This Selected Issues paper focuses on the fiscal position of Sri Lanka. The standard analysis shows that, prior to the adjustment announced in the 2002 budget, fiscal policy was clearly unsustainable, leading to a rising debt-to-GDP ratio. The paper looks at external debt and complements the analysis of the public debt dynamics. The baseline scenario shows that debt ratios decline significantly in the medium term, as a result of strong growth founded on renewed peace and political stability, far-reaching structural reforms, and stable macroeconomic conditions.

Abstract

This Selected Issues paper focuses on the fiscal position of Sri Lanka. The standard analysis shows that, prior to the adjustment announced in the 2002 budget, fiscal policy was clearly unsustainable, leading to a rising debt-to-GDP ratio. The paper looks at external debt and complements the analysis of the public debt dynamics. The baseline scenario shows that debt ratios decline significantly in the medium term, as a result of strong growth founded on renewed peace and political stability, far-reaching structural reforms, and stable macroeconomic conditions.

IV. External Current Account Sustainability27

A. Introduction

1. As a prior action for the approval of the stand-by arrangement (SBA), the Central Bank of Sri Lanka (CBSL) floated the rupee on January 23, 2001. The move to the floating exchange rate regime was preceded by a period of high interest rates low reserves, large import bills and an exchange rate level and regime (crawling band) that was no longer credible.

2. Despite the adoption of a flexible exchange rate regime and the subsequent monetary easing, the exchange rate remained broadly stable during most of the year. Specifically, during 2001 the reverse repo rate was reduced by 900 basis points, thus dwarfing the reduction in both the U.S. federal funds rate and neighboring countries’ rates for the same period. Notwithstanding the monetary easing and the elimination of the exchange market regulations that were imposed soon after the float, the rupee showed remarkable stability and remained at Rs 90/US$ during most part of 2001.28

3. Against this background, the principal objective of this chapter is to assess the sustainability of the external current account balance (both historically and looking forward) given the level of the real exchange rate. The chapter is organized as follows. Section B summarizes the background prior to the float in January 2001. Section C provides a brief summary of the empirical methodology used to judge the consistency of the external current account and the real exchange rate-the macroeconomics balance approach, which uses the saving-investment balance method. Section D presents the estimated equilibrium savings-investment balance equation, its extension to both equilibrium real exchange rate analysis and an analysis of external current account sustainability over the medium term. Section E summarizes the findings and the policy implications of the results.

B. Background

4. Serious macroeconomic imbalances began to emerge in late 1999, and by late 2000 Sri Lanka was on the verge of a foreign exchange crisis. Whereas GDP growth was buoyant, external reserves fell to vulnerable levels, and inflation picked up.

  • Real GDP grew at 6-6½ percent between mid-1999 and the third quarter of 2000, boosted by strong exports, but growth eased in the fourth quarter as poor monsoons affected agricultural output and high interest rates dampened domestic demand.

  • The rupee was allowed to depreciate by progressively widening the exchange rate band (to +/-5 percent in early January 2001). Due to political concerns in the run up to the parliamentary elections in December 2000, the required policy adjustments were delayed, resulting in accelerated market pressures on the rupee.

  • In response to these pressures, the CBSL raised domestic interest rates sharply and intervened heavily in the foreign exchange market to defend the rupee.29 By late 2000, Sri Lanka had low reserves, large import bills due, and an exchange rate level and regime (a crawling band) that was no longer credible.

  • Inflation rose sharply to 11 percent (on a 12-month basis) by December 2000, reflecting largely the depreciation of the rupee and increased administered prices.

5. Against this background, the authorities made a fundamental shift in exchange rate policy on January 23 2001, moving to a floating exchange rate regime. Initially, to support the float, monetary conditions were kept tight during the first quarter of 2001 with high real interest rates (about 9 percent) and some temporary foreign exchange regulations were put in place to curb speculative activities. After some initial volatility, the exchange rate stabilized at about Rs 90/US$ with no significant premium in the parallel market. The imposition of foreign exchange regulations raised concerns about the true commitment of the authorities to the flexible exchange rate regime. However, most of these regulations were removed by end-August 2001. Moreover, from April 2001, interest rates were progressively reduced-by end-2001 the reverse repo rate was 9 percent below its peak level of 23 percent in January, 2001.30 Notwithstanding these policy changes, the exchange rate remained generally stable during most of the year.

6. Subsequent developments in the foreign exchange market, however, did not suggest a clear pattern of whether the rupee was overvalued. The CBSL purchased about $90 million in August 2001 alone with no pressure on the exchange rate and despite the significant reduction in policy rates. Moreover, a rising parallel market premium combined with foreign exchange rationing are classic symptoms of an overvalued exchange rate, but during most of 2001, parallel market rates in Sri Lanka were in fact slightly more appreciated than the official rate.

7. Developments in the overall net foreign assets position of the country were also not conclusive. Although the SB A program’s NIR targets for the monetary authorities were met, NFA of the banking system as whole was about Rs 55 billion lower than programmed at end-December 2001 which suggests that the build-up of the monetary authorities’ NFA was at the cost the large decline of the NFA of the commercial banks (which became significantly negative by end-2001).

8. In summary, the basic behavioral pattern of the foreign exchange market and key macroeconomic indicators did not suggest that the rupee was overvalued in the short run. At the same time, the remarkable stability of the rupee raised concerns about the consistency of the real exchange rate with medium-term external sustainability.31 These developments provide the basis to conduct an empirical analysis of the sustainability of the external current account deficit.

Figure IV.1.
Figure IV.1.

Real Effective Exchange Rate, 1990-2002

(January 1997 = 100)

Citation: IMF Staff Country Reports 2002, 208; 10.5089/9781451823516.002.A004

C. Empirical Methodology

9. The literature on equilibrium real exchange rates is vast and this partly reflects the considerable difficulties in estimating equilibrium real exchange rates (ERER).32 These models aim at determining the level of the real exchange rate that is consistent with both external equilibrium (sustainable current account) and internal equilibrium (in terms of goods and labor market).

10. In this chapter, we use the macroeconomic balance approach to assess the overall consistency of the external current account and the real exchange rate.33 The macroeconomic balance approach makes quantitative assessments of exchange rates that are consistent with “appropriate” current account positions (external balance) when economies are operating at potential output (internal balance). In operational terms, it essentially involves two broad steps which can be readily applied on the Sri Lankan data. First, the measures of equilibrium savings-investment balances are derived from a model-based savings-investment estimated equation, based on the econometric estimates of the relationship between the saving-investment balance and a set of medium-term macroeconomic determinants. Second, the actual savings-investment balance is compared with this equilibrium model-based norm. The difference between the actual current account and the norm is then used to calculate the degree of exchange rate misalignment (Isard and Mussa, 1998).

D. Application of the Macroeconomic Balance Approach on Sri Lanka

11. This section presents the application of the macroeconomic balance approach to the Sri Lanka data.34 The first step is to estimate a basic current account (savings-investment=S-I) balance equation as specified in equation 1 below,

(CurrentAccount=SI)t=α0+α1(MACROFUNDAMENTALS)t+μt(1)

where MACROFUNDAMENTALS are the determinants of the medium-term savings and investment (current account) balance. Specifically,

  • Fiscal policy will affect national saving through changes in public saving unless full Ricardian equivalence holds.35 Fiscal policy may also affect investment through real interest rates and its impact on business confidence.

  • Demographic factors affect private saving if, as the life cycle hypothesis suggests, older people save less. If a country has a relatively low dependency ratio, it would be expected to have a higher private saving rate than one with higher dependency ratio. The dependency ratio may also affect public saving through its impact on the fiscal accounts. To the extent that capital-labor ratios are affected by the number of available workers, demographics may also affect investment.

  • Terms of trade volatility may induce countries to save more as a buffer against the variability of their income. Systematic changes in terms of trade volatility could affect savings and the current account balance.

  • Countries with a greater degree of openness to international trade may be able to finance larger current account deficits, as more open economies can have a greater capacity to generate earnings through exports, and hence be better able to service their external debt.

  • Financial deepening can induce greater saving by providing a vehicle for the accumulation of surplus funds, and thus be positively correlated with the current account balance.

12. The estimated regression equation for the “equilibrium” savings-investment (current account) balance for Sri Lanka appears in Table IV.1. The estimated equation suggests that the larger public sector deficit was the most significant contributor to the larger current account deficit in Sri Lanka. Large fiscal imbalances, averaging more than 9 percent of GDP during the period 1980-2001, led to prolonged periods of public dissaving. This is consistent with the point made in Chapter II that in recent years fiscal policy led to a rising debt-GDP ratio.36 Other variables such as demographic factors and terms of trade volatility did not seem to have significantly affected the estimated equilibrium savings-investment balance. Specifically, the relatively low and declining dependency ratio did not have a significant impact on the external current account via its impact on private savings. Moreover, Sri Lanka’s relatively low level of financial development and openness to trade do not seem to have been major factors driving the external current account balance.

Table IV.1.

The Estimated Current Account = S - I Equation 1/2/

(Sample period: 1971-2001)

article image

The savings-investment balance is specified in percent of GDP.

Initially, all the variables were tested for stationarity and the results of both the augmented Dickey-Fuller and Phillips-Perone tests indicate that the variables are either I(0) - stationary or borderline I(0)/I(1) series. The results of the regression analysis presented here are broadly consistent with a co-integrated long-run solution for these variables.

13. Figure IV.2 shows the plot of the actual underlying savings-investment balance, the estimated equilibrium savings-investment balance, and the deviation of the actual savings-investment balance from the norm. The estimated model tracks well the actual savings-investment balance. It also shows that during the period 1995-1998 the actual savings-investment balance was below its estimated equilibrium level. However, the disequilibrium emerged in 1999 and widened in 2000. By end-2000, the savings-investment balance was 1½ percent larger than the equilibrium savings-investment balance. Further analysis shows that this yielded a real exchange rate misalignment of about 8 percent at end-2000. However, the results also show that by end-2001, the external current account imbalance had been eliminated.

Figure IV.2.
Figure IV.2.

Savings-Investment Balance, 1971-2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 208; 10.5089/9781451823516.002.A004

14. Moving to a forward looking analysis, we used our estimated equilibrium model to generate medium-term forecasts for the savings-investment balance through 2006 based on a policy adjustment scenario. The results from our ex ante forecasts (Figure IV.3) show that with policy adjustments (in particular fiscal consolidation), the savings-investment balance would stay on a sustainable path that is broadly consistent with the baseline medium-term projections.37 Further sensitivity analysis was conducted by employing a VAR and generating selected impulse response functions from the basic model. The results show that fiscal shocks (with a shock dying out after four years) have a significant impact on the savings-investment balance (Figure IV.4). Thus, any radical departure from the fiscal stance assumed in the baseline scenario would pose a risk to medium-term external current account sustainability.

Figure IV.3.
Figure IV.3.

Savings-Investment Balance, 2002-2006

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 208; 10.5089/9781451823516.002.A004

Figure IV.4.
Figure IV.4.

Savings-Investment Balance, 2002-2006

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 208; 10.5089/9781451823516.002.A004

E. Conclusions

15. Sri Lanka’s experience with the flexible exchange rate system has been generally favorable. The current account deficit balance has narrowed and the overall external position has strengthened considerably. However, the general stability of the rupee since the adoption of a floating exchange rate regime has raised questions about the overall consistency of the real exchange rate with medium-term external sustainability.

16. This paper has attempted to provide an analytic basis for external current account sustainability using both backward and forward looking analysis. Using the macroeconomic balance approach, this paper finds that during the period 1999-2000, the actual savings-investment balance was out of line with the estimated equilibrium savings-investment balance, reflecting the large public sector deficit. However, by end-2001 the imbalance had been eliminated. Extending the savings-investment balance analysis to equilibrium real exchange rate analysis, shows that the real exchange rate was overvalued during 1999-2000, compared with the estimated equilibrium values. A forward looking analysis shows that, if adjustment measures continue, the external current account deficit would stay on a sustainable path. However, any radical departures from the fiscal stance assumed in the baseline would pose a risk to medium-term external sustainability.

17. The empirical methods and the results presented in this chapter have limitations. First, an analysis of current account sustainability that is partly based on an estimated equilibrium relationship implicitly assumes that the established historical relationship would remain stable and continue over the medium term. Moreover, a sustainable level of current account deficit for the medium-term would also depend on the sustainable level of capital inflows.

References

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  • Williamson, John (1994). “Estimating Equilibrium Exchange Rates,Washington, Institute for International Economics.

27

Prepared by Lamin Leigh (APD).

28

At meetings with bankers during various missions, a few argued that the rupee was somewhat “overvalued” and artificially held up by the CBSL’s foreign exchange regulations.

29

During the second half of 2000, official reserves (excluding Asian Clearing Account balances) dropped by more than $600 million.

30

During policy discussions the authorities argued that drastic reduction in policy rates was aimed at bolstering economic activity given the marked slowdown of the economy in 2001- at end-2001, GDP contracted by about 1½ percent.

31

We should note that the absence of overvaluation in the short-run does not preclude medium-term misalignment.

32

An excellent survey of the literature is available in Chapter 1 of Williamson ed (1994).

33

We used this methodology given the limitations of the purchasing power parity (PPP) hypothesis and the difficulties of interpreting meaningful single-equation or systems of reduced-form models for Sri Lanka. For instance, the assumption of the constancy of the ERER is a basic flaw of the PPP approach, while single-equation reduced reform specifications do not yield explicit estimates of equilibrium current account positions.

34

Based on the Chinn and Prasad (2000) data set, extended to end-2001.

35

Ricardian equivalence implies that fiscal deficits have no effect on aggregate saving or investment and, through the S-I identity, on the external current account.

36

However, one caveat here is that despite the fiscal deficit rising from about 10 percent in 2000 to about 11 percent in 2001, the overall savings-investment balance improved in 2001. This is largely related to the decline in private sector investment (due to the combination of the economic contraction and the impact of the adjustment policies), which more than compensated the public sector dissaving.

37

While this suggest that the estimated equilibrium savings-investment balance equation is reasonably robust, we should note that medium-term forecasts of the external current account balance that are based on an estimated regression equation have their own limitations. For a start, they assume that the established historical relationship would remain stable and continue over the medium term. Furthermore the analysis here assumes a sustainable level of capital inflows.

Sri Lanka: Selected Issues and Statistical Appendix
Author: International Monetary Fund