Capital Inflows and Foreign Reserves: Questioning the IMF’s Advice

06 Oct 2013 - Editorial

The recent devaluing of the Indian rupee and the capital flight from India are warning signs for Sri Lanka and increases pressure on its foreign reserves. The long term trend in developing countries since the 1990s is to increase foreign reserves as a form of “insurance” against short-term borrowing in addition to controlling their exchange rate. The IMF has been promoting the increase in reserves, flexible exchange rates and effectively the inflow of short-term capital. Now with a crisis having hit the “emerging markets”, Sri Lanka’s foreign reserves will have to be used to contain the fallout, particularly, if there is capital flight from the country.

As economist Dani Rodrik points out, however, the strategy of increasing reserves to shore up short-term borrowing is an economic policy fraught with indirect social costs. There are alternatives, including reducing short-term borrowing while shoring up investment and growth in the national economy. This is opposed to the current 'indirect tax' on the national economy imposed by increasing reserves as insurance against excessive borrowing.

Rather than the IMF's ad hoc proposal of using flexible exchange rates, a more sustainable alternative will require both capital controls and long-term curtailment of short-term borrowing. What follows will critique the IMF's problematic engagement with long-term crisis dynamics in Sri Lanka.

As in the Asian financial crisis of 1997-98, when the IMF begins to contradict itself, it is usually a sign that a latent financial crisis is beginning to unravel. On 25th September 2013, after the conclusion of the IMF Staff Mission to Sri Lanka, the IMF statement made the following observations:

“Given the possible tapering of exceptional monetary stimulus by the U.S. Federal Reserve in the months ahead, emerging and frontier markets are likely to face a period of slowdown or even reversal of capital inflows. While the rupee has been relatively resilient so far, the balance of external risks for Sri Lanka has shifted to the downside. In this more complex global environment, it will be essential to adhere to the flexible exchange rate regime that has been a core component of the policy framework since early 2012. Intervention should be limited to dealing with excessive short-term volatility. Contingency plans—including a mix of fiscal and monetary policies to counter potential market pressures—should be prepared in anticipation of possible shifts in market conditions. New external borrowing should also be done with a close eye to sustainability, and the need to ensure that investments generate the resources needed to service these obligations.”

The IMF is warning that the flow of capital to the emerging markets after the global economic crisis of 2008 might now be reversing. In other words, the new tendency is encouraging capital to flow back from the periphery to the metropolis. This has been compounded by the financial troubles in India in recent weeks. In this period of volatility then, why does the IMF still insist in the same statement above on a flexible exchange rate? Shouldn’t it be the time in fact to implement fixed controls? Finally, why did the IMF not consider warning the Sri Lankan Government earlier about the importance of external borrowings channelled into investments that must produce adequate returns? It is as if the IMF is asking to shut the stable door after the horses have bolted.

The central question here is whether flexible exchange rates and the free flow of capital including short-term borrowing have in fact made countries such as Sri Lanka more vulnerable to financial crisis. This is the subject of an important paper by economist Dani Rodrik titled, ‘The Social Cost of Foreign Exchange Reserves’, published in the International Economic Journal Vol. 20, No. 3, 253–266, September 2006. Rodrik is quite aware of the numerous and repeated financial crises since the advent of neoliberal globalisation in the 1970s. In the paper, he is specifically interested in the question of short-term external debt and the push by the IMF and others to encourage larger foreign reserves among developing countries.

Rodrik questions the neoclassical economic logic of opening up the capital markets, increasing short-term debt, while simultaneously calling for larger foreign exchange reserves to provide the buffer against capital flight in the face of unsustainable debt or fall in financial confidence for a range of reasons. Such speculative flows and flight are subject to “animal spirits” as J. M. Keynes had famously stated. Rodrik goes onto argue that there is in fact a measureable cost incurred by the funds kept as foreign reserves, as these funds are diverted from investment in the national economy.

To use a recent example, it was the US $2.6 billion Standby Arrangement of 2009 with the IMF that encouraged global capital flows into Sri Lanka. Not only has Sri Lanka floated US$ 4 billion in sovereign bonds, but commercial banks have also floated billions more in Euro dollar bonds. The Bank of Ceylon is a case in point with its two US $500 million bonds over the last year and half. There have also been increased capital flows into the stock market. Toward this end, the IMF gave a report card of confidence to global capital. Furthermore, in the event of a crisis the IMF will bail them out. This resulted in the increase of such capital flows.

In recent weeks the US $750 million dollar bond float by the National Savings Bank is yet another worrying sign of the continuing process of financialisation. This five-year Euro dollar bond was floated at 8.875% interest, much higher than the interest rate on the Bank of Ceylon bonds. But the Central Bank Governor claims this has boosted Sri Lanka’s foreign reserves. The need to boost such reserves with high interest short term loans has a social cost. While the country will have to pay the interest on such loans, most of such flows are not productively invested. These are precisely the problems that Rodrik analyses.

Further compounding the problem is the fact that this debt is dollar denominated. If the exchange rate is flexible and there is a great fall in the value of the rupee, the Government is going to find it even more difficult to pay back these bonds. It will be squeezed by the high interest rate payments and the devalued rupee, forcing the Government to further tax the public, cut social welfare or launch a program of privatisation to find the funds locally.

In conclusion some may argue that it is better that the IMF make its warnings later rather than never. In contrast we argue that its silence and in fact subtle encouragement of short-term debt, exchange rate flexibility and larger foreign reserves are contradictory and simply bad macro-economic policy. While in the short-term, increasing foreign reserves will wade off a balance of payment crisis, any long-term solution needs to address short-term debt. It is high time the citizenry challenge the Government to reverse the process of financialisation pushed by global and national financial interests. Otherwise, a future financial crisis will hit us that much harder. And with any such financial crisis the consequences may be similar to the effects of the global economic crisis of 2008 on Western countries. The pattern is all too familiar, where banks and financial institutions will be bailed out as austerity measures lead to further cuts to social welfare such as free education and healthcare.

This piece also appeared in The Sunday Island 6 Oct 2013