ability to extricate its economy from the onset of one remains very limited indeed.