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Economy, Opinion

Economy: V-Shaped Recovery From A BOP Crisis Or A Sudden Stop

By Arujuna Sivananthan

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.

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.

A series of papers by Professor Guillermo Calvo of Columbia University and other academics study this feature and also conclude that such crises 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 characterized by a deeper economic downturn.

A small domestic production base of tradable goods relative to their level of consumption, and the dollarization 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 somewhat sought to mitigate these risks.

Sudden stops can be followed by 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. And, 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.

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Discussion

One thought on “Economy: V-Shaped Recovery From A BOP Crisis Or A Sudden Stop

  1. Another one of Arujuna Sivanathan’s academic “scholarly” aticles with verbiage like “axiomatic with almost all its external liabilities consisting of sovereign debt”. Really high flown “scholarly” words for an Internet Newspaper, with readers (you know I could have used the word audience to sound more impressive) who are mainly non academic.

    The main point of the article is from a 1998 (yes 1998) on Sudden Stops by Calvo, Guillermo . So this was written long before the global financial crisis so maybe this paper might be outdated.

    Another analysis is that “That is, to impose restrictions on outward bound remittances”. Of course Sivanathan does not say that a first measure of such controls would be increase in black market rates for foreign currency. That would be educating readers. This is about Arujuna Sivanathan grinding his axe while writing pseudo scholarly articles in an Internet Newspaper.

    Arujuna Sivanathan’s claim to academic fame is his reference to his “PhD supervisor Professor Vito Antonio “Anton” Muscatelli FRSA FRSE AcSS who is the Principal of the University of Glasgow”. As far as we know Arujuna Sivanathan has not had any peer reviewed article on his excellent abilities of Economic analysis.

    What we know is that Arujuna Sivanathan published a call for “Sri Lanka must be subject to a regime of punitive economic sanctions”. We also know that Sivanathan is a member of the British Tamil Conservative whose website until recently had photos of gatherings with LTTE flags and also wined and dined Robert Halfon

    Arujuna Sivanathan is writing for like minded people who have his same agenda. This way when goes for those “voluntary political activist” meetings he can raise up his hand and like any armchair warrior proudly roar, I too have worked for the CAUSE; ….of a “regime of punitive economic sanctions” against Sri Lanka. My opinion is to take Arujuna Sivanathan’s economic analysis of Sri Lanka with large doses of the proverbial doses of salt.

    Posted by sbarrkum | March 12, 2012, 3:12 am

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