Was Sri Lanka forced into a ‘Balance Sheet Recession’? 3 912

By Dr. Kenneth De Zilwa


The Central Bank of Sri Lanka had come under increasing criticism over its Inflation Targeting hedonistic regime adopted over the past 5.5 years which saw the country pushed to a virtual standstill. During this period we witnessed the real economy crumble, recording its worst GDP growth trend recording a decline in GDP from 5.0pct in 2015 to 2.3pct in 2019¹, the lowest growth recorded since 2001². Despite the glaring evidence of a declining GDP trend the Central Bank of Sri Lanka ably supported by the IMF continued to drum up the rhetoric on the need for austerity measures, as a solution for Sri Lanka’s economic pains. The announcement sent shivers down the spines of many alternative schooled economists. World-renowned economist
Paul Krugman was quoted saying

“every country that introduced significant austerity has seen its economy suffer, with the depth of the suffering closely related to the harshness of the austerity”


therefore, it is mind-blowing how Sri Lankan Central Bank could advocate such policies. Fueling this announcement was also the common belief by Central Bankers that excess money supply or printing money caused ‘galloping inflation’ – a myth, which resulted in hawkish policy measures being adopted by Central Bank. It was, therefore, a matter of time before the real economy was choked with high real interest rates, which was among the highest in the Asia Pacific countries in 2018 (Figure 1).

What is interesting to note is that contrary to the theory that high real interest rates lead to increased national savings, Sri Lanka’s national savings to GDP data (i.e. national savings rate measures the amount of income that households, businesses, and governments save), did not indicate any such linear progression, as the national savings trend had steadily declined from a high of 30pct in 2014 to 25pct in 20194.

The declining GDP data trend captured in (Figure-2), confirms that the country was now in dire straits and heading towards greater depression, requiring a significant change in direction from the hawkish monetary policy approach and growth retarding fiscal framework that existed, to a pro-production and pro-growth framework. It can be argued that an inevitable outcome of both high tax rates and inconsistent monetary policy measures contributed to the rising of non-performing loans in the banking system, thereby increasing the gross NPL ratio by 38pct on a year on year basis, from 3.4pct in 2018 to 4.7pct in 2019, or in other words, gross NPLs increased from LKR 263 billion to LKR 382 billion which was the highest year on year increase since 2015, according to the 2019 Central Bank Annual Report.

It is evident that fresh thinking needs to be adopted towards inflation targeting and the problem must be approached from a business model perspective. Unfortunately, this fresh perspective was not forthcoming during the period under review (i.e. 2014 to 2019). Cambridge University, development economist Prof. Ha Joon Chang has highlighted in his book titled “Bad Samaritans- the myth of free trade and the secret history of capitalism” that many such growth retarding monetary and fiscal policy tools and false theories have been used extensively against developing countries by developed countries, preventing and stifling their economic development journeys. Empirical evidence suggests that Sri Lanka too has fallen prey to this austerity and inflation targeting trap.


With the collapse of the Bretton Woods system in 1970 which focused on maintaining a fixed exchange rate, global superpowers and neo-classical i.e. monetarist school of economic thought were looking for another similar type of a potent policy tool to support their global monetary supremacy agenda, which would ensure that the standards were set for other countries to follow. Central Banks of developed countries had to demonstrate that they cannot control inflation as both the business community and the general public had lost faith in their ability to do so, having often missed their target by a long shot on many occasions. This very fact was aptly highlighted in 2009 by Maurice Saatchi, Chairman, of the Centre for Policy Studies, United Kingdom.

A closer examination of ‘inflation targeting’ would reveal that the whole notion is based on the premise that long-term economic growth is best achieved by maintaining stable prices, and that it could be done by controlling prices i.e. inflation. This approach is typically characterized, by the announcement of official target ranges for inflation by the Central Banks at one or more time horizons, while they explicitly acknowledge that low and stable inflation is the overriding goal of monetary policy.

Herein lies the problem, when the National Consumer Price Index NCPI (Base 2013=100), is based on data from the Household Income and Expenditure Survey conducted in 2012/13 which is highly skewed towards food (45pct of the basket) and even the non-food components (55pct of the basket). The weights in both categories are dependent on import prices. In such situations, exchange rate pressure builds up and as a tradeoff for managing the pass-through of exchange rates, monetary policy i.e. inflation targeting mantra, has been predominantly used as its solution. How can price stability be achieved in a country when it has sacrificed its domestic food supply and is heavily import depended on its basic food requirements for its people, apart from energy supply, household items, and fuel supply? If inflation rises because of such external supply-side shocks, it is a no brainer that the Central Bank of Sri Lanka would be compelled to increase its key policy rates expecting to go by the rule of inflation targeting. But in fact what it does is make matters worse causing more damage to the real economy, as balance sheets of companies suffer from higher debt financing costs and raw material costs, thus eroding profitability i.e. national savings. The International Labor Organization in a research paper (2011) validated this observation when it stated that “implementing inflation targeting regimes represents a major challenge in the presence of supply-shocks which are a common phenomenon in developing countries”.

Therefore, in adopting such a one-dimensional approach the Central Bank of Sri Lanka could be literally ‘shooting itself in the foot’ and together with it the entire real economy. This phenomenon is because most Central Banks are not trained to look at corporate balance sheet behavior, leverage, and factors affecting revenue conditions. Inflation targeting has been globally rebuked and many Central Banks do not go by this indicator alone, anymore. According
to a research paper published in 2015 by the Peterson Institute for International Economics (PIIE) claimed that inflation targeting is a myth and said to be the root cause for retarding economic growth of developing countries, quote, “Simple inflation targeting lowers growth in developing countries”. In a separate research study undertaken by Ricardo Brito and Brianne Bystedt titled ‘Inflation Targeting in Emerging Economies: Panel Evidence’, published in the Journal of Development Economics, 2010, (volume 91, issue 2, pages 198-210), the authors examined panel data samples of 46 developing countries over 27 years, (from 1980 to 2007), in which they found evidence that “inflation targeting by the developing country Central Banks, in fact, was the cause of reduced (economic) growth”.

This is could not be truer from a Sri Lankan perspective too. For at a time when corporate business sales turnovers have been negatively impacted as a result of internal shocks caused by draughts, floods, and terror attacks and the exchange rate depreciation viz a viz the US dollar, any form of growth reviving strategy seems to be a miss. While more growth retarding austerity measures were spoken of such as increased taxes (i.e. fiscal strangulation) more inflation targeting policy measures saw real interest rates at its highest making matters worse for corporate balance sheets as they hemorrhaged cash on the back of higher debt levels and continued low earnings saw the collapse in real GDP (Figure-3). Evidence indicates that the Central Bank without understating the implication on corporate balance sheets given their hedonistic inflation targeting policy approach – a purely mechanical process, caused many businesses to involuntarily close down, pushing the banking sector into jeopardy with un-serviceable loans that kept piling on in the books of banks and (i.e. banking non-performing loans reached 13.0 percent in some instances), thereby increasing the overall risk to the country’s financial stability (Figure-4). The decline of economic activity in the country also saw the national unemployment rate increase to 5.1pct in Q3 of 2019 from 4.4pct in Q2 2019.








Bank of Japan (BOJ) was faced with a balance sheet recession and attempted inflation targeting in the 1990s and until 2000s, and finally admitted that it failed to inflate the economy despite the flood of money in the domestic market. The excess money supply did not create inflation nor did it help pull the economy out of its 20-year long recession. In 2013 too Bank of Japan once again set an inflation target of 2.0pct as Governor Haruhiko Kuroda took office, seven years on, inflation has remained a significant distance from that goal. Data showed core consumer prices rose by just 0.37pct during this period. Unlike Japan, the USA’s President Donald Trump did understand that inflation cannot rise despite the flush of money supply when corporate balance sheets are significantly stressed with debt, and thus the demand for money is not plausible. While accelerated loan repayments i.e. debt repayments, only makes matters worse as BOJ too faced similar problems and was flushed with money supply, that no one wanted, as demand for money disappeared causing commercial bank lending to decline sharply recording a negative 1.0pct in the 1990s reaching negative 7.0pct by 20005. Nomura Research Institute economist, Richard Koo, wrote extensively on this matter and argued that deleveraging (i.e.paying down debt) by private sector companies caused the recession in Japan. He pointed out that when corporate balance sheet debt stock rises, servicing runs into trouble when there is a lack of domestic demand, resulting in an asset price collapse while debt i.e. liabilities remain on the balance sheet.

This phenomenon of cash flow compression causes private sector balance sheets to go underwater and deleveraging commences. During the period between 2002 and 2003 Japanese companies paid down USD 260 billion worth of loans, when as per the monetary theory companies should be borrowing at near-zero interest rates.

In such a situation, the turnaround is only possible with debt deflation (i.e. writing off/downsizing), and economic policies are targeted at regaining the financial health of companies and improving their balance sheets. It is important to note that in situations of debt deflation i.e. downsizing, (as a result of slower GDP and declining revenues) businesses are forced to take drastic action to repair their balance sheets by either increasing internal savings i.e. cutting costs, or paying down debt by fire sales of assets or a mix of both methods could also be on the table. This desperate act of deleveraging reduces aggregate demand for money and inflationary pressures decline, thereby throwing the economy into a tailspin and subsequent recession, which can be termed ‘Balance Sheet Recession’. It is important to have a mechanism to insulate companies when faced with or unknowingly placed in such balance sheet recessionary situation by the Central Bank’s own austerity measures. Therefore, in such situations, businesses should get some reprieve by way of a debt-moratorium or a write off as they require time to restructure their debt. In the USA according to Chapter-11 bankruptcy code 6, a petition could be filed, and voluntary bankruptcy could be declared by the debtor to reorganize existing debt, or it could be an involuntary petition, which is filed by creditors or creditors that meet certain requirements. Sri Lankan businesses do not have this luxury when faced with a ‘Balance Sheet Recession’ situation.

Therefore, until such time businesses are back in good shape with strong balance sheets, having gained production capacity in order to capture market share, growing revenues, and expanding its asset base any form of monetary stimulus or fiscal stimulus will not have any significant impact on inflation. For the lack of demand for money or credit, paves the way into the decline for goods and services. This is what saw in Japan and now we see it happening in the USA too and President Donald Trump has managed to put a stop to Federal Reserve’s inflation targeting phobia, understanding the implications of balance sheets and the need to gradually deleverage post an economic crisis, such as that witnessed in 2009/2010 period. President Trump was critical of the Fed’s hawkish monetary policy stance and called it “very, very disruptive” as they were contemplating raising interest rates too quickly too soon, thereby squeezing out the air in profitability and not making room for businesses’ balance sheets to be cured and repaired.


Thankfully in Sri Lanka too we see the dawn of a new monetary policy framework that is now gradually taking shape in the parlance of decision making, and that too is based on ‘Balance sheet based economics’ which is considered when factoring monetary and fiscal policies. Therefore, we could expect a more growth-oriented Central Banking to emerge in the months ahead. A pre-condition in this process must be to stimulate businesses and to create new
business models to look at external markets by enlarging the economic pie by way of using unconventional monetary and fiscal policy in the new normal economic environment that we have come to embrace. Herein, the restructuring of SME and ushering an Agro industrialization transformation is pivotal in this process of reorienting the economy. The Central Bank of Sri Lanka and Monetary Board should think out of the box and adopt new tools and have in place new mechanisms to examine corporate balance sheets, understand them, and work towards strengthening them as part of key focuses in achieving full employment and macroeconomic stability. Thus moving away from its preconditioned (flexible) inflation targeting and balance sheet contracting ‘austerity mindset’ which world-renowned economist Paul Krugman admitted has failed miserably globally7.

The Monetary Board and the present government seems to have understood this “Balance Sheet Recession” aspect and have moved expeditiously with initially providing fiscal support by way of tax cuts and also have decided to inject liquidity and reduce the cost of borrowing for companies by slashing the Statutory Reserve Ratio (SRR) by 2pct, and the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank to 5.5pct and 6.5pct respectively. The cost of debt was reduced on four occasions within the year initially by 50 basis points and 25 basis points, respectively, with effect from 30 January, 16th March, and thereafter by 50 basis points once again on the 3rd April and on 6th May 2020. While introducing the debt repayment moratorium and credit guarantee scheme to enable businesses to access much-needed funds to function and encouraging banks to restructure corporate balance sheet debt with the intention of gradually deleverage over time. This synchronized
action is a very important point of departure in the context of the Sri Lanka inflation-targeting approach, which suffered in the past 5 years with below-par growth rates achieved, and was placed even below the Afghanistan rate of growth of 2.3 pct.


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Bilateral Free Trade Agreements: Are we on the Right Track? 0 719

The process of Sri Lankan policy reforms of liberalisation since 1977 has been predominantly unilateral. These reforms were undertaken in a global context of multilateral trade and tariff reforms under the guidance of international organizations like GATT and WTO. In addition, Sri Lanka joined in the efforts of liberalisation at regional level, e.g. the South Asia Free Trade Agreement (SAFTA) under SAARC initiatives. Multilateral and even regional trade negotiations however, have proved very slow and cumbersome. Bilateral and preferential trade agreements have become attractive globally, as well as in Sri Lanka.

The first experience of post-independence Sri Lanka in bilateral trade agreements was the well-known Rubber-Rice Pact of 1951 between Sri Lanka (then Ceylon) and the People’s Republic of China. It was a simple bilateral bartering agreement which provided a win-win solution to the two participating countries. The recent Sri Lankan interest in pursuing bilateral and preferential trade agreements can be traced to the 1990s. Three FTAs have been signed and implemented since then. The India-Sri Lanka Free Trade Agreement (ISFTA) was signed in 1998 and entered into force in March 2000. The Pakistan-Sri Lanka Free Trade Agreement (PSLFTA) came into force in June 2005. The Sri Lanka Singapore Free Trade Agreement (SLSFTA) was signed and made effective in 2018.

The ISFTA and PSLFTA are simple agreements covering the trade of goods between the respective partner countries. The SLSFTA in contrast, is a comprehensive agreement covering trade in goods, sanitary and phy-to-sanitary measures, and technical barriers to trade, customs procedures and trade facilitation, trade in services, telecommunications, E-commerce, government procurement, foreign investment, competition, intellectual property rights, transparency rules and matters of economic and technical cooperation. Sri Lanka may choose to negotiate its future FTAs in the same format as that of the SLSFTA. The new FTAs would then be comprehensive/deep agreements. Such ‘deep’ FTAs influence border-related policies as well as beyond-the-border policies. Liberalization through bilateral FTAs is being given priority with multiple objectives.

Several issues must be raised on this declared approach of expanding the policy scope of FTAs. A fundamental issue is that FTAs, particularly comprehensive FTAs, restrict the policy autonomy of the government to a significant extent. In today’s global institutional and organizational structure the policy autonomy of a small country is no doubt extremely limited. It may be for good reasons that the policy makers in Sri Lanka opt to get their policy autonomy further constrained by a series of FTAs. Here the opinion makers in the country seem to demand the following. The reasons for signing an FTA ought to be transparently shared with the public. Adequate research ought to be conducted to establish that any envisaged FTA would generate net positive benefits to Sri Lanka. Further the feasibility of the envisaged FTA should be carefully examined without rushing into signing. The planned FTAs are to be signed with countries with greater experience and equipped with better institutions. If adequate care is not taken, the signing of an FTA could produce extensive adverse effects on the country’s development efforts.

”From an overall point of view, Sri Lanka, as it stands today, is in an extremely weak competitive position in the global economic set up”

There are many needed domestic economic reforms. Some of these could lead to further liberalization. At the same time, there could also be critical intervention by the state in some fields. Before envisaging any more FTAs, priority must be accorded to domestic policy reforms based on a coherent national development framework and a widely-accepted national foreign trade policy.

There is another danger in the current declared policy of moving toward two more FTAs and a comprehensive agreement with India, in addition to the three FTAs currently in force. FTAs are not the best way to improve Sri Lanka’s competitiveness or productivity which is constrained by various structural and institutional factors. None of these factors can be resolved by entering into FTAs. In addition, operating a number of FTAs with different countries, involving multiple Rules of Origin, can make the foreign trade system extremely complicated, distorted and cumbersome.

Sri Lanka does not yet have a firmly established institutionalised procedure within which international trade agreements, particularly those so-called comprehensive agreements, can be negotiated and implemented. Strong legal, regulatory and institutional frameworks are needed if the national interest is to be safeguarded in the process of negotiation and implementation of bilateral preferential FTAs. Entered into without due care, bilateral trade agreements could turn out to be, in the long run, contractual traps with obligations, without worthwhile advantages to gain.


BIZnomics Note Pad 0 679

China and India – the second and seventh largest economies in the world (two largest economies in Asia) – are slowing down in 2019. The GDP growth rate in China is expected to be 6.2 percent, down from 6.7 percent in 2018 – the weakest in 3 decades. The GDP growth rate of India is projected at 6.7 percent, down from 7.0 percent in 2018. Chinese policy makers are saddled with trade talks with the US government to remove the recently imposed two way high tariff while Indian policy reforms take a backseat in the backdrop of impending National Elections in June 2019.

British Prime Minister Theresa May suffered a setback as parliament voted against her BREXIT proposal. The loss throws more uncertainty on UK’s plan to leave the EU on March 29. The European Central Bank down grading its economic forecast for the Euro Zone for 2019 and 2020 due to persistent uncertainties and risks in the region, expect inflationary pressures to rise slowly as capacity diminishes.

The World Bank sees darkening prospects for global growth that will slow to 2.9 percent in 2019 in the backdrop of moderating international trade and investment, elevated trade tensions and tightening financial conditions. The World Bank observed that debt vulnerability in low income countries are rising. Debt to GDP ratio for low income countries have climbed and the composition of debt has shifted toward more expensive market based financing. The Bank suggests that these economies should focus on mobilizing domestic resources, strengthening debt and investment management practices, and building resilient macro fiscal frameworks.

Sri Lanka’s official reserves declined to USD 6,142 million by end of January 2019 from USD 6,919 million reported at the end of December 2018. Short term (within 01 year) liabilities on foreign currency assets remain at USD 6,547 million placing net reserve on a negative terrain. Selling rates of major currencies remained under pressure with import demand picking up in mid-February. The selling rate of the US dollar declined from Rs.180.28 on 15th February 2019 to Rs.177.59 a week ago.

US – China trade talks aimed at ending the use of new two way tariff continue in Washington following a no deal in the talks in Beijing during the second week of February. The US President has indicated that the March 01st deadline could be extended for an agreement to be reached. China and US have imposed duties on more than USD 360 million in the two way trade which has shaken the global economy.

The Asian Development Bank (ADB) revealed that the GDP for South East Asia’s 5 major economies – Indonesia, Malaysia, Philippines, Singapore and Thailand – has declined from 5.1 percent in 2017 to 4.8 percent in 2018. The ADB highlights that South East Asia with 650 million people and one of the world’s fastest growing regions, faces several headwinds such as escalating US – China trade tensions and weakening local currencies.

By: Econsult