Some advice for Sri Lanka’s establishment
by Aravinda Korala
As I write this article in January 2022, Sri Lanka has its back to the wall. There is a raging foreign exchange (forex) crisis with low levels of forex reserves held by the central bank, a significant monthly trade deficit with the external world, large foreign debt repayments due to be paid this year and for years to come, and no obvious way out of this crisis. The public debate hovers around whether the country should go to the IMF and restructure the debt, or perhaps borrow more from China and other Asian countries, or even default on the debt. None of these is attractive, but more importantly, none of these options will by themselves fix the long-term problem that Sri Lanka has. Any kind of new debt, or a debt restructuring will simply give Sri Lanka a short-term respite, but the forex monster will soon be back asking for more. This article takes a longer-term view, as we need to know what the solution to Sri Lanka’s problem is, before we look at what short-term tactical steps are available in the coming months.
Introduction
My hope in writing this article is to stimulate a broad discussion in the Sri Lankan establishment – and by that I mean government, business, the media as well as all those individual Sri Lankans with an interest in the subject – and move the conversation away from what I currently see as a very narrow party-political debate of whether to restructure or default and who is to blame for the current mess. That conversation will not get us much beyond political point scoring.
I have organised the article in sections as it is fairly long. I have numbered the sections so that it is easier to refer to them and debate them. I hope this will help the discussion.
1. What is debt?
Most people do not know what debt actually is. A common misconception is that banks take deposits from customers and then lend it out as loans. Well let me surprise you – that is wrong. When you take out a loan from a commercial bank, the bank creates money out of thin air and lends that money to you as debt. You might then buy a house with that money, which then passes to the seller of your home, and that seller might deposit that money in her own bank account – which then creates a deposit. So, loans create deposits, and not the other way around. Most people reading this article are bound to be surprised by that. If you do not believe me, read this.
I started with that surprise because I want you to rethink your assumptions about debt and money.
So, for example, do you know what happens when you repay the loan back to the bank? That money is destroyed! Yes, it is destroyed. So, the stuff we call money that we use every day to buy things and do transactions, is an aggregation of our total debt. In fact, if there was no debt, there’d be no money. (A small amount of money though is created by the central bank of each country, also out of thin air, known as M0 money).
Let us put it this way then; if commercial banks did not create money in this way through lending, there would not be enough money to run the economy. Most money in the economy is created by commercial banks with a simple press of a button on a computer when someone borrows from that bank. If everybody repaid their debts on the same day, the economy would in fact run out of money, and it would not be possible to do day-to-day transactions. Weird but true.
2. What is money?
Is debt the only kind of money there is? Well not quite. In all countries notes and coins are created by the central bank. Although definitions vary by country, central bank money is what is usually known as M0, MB or “narrow money”. Money created by commercial banks fall into categories M1, M2 and M3, or “broad money”. The amount of money in the economy varies by country but is related to the GDP of that country. See this world bank chart below:
As you can see the amount of “broad money” in the Sri Lanka economy is around 60% of GDP and is low compared with the US, UK and China.
There are several important things that I want to point out here. The amount of money in the economy is not fixed. It increases with GDP but also varies by country. As economies grow, more money is needed for transactions and for savings. Somebody has to create that new money – and that is usually done by commercial banks. The amount of money created by central bank’s is usually small compared with the total – but that has not been true in the recent past. The US federal reserve, for instance, has been printing (creating) vast quantities of cash under its Quantitative Easing program – also known as QE. So has much of the rest of the West – Japan, the EU, the UK. And so has the Sri Lankan central bank.
3. Doesn’t printing money create inflation?
It is incorrect to say that printing money directly causes inflation. Some Sri Lankan media is focussed on money printing by the central bank as the root cause of Sri Lanka’s troubles. Keep in mind that commercial banks are always printing money each time they lend. They also destroy money when debt is repaid. But in general, the amount of money in growing economies always increases. The relationship between the quantity of money and inflation is not well understood and no economist has successfully predicted future inflation. All they can do is to say whether a certain action might help or hinder inflation. The actual outcome is as hard to predict as the stock market index or the weather. Why is that? The reason is that the final outcome of inflation at any given time is the aggregate result of the actions of the whole of the population. If for example when money is printed, people or banks simply save that money, inflation may not increase. Look at what happened to Japan. The central bank of Japan printed new money like there was no tomorrow for two decades and still failed to get inflation going!
However, the best way to know whether there is too much money in the economy is after the fact – ie by measuring actual inflation. That is why some central banks have a policy of targeting inflation itself. If inflation is rising too fast, central banks increase interest rates, and that reduces the amount of loans people are willing to take out, and that in turn dampens inflation.
So is Sri Lanka creating too much money at the moment on the 22nd January 2022? The answer must be yes – inflation is high, and the central bank increased interest rates a few days ago.
But this is not Sri Lanka’s primary problem.
4. Does Sri Lanka have too much debt?
The primary problem Sri Lanka has is that everyone seems to agree the country has too much debt. Is that correct? The answer is not a simple yes or no.
The first thing to note is that there is internal debt denominated in Sr Lanka rupees (LKR) that is owed by the government, businesses and consumers to the Sri Lankan banking system. Is there too much debt there? – probably yes as domestic inflation is high and that indicates too much LKR-denominated debt.
But as we all know the real crisis is Sri Lanka’s external debt. The government has a total external debt of about $50b USD which needs to be repaid over a period of time. About $6b of that has to be repaid in 2022.
Now we talked about how banks print money – so why do we not simply print that money? Well, the US banking system can print as many USD as they like – but our institutions cannot. We can only print LKR. The irony here is that when we borrow dollars, US institutions simply print that money and lend it to us. But we have to pay it back in USD we earn. Why do we have to pay it back? Because that is the deal when you borrow. You have to pay back the capital that you borrow plus the interest – unless you are the government controlling that currency. So here is an interesting thing to notice. If you are an ordinary person and you borrow money from your bank, you know of course that you must pay that money back with interest. Globally anyone that wished to borrow USD is in the same situation as an ordinary citizen of a country – you must pay back that loan. Similarly, if you borrow Euro, you must pay it back – unless you are the European banking system. And the mirror image of that is true for Sri Lanka too – if a foreign institution (including the US government) wishes to borrow LKR – they have to pay it back to us! Unfortunately for us, nobody outside Sri Lanka is queuing up to borrow LKR.
Aravinda Korala is the Founder & Chief Executive Officer of KAL
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