Balance of payments Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country and

the rest of the world. These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers. The BoP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items. When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways such as by funds earned from its foreign investments, by running down central bank reserves or by receiving loans from other countries. While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the central bank's reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted. The term "balance of payments" often refers to this sum: a country's balance of payments is said to be in surplus (equivalently, the balance of payments is positive) by a certain amount if sources of funds (such as export goods sold and bonds sold) exceed uses of funds (such as paying for imported goods and paying for foreign bonds purchased) by that amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter. Under a fixed exchange rate system, the central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from affecting the exchange rate between the country's currency and other currencies. Then the net change per year in the central bank's foreign exchange reserves is sometimes called the balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include

a managed float where some changes of exchange rates are allowed, or at the other extreme a purelyfloating exchange rate (also known as a purely flexible exchange rate). With a pure float the central bank does not intervene at all to protect or devalue its currency, allowing the rate to be set by the market, and the central bank's foreign exchange reserves do not change. Historically there have been different approaches to the question of how or even whether to eliminate current account or trade imbalances. With record trade imbalances held up as one of the contributing factors to the financial crisis of 20072010, plans to address global imbalances have been high on the agenda of policy makers since 2009. A record of all transactions made between one particular country and all other countries during a specified period of time. BOP compares the dollar difference of the amount of exports and imports, including all financial exports and imports. A negative balance of payments means that more money is flowing out of the country than coming in, and vice versa.

Balance of payments may be used as an indicator of economic and political stability. For example, if a country has a consistently positive BOP, this could mean that there is significant foreign investment within that country. It may also mean that the country does not export much of its currency.

This is just another economic indicator of a country's relative value and, along with all other indicators, should be used with caution. The BOP includes the trade balance, foreign investments and investments by foreigners.

Composition of the balance of payments sheet BOP The two principal parts of the BOP accounts are the current account and the capital account. The current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit. It is the sum of thebalance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign

investors) and cash transfers. It is called the current account as it covers transactions in the "here and now" - those that don't give rise to future claims. The Capital Account records the net change in ownership of foreign assets. It includes the reserve account (the foreign exchange market operations of a nation's central bank), along with loans and investments between the country and the rest of world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded in the current account). The term "capital account" is also used in the narrower sense that excludes central bank foreign exchange market operations: Sometimes the reserve account is classified as "below the line" and so not reported as part of the capital account. Expressed with the broader meaning for the capital account, the BOP identity assumes that any current account surplus will be balanced by a capital account deficit of equal size - or alternatively a current account deficit will be balanced by a corresponding capital account surplus:

The balancing item, which may be positive or negative, is simply an amount that accounts for any statistical errors and assures that the current and capital accounts sum to zero. By the principles of double entry accounting, an entry in the current account gives rise to an entry in the capital account, and in aggregate the two accounts automatically balance. A balance isn't always reflected in reported figures for the current and capital accounts, which might, for example, report a surplus for both accounts, but when this happens it always means something has been missedmost commonly, the operations of the country's central bank and what has been missed is recorded in the statistical discrepancy term (the balancing item). An actual balance sheet will typically have numerous sub headings under the principal divisions. For example, entries under Current account might include:

Trade buying and selling of goods and services

Exports a credit entry Imports a debit entry

Trade balance the sum of Exports and Imports

Factor income repayments and dividends from loans and investments

Factor earnings a credit entry Factor payments a debit entry

Factor income balance the sum of earnings and payments.

Especially in older balance sheets, a common division was between visible and invisible entries. Visible trade recorded imports and exports of physical goods (entries for trade in physical goods excluding services is now often called the merchandise balance). Invisible trade would record international buying and selling of services, and sometimes would be grouped with transfer and factor income as invisible earnings.[1] The term "balance of payments surplus" (or deficit a deficit is simply a negative surplus) refers to the sum of the surpluses in the current account and the narrowly defined capital account (excluding changes in central bank reserves). Denoting the balance of payments surplus as BOP surplus, the relevant identity is

[edit]Variations in the use of term "balance of payments" Economics writer J. Orlin Grabbe warns the term balance of payments can be a source of misunderstanding due to divergent expectations about what the term denotes. Grabbe says the term is sometimes misused by people who aren't aware of the accepted meaning, not only in general conversation but in financial publications and the economic literature.[3] A common source of confusion arises from whether or not the reserve account entry, part of the capital account, is included in the BOP accounts. The reserve account records the activity of the nation's central bank. If it is excluded, the BOP can be in surplus (which implies the central bank is building up foreign exchange reserves) or in deficit (which implies the central bank is running down its reserves or borrowing from abroad).[1][3] The term "balance of payments" is sometimes misused by non-economists to mean just relatively narrow parts of the BOP such as thetrade deficit,[3] which means excluding parts of the current account and the entire capital account. Another cause of confusion is the different naming conventions in use.[4] Before 1973 there was no standard way to break down the BOP sheet, with the separation into

invisible and visible payments sometimes being the principal divisions. The IMF have their own standards for BOP accounting which is equivalent to the standard definition but uses different nomenclature, in particular with respect to the meaning given to the term capital account. [edit]The IMF definition The International Monetary Fund (IMF) use a particular set of definitions for the BOP accounts, which is also used by the Organisation for Economic Co-operation and Development (OECD), and the United Nations System of National Accounts (SNA).[5] The main difference in the IMF's terminology is that it uses the term "financial account" to capture transactions that would under alternative definitions be recorded in the capital account. The IMF uses the term capital account to designate a subset of transactions that, according to other usage, form a small part of the overall capital account.[6] The IMF separates these transactions out to form an additional top level division of the BOP accounts. Expressed with the IMF definition, the BOP identity can be written:

The IMF uses the term current account with the same meaning as that used by other organizations, although it has its own names for its three leading sub-divisions, which are:

The goods and services account (the overall trade balance) The primary income account (factor income such as from loans and investments) The secondary income account (transfer payments)

[edit]Imbalances While the BOP has to balance overall, surpluses or deficits on its individual elements can lead to imbalances between countries. In general there is concern over deficits in the current account. Countries with deficits in their current accounts will build up increasing debt and/or see increased foreign ownership of their assets. The types of deficits that typically raise concern are

A visible trade deficit where a nation is importing more physical goods than it exports (even if this is balanced by the other components of the current account.)

An overall current account deficit. A basic deficit which is the current account plus foreign direct investment (but excluding other elements of the capital account like short terms loans and the reserve account.)

As discussed in the history section below, the Washington Consensus period saw a swing of opinion towards the view that there is no need to worry about imbalances. Opinion swung back in the opposite direction in the wake of financial crisis of 2007 2009. Mainstream opinion expressed by the leading financial press and economists, international bodies like the IMFas well as leaders of surplus and deficit countrieshas returned to the view that large current account imbalances do matter.[9] Some economists do, however, remain relatively unconcerned about imbalances[10] and there have been assertions, such as by Michael P. Dooley, David Folkerts-Landau and Peter Garber, that nations need to avoid temptation to switch to protectionism as a means to correct imbalances.[11] [edit]Causes of BOP imbalances There are conflicting views as to the primary cause of BOP imbalances, with much attention on the US which currently has by far the biggest deficit. The conventional view is that current account factors are the primary cause[12] - these include the exchange rate, the government's fiscal deficit, business competitiveness, and private behaviour such as the willingness of consumers to go into debt to finance extra consumption.[13] An alternative view, argued at length in a 2005 paper by Ben Bernanke, is that the primary driver is the capital account, where a global savings glut caused by savers in surplus countries, runs ahead of the available investment opportunities, and is pushed into the US resulting in excess consumption and asset price inflation.[14] [edit]Reserve asset Main article: Reserve currency

The US dollar has been the leading reserve asset since the end of the gold standard. In the context of BOP and international monetary systems, the reserve asset is the currency or other store of value that is primarily used by nations for their foreign reserves.[15] BOP imbalances tend to manifest as hoards of the reserve asset being amassed by surplus countries, with deficit countries building debts denominated in the reserve asset or at least depleting their supply. Under a gold standard, the reserve asset for all members of the standard is gold. In the Bretton Woods system, either gold or the U.S. dollar could serve as the reserve asset, though its smooth operation depended on countries apart from the US choosing to keep most of their holdings in dollars. Following the ending of Bretton Woods, there has been no de jure reserve asset, but the US dollar has remained by far the principal de facto reserve. Global reserves rose sharply in the first decade of the 21st century, partly as a result of the 1997 Asian Financial Crisis, where several nations ran out of foreign currency needed for essential imports and thus had to accept deals on unfavourable terms. The International Monetary Fund (IMF) estimates that between 2000 to mid-2009, official reserves rose from $1,900bn to $6,800bn.[16] Global reserves had peaked at about $7,500bn in mid-2008, then declined by about $430bn as countries without their own reserve currency used them to shield themselves from the worst effects of the financial crisis. From Feb 2009 global reserves began increasing again to reach close to $9,200bn by the end of 2010.[17] [18] As of 2009 approximately 65% of the world's $6,800bn total is held in U.S. dollars and approximately 25% in euros. The UK pound,Japanese yen, IMF special drawing rights (SDRs), and precious metals[19] also play a role. In 2009 Zhou Xiaochuan, governor of thePeople's Bank of China, proposed a gradual move towards increased use of SDRs, and also for the national currencies backing SDRs to be expanded to

include the currencies of all major economies.[20] [21] Dr Zhou's proposal has been described as one of the most significant ideas expressed in 2009.[22] While the current central role of the dollar does give the US some advantages such as lower cost of borrowings, it also contributes to the pressure causing the U.S. to run a current account deficit, due to the Triffin dilemma. In a November 2009 article published inForeign Affairs magazine, economist C. Fred Bergsten argued that Dr Zhou's suggestion or a similar change to the international monetary system would be in the United States' best interests as well as the rest of the world's.[23] Since 2009 there has been a notable increase in the number of new bilateral agreements which enable international trades to be transacted using a currency that isn't a traditional reserve asset, such as the renminbi, as the Settlement currency. [24] [edit]Balance of payments crisis Main article: Currency crisis A BOP crisis, also called a currency crisis, occurs when a nation is unable to pay for essential imports and/or service its debt repayments. Typically, this is accompanied by a rapid decline in the value of the affected nation's currency. Crises are generally preceded by large capital inflows, which are associated at first with rapid economic growth.[25] However a point is reached where overseas investors become concerned about the level of debt their inbound capital is generating, and decide to pull out their funds.[26]The resulting outbound capital flows are associated with a rapid drop in the value of the affected nation's currency. This causes issues for firms of the affected nation who have received the inbound investments and loans, as the revenue of those firms is typically mostly derived domestically but their debts are often denominated in a reserve currency. Once the nation's government has exhausted its foreign reserves trying to support the value of the domestic currency, its policy options are very limited. It can raise its interest rates to try to prevent further declines in the value of its currency, but while this can help those with debts denominated in foreign currencies, it generally further depresses the local economy.[25] [27] [28]

[edit]Balancing mechanisms One of the three fundamental functions of an international monetary system is to provide mechanisms to correct imbalances.[29][30] Broadly speaking, there are three possible methods to correct BOP imbalances, though in practice a mixture including some degree of at least the first two methods tends to be used. These methods are adjustments of exchange rates; adjustment of a nations internal prices along with its levels of demand; and rules based adjustment.[31] Improving productivity and hence competitiveness can also help, as can increasing the desirability of exports through other means, though it is generally assumed a nation is always trying to develop and sell its products to the best of its abilities. [edit]Rebalancing by changing the exchange rate An upwards shift in the value of a nation's currency relative to others will make a nation's exports less competitive and make imports cheaper and so will tend to correct a current account surplus. It also tends to make investment flows into the capital account less attractive so will help with a surplus there too. Conversely a downward shift in the value of a nation's currency makes it more expensive for its citizens to buy imports and increases the competitiveness of their exports, thus helping to correct a deficit (though the solution often doesn't have a positive impact immediately due to the MarshallLerner condition).[32] Exchange rates can be adjusted by government[33] in a rules based or managed currency regime, and when left to float freely in the market they also tend to change in the direction that will restore balance. When a country is selling more than it imports, the demand for its currency will tend to increase as other countries ultimately[34] need the selling country's currency to make payments for the exports. The extra demand tends to cause a rise of the currency's price relative to others. When a country is importing more than it exports, the supply of its own currency on the international market tends to increase as it tries to exchange it for foreign currency to pay for its imports, and this extra supply tends to cause the price to fall.

BOP effects are not the only market influence on exchange rates however, they are also influenced by differences in national interest rates and by speculation. [edit]Rebalancing by adjusting internal prices and demand When exchange rates are fixed by a rigid gold standard,[35] or when imbalances exist between members of a currency union such as the Eurozone, the standard approach to correct imbalances is by making changes to the domestic economy. To a large degree, the change is optional for the surplus country, but compulsory for the deficit country. In the case of a gold standard, the mechanism is largely automatic. When a country has a favourable trade balance, as a consequence of selling more than it buys it will experience a net inflow of gold. The natural effect of this will be to increase the money supply, which leads to inflation and an increase in prices, which then tends to make its goods less competitive and so will decrease its trade surplus. However the nation has the option of taking the gold out of economy (sterilising the inflationary effect) thus building up a hoard of gold and retaining its favourable balance of payments. On the other hand, if a country has an adverse BOP it will experience a net loss of gold, which will automatically have a deflationary effect, unless it chooses to leave the gold standard. Prices will be reduced, making its exports more competitive, and thus correcting the imbalance. While the gold standard is generally considered to have been successful[36] up until 1914, correction by deflation to the degree required by the large imbalances that arose after WWI proved painful, with deflationary policies contributing to prolonged unemployment but not re-establishing balance. Apart from the US most former members had left the gold standard by the mid 1930s. A possible method for surplus countries such as Germany to contribute to rebalancing efforts when exchange rate adjustment is not suitable, is to increase its level of internal demand (i.e. its spending on goods). While a current account surplus is commonly understood as the excess of earnings over spending, an alternative expression is that it is the excess of savings over investment.[37]That is:

where CA = current account, NS = national savings (private plus government sector), NI = national investment. If a nation is earning more than it spends the net effect will be to build up savings, except to the extent that those savings are being used for investment. If consumers can be encouraged to spend more instead of saving; or if the government runs a fiscal deficit to offset private savings; or if the corporate sector divert more of their profits to investment, then any current account surplus will tend to be reduced. However in 2009 Germany amended its constitution to prohibit running a deficit greater than 0.35% of its GDP[38] and calls to reduce its surplus by increasing demand have not been welcome by officials,[39] adding to fears that the 2010s will not be an easy decade for the eurozone.[40] In their April 2010 world economic outlook report, the IMF presented a study showing how with the right choice of policy options governments can transition out of a sustained current account surplus with no negative effect on growth and with a positive impact on unemployment.[41] Rules based rebalancing mechanisms Nations can agree to fix their exchange rates against each other, and then correct any imbalances that arise by rules based and negotiated exchange rate changes and other methods. The Bretton Woods system of fixed but adjustable exchange rates was an example of a rules based system, though it still relied primarily on the two traditional mechanisms. John Maynard Keynes, one of the architects of the Bretton Woods system had wanted additional rules to encourage surplus countries to share the burden of rebalancing, as he argued that they were in a stronger position to do so and as he regarded their surpluses as negative externalities imposed on the global economy.[42] Keynes suggested that traditional balancing mechanisms should be supplemented by the threat of confiscation of a portion of excess revenue if the surplus country did not choose to spend it on additional imports. However his ideas were not accepted by the Americans at the time. In 2008 and 2009, American economist Paul Davidson had been promoting his revamped form of Keynes's plan as a possible

solution to global imbalances which in his opinion would expand growth all round without the downside risk of other rebalancing methods.

Govt. mismanaged balance of payments crisis, now remedies more painful *Central Bank needs to be modest enough to accept criticism *How Cabraal debunked concerns raised last year Reiterating what has been said in these pages over the past few days, Dr. Harsha De Silva MP, economic spokesman for the UNP, said mismanagement of the balance of payments crisis has resulted in the prescribed remedies being more costlier to the economy.

"In complete contrast to the picture painted by Governor Nivard Cabraal and subsequently showcased by politicians, the sad reality of the economy of Sri Lanka has been revealed, the opposition lawmaker said.

"The mismanagement of the problem; particularly ignoring the ballooning trade deficit and under-pricing energy in an artificially controlled exchange rate and interest rate regime, had no other possible ending other than the one that is unfolding right before our eyes.

The domino effect of the erroneous decision making by the miserably politicized Central Bank resulting in a massive depreciation and an unprecedented increase in energy prices will be widespread and be felt by all. The enormity of the fallout will become clear in the coming days with people unable to meet their daily requirements resulting in worker agitations for salary increases which could even spin out of control.

"The government has no one to blame but themselves for this predicament and the public would now realize the vituperative attacks made on their critics were of bad taste and unprofessional. Going forward we hope for the sake of the millions of innocent people of this country that persons knowledgeable in the subject of economics and modest enough to take criticism from others would be handed over the responsibility to manage this nations complex economy," Dr. De Silva said.

As highlighted in the pages yesterday, several leading economists in the country were ostracized for highlighting the structural deficiencies in the countrys balance of payments. Had authorities

headed the warnings last year, the rupee would not have had to be depreciated as much as it is today, interest rates would not be so tight and fuel price increases could have been gradual and less of a shock to the economy.

"The overnight adjustment to fuel prices is pretty significant," a young economist attached to the Institute of Policy Studies, Anushka Wijesinha told The Island Financial Review.

"While the transport, agriculture and fishery sectors will get government subsidies and the impact on them will be dampened, the manufacturing sector will feel the full brunt. More generally, though, Sri Lanka needs to rethink its domestic oil pricing mechanism, and move towards a market-reflective pricing that follows world Brent crude prices, so we dont have sudden hikes like this," he said.

Central Bank Governor Ajith Nivard Cabraal had strongly criticised those economists sounding off the alarm over the impending balance of payments crisis. Last October, in an article published in The Island, Cabraal swept aside concerns that a balance of payments crisis was looming large and that the reserves position was not very comfortable. We reproduce some of his statements below. Cabraal framed the following response to the question Arent we heading for a balance of payment crisis?: "Certainly not! We expected this growth in imports to take place this year as a result of lower duties, higher fuel prices, greater quantum of intermediate goods imported, and the overall improvement of per capita incomes of the people. Therefore, the increase in imports which has resulted in the widening trade deficit has been factored into our estimates.

What is important is for us to have a clear picture in relation to our current account balance, and the capital and financial account balance which finally leads to the balance of payments. Although we have a trade deficit, the other inflows have more than adequately compensated for this shortfall, and therefore we expect the balance of payments to record a comfortable surplus by the end of the year. On that basis, we see no reason to react to monthly changes in inflows and outflows. Reacting to daily and monthly changes is what speculators and hedge funds do, but, we

as a Central Bank need to behave and act differently. We take a long-term view of economic trends. Our current trends clearly indicate that there will be very definite inflows. That is why we are confident about our stance."

Around that time, economists had also warned against falling reserves, and this is what Cabraal had to say: "Sri Lankas international reserves are calculated in exactly the same manner that it is done all over the world. Whether it is a developed country or a developing country, they all follow the same basis of reserve computation. Every country has borrowed and non-borrowed reserves. So, there is no difference from our situation. What is important is to understand is as to how stable such reserves are. Sometimes, reserves that are built up with FDI or portfolio investments could be even more vulnerable to quick flight in a difficult situation, than long-term debt capital which is obtained on a fixed term basis. Very often, sweeping statements and vague generalizations are made by persons who do not see the long-term trends or the big picture. Managing an economy is not an exercise which ends at a year end, or at the end of a quarter. On the contrary, it is an ongoing process. For some people who are only looking at programmes, year-end targets or theories, the quarter end targets, and numbers may be highly important and relevant, and that could be their only focus. But, for those who manage economies of countries on a long-term basis, what is most important is the direction of the economy.

"We cannot de-stabilise a country or an economy just to satisfy some temporary theoretical concept. I can confidently assert that our reserve consolidation path is a well-balanced and wellexecuted process which includes many components which function under different paths. Certain components may be more visible and more active at certain times. At other times, different components may be more active. Some theoreticians do not understand this "total" approach and that is why some of them make such statements. Of course, some others with ulterior agendas and motives understand this, but try to cause panic in the minds of people by making twisted statements based on some temporary phenomenon. Once again, I must reiterate that we are confident of the path we have chartered, and we will diligently follow such path, which we know will realize the desired long-term results," Cabraal said.

Nearly four months since this interview was published, the Central Bank has had to reverse all its policy stances as it became too obvious to ignore that a balance of payments crisis was indeed looming and that the reserves position was fast deteriorating.

Sri Lanka is heading deeper into balance of payments trouble with the monetary system moving into an active sterilized intervention phase, leaving behind any opportunity for an interest rate defence of the peg. This is no drill The central bank has given a firm signal that it will not depreciate the currency and take International Monetary Fund advice to float the rupee. Rates are also not being allowed to go up and money is being printed to keep rates down via sterilized interventions, fuelling demand and adding to balance of payments pressure. As mentioned in the last column, the developments in the monetary system in July turned out to be just a dress rehearsal. Now sustained sterilization of the balance of payments has begun. The central bank's T-bill stock rose to 42 billion on September 20 and excess liquidity was lower than that level at 31.4 billion rupees. Put another way, all the excess liquidity can be accounted for by freshly injected rupee reserves. This money is now being re-absorbed by the newly started repo auctions. Reserve Outflow

Central Bank's August forex intervention data is now delayed by over two weeks. It is not unusual in Sri Lanka for data to be delayed during a balance of payments crisis. A back-of-the-envelop calculation, working backwards from available domestic asset data can give some idea of reserve outflows. Sri Lanka's monetary base expanded from 413.2 billion rupees in end July to 427.2 billion rupees by September 15. In the same period excess rupee liquidity in banks fell to 29.8 billion rupees from 75.3 billion rupees. The central bank's Treasuries stock which represents fresh injections of rupees through direct bill purchases or reserve appropriations by the state, rose from 1.7 billion rupees to 33.1 billion rupees in the same period. The sum of the net fall in excess liquidity and the net increase in domestic assets in the period is 76.9 billion rupees. Adjusted for the expansion in reserve money, the net change is 62.9 billion rupees. It points to an approximate reserve outflow of 570 million dollars in six weeks when an average exchange rate of 110.10 rupees is applied. Assuming no material change in the monetary base, reserve outflows to September 20 amounts to about 640 million dollars. If the monetary base contracted it is higher, or vice versa. When added to the 416 million dollar interventions in July the total comes to about a billion dollars, over a period of some 10 weeks. Interest Rates

Interest rates are at the moment being held back with an expansionary sterilization cycle. Rates will start to move only when sterilization becomes less than 100 percent. The monetary authority has started cash auctions and it is for the moment withdrawing excess liquidity which was pumped by its own actions and keeping overnight rates at 7.08 percent. There was a story where in response to a question from an LBO reporter the IMF mission chief advised against an interest rate defence of the peg. But even at the time it was probably an academic question. Call market data show that if rates were allowed to move up in June as the system tightened it may have been possible to save the peg. Jack To some observers the central bank's defence of the peg by targeting both the exchange rate and interest rate seems inexplicable. But from the point of view of a soft pegged central bank it is not that difficult to explain. Even the IMF encourages the central bank to collect large amounts of reserves. After being encouraged to collect reserves, which after all are supposed to be there to be spent when the need arises, everyone suddenly turns around and advises the central bank not to spend the money. There is a pithy Sinhalese saying that captures the situation very clearly: Yuddeta nethi kaduwa kos kotannader? It means 'If the sword is not available for war, is it being kept around to cut up jack fruit?' Unfortunately reserve collections - far above the monetary base - is a scam that only benefit the governments of reserve currency central banks, principally the US where they are invested.

It is funny that investors actually draw confidence from looking at large reserves. But large amounts of reserves actually encourage Central Banks to defend pegs and keep rates down, leading to predictable consequences. External Anchor There is no doubt that a peg is a useful tool. It impersonally acts as an escape valve for periodic build ups of domestic demand pressure, by dynamically adjusting the money supply to economic needs via the balance of payments. It stops inflation to around the level generated by the anchor currency. It stops rulers from destroying the real value of salaries of working people and lifetime financial savings of the old and the weak through currency depreciation - which is already being done to a great extent by the anchor currency central bank that is also printing fiat money. But all this happens only if the monetary authority is prepared to drop policy rates, like in Singapore (with limited sterilization) and Hong Kong (no sterilization). To build a peg that is sustainable we need to change our monetary laws. A 'float' is similar to what gold exchange standard central banks used to call a 'lifting of gold convertibility'. Essentially dollar convertibility at a fixed rate is lifted by a float. What Next? The next step may be the start of reverse repo auctions. Some foreign banks are still liquid. They also have limits for local banks. So some amount of excess liquidity can be expected to remain even if reverse repo auctions start eventually. If some bond holders quit, foreign banks will take paper into their balance sheets and liquidity may also gradually diminish. Bond holders however need not panic, as over the longer term, the peg is likely to brought back to near earlier levels following a float.

Instead of a reverse repo auction, the central bank could continue to buy Treasuries direct and sterilize its effect later. In the past, the market has seen outright rejections of entire Treasuries auctions, when balance of payments pressures reached crisis territory. As already mentioned in the last column, higher import taxes could be expected on what authorities quaintly (some would say in a fascist manner) call 'non-essential' consumer goods as if they have a divine right to decide for individual citizens what is essential or not. Though the spot dollar rate is around 110 rupees, in the forward markets rates have moved up. The three month rate is now about 111.10/15, up about 50 to 60 cents over several weeks. Waiting Game Sri Lanka's IMF program is "in abeyance" to use a neutral expression. The mission who left with an "uncompleted review" expects to continue discussions. In July the Central Bank had eight billion dollars in reserves. At the rate of 300 to 400 million dollar losses of reserves a month it will take several months for reserves to deplete to the level of the monetary base, where it can no longer meet its domestic liabilities in dollars. In a sterilized intervention phase however, state debt repayments can also become net reserve losses. Treasuries acquired by the monetary authority in place of reserve appropriations in the middle of an expansionary sterilization cycle cannot be sold to the market to dampen domestic demand in the economy and re-build fresh reserves. All this can at any time be stopped by a float. Unfortunately until the imbalance is resolved market participants will stop their normal growth generating activities and instead watch the BOP. This is costly for the economy at a time the global outlook is also far from rosy.

Sri Lanka's balance-of-payments position is highly sensitive to price changes in the world market because it depends in large part upon a few export crops to pay for its imports. Since 1983, sharply rising defense expenditures, a decline in tourism caused by continuing civil violence, and slumping world tea and coconut prices combined to exert pressure on the balance of payments. The deficit has also been partially offset by substantial foreign exchange earnings from tourism and from remittances by Sri Lankans working abroad. The current account deficit has declined each year since 1994 when it stood at $860 million. Export growth in 1999, however, slowed considerably to 2% and earnings from tea exports had declined 40% due to the impact of the Russian economic crises in 1998.

In 2000, exports increased by close to 20% to $5.5 billion, and exports of garments and tea did very well. Other exports, such as food, rubber products, machinery, and processed diamond exports, also performed well that year. Sri Lanka floated the rupee in 2001, and the central bank began employing currency controls. Since then, the controls were relaxed. In addition, the government imposed an import duty surcharge to stem the flow of imports. The country's external debt stood at $9.9 billion at the end of 2000, equal to 60% of GDP. The US Central Intelligence Agency (CIA) reports that in 2001 the purchasing power parity of Sri Lanka's exports was $4.9 billion while imports totaled $6 billion resulting in a trade deficit of $1.1 billion. The International Monetary Fund (IMF) reports that in 2001 Sri Lanka had exports of goods totaling $4.82 billion and imports totaling $5.38 billion. The services credit totaled $1.37 billion and debit $1.76 billion. The following table summarizes Sri Lanka's balance of payments as reported by the IMF for 2001 in millions of US dollars.

Enhancing confidence in Sri Lankan economy The government of Sri Lanka introduced a number of bold macroeconomic stabilization measures in February/March 2012. These were necessary as the country was on a trajectory to a very destructive balance of payments crisis. It is still too early to determine whether enough has been done to stabilize the balance of payments, particularly the trade deficit. As the Pathfinder Foundation has pointed out in several previous articles, the trade deficit doubled last year, despite a 22% increase in exports. The current account deficit deteriorated from 2.8% of GDP in 2010 to 6.8% in 2011. The overall balance of payments was in deficit to the tune of $1 billion. The deterioration in the external account led to pressure on the currency and a hemorrhaging of reserves.

No room for complacency It is still too early to be confident that the courageous measures introduced by the government are sufficient to stabilize the countrys external account. This is particularly so, as the risks associated with global economic performance have become much more elevated. The persistence of the Euro Zone crisis, the fragility of recovery in the US and the slowdown in China and India have combined to create an adverse external environment for the exports of a country like Sri Lanka. The decline in oil prices, following the weakness in the global economy, will have a positive impact on Sri Lankas trade deficit. However, the US sanctions on Iran and the potential loss of deferred payment terms for our oil imports could well reduce the beneficial impact of the falling oil prices.

Monitoring performance, a must! The data for 1Q2012 continues to be worrying. Though there has been a slowdown in import growth this has been more than offset by the reduction in the rate of expansion of exports. The upshot has been a worse trade deficit in the first quarter of this year compared with the corresponding period in 2011. However, it is important to emphasize that the 1Q2012 data would not have reflected the full effects of the stabilization measures that were introduced in February/March. A clearer picture will emerge once data for April and May become available. It is of paramount importance that the authorities monitor the developments in the countrys external account very carefully to ensure that the desired trajectory of stabilization is attained.

Failure to do so will inevitably lead to a devastating balance of payments crisis, particularly, as Sri Lanka is now more exposed to international capital markets and the assessment of its economy by rating agencies. Net & Gross Foreign Reserves In assessing the health of the countrys external account, it is important to differentiate between net and gross foreign reserves. Evidence is emerging that there has been some loss even in gross reserves in recent weeks. In addition, the net reserves position continues to be a matter of concern. It is important to recognize that it is not possible to borrow ones way out of the current predicament. Recourse to borrowing (by the Government or Banks) can only postpone for a short time the inevitability of serious balance of payment pressure. A sustainable external account can only be achieved by effective stabilization measures that are supported by reforms that strengthen the growth framework of the economy (see Economic Alert 27).

IMF: Looking beyond SBA In the prevailing uncertain global and domestic environments, it is reassuring that the Senior Minister of the International Monetary Cooperation has indicated that the authorities are considering a follow-on arrangement to the current IMF Stand-by Agreement. The IMF team currently in the country is in the process of undertaking an assessment in relation to the release of the final tranche ($500 million) of the existing Stand-by. The negotiation of a successor to the current arrangement assumes greater significance now that Sri Lanka is exposed to the whims and fancies of international capital markets which have become extremely risk averse in the current global environment. At present, foreign holdings of short-term Treasury instruments exceed $3 billion. In addition, the government has issued Eurobonds worth $3 billion, of which $500 million needs to be rolled over later this year. The upshot is that over $3.5 billion of foreign holdings of treasury instruments needs to be rolled-over, during the next 6 months. Priority would need to be attached, therefore, to maintaining foreign investor confidence.

Vulnerabilities and safeguards In the same vein, it is also instructive to examine the performance of Foreign Direct Investment (FDI). Such flows amounted to $220 million in 1Q2012. On a pro rata basis, this falls

considerably below the level required to attain the $2 billion target set out by the authorities. It also falls short of the investment path required to meet last years FDI figure of $1 billion. One may conclude that it is currently a major challenge to maintain investor confidence in the Sri Lankan economy. The risk appetite in international markets is low and the risks associated with the domestic economy are high. Such a conjuncture of events places an extremely high premium on maintaining investor confidence. In this connection, it would be in the countrys interest to maintain an arrangement with the IMF to provide comfort to investors in these difficult times. A lack of such an arrangement would make Sri Lanka vulnerable not only in terms of accessing additional resources but there may well be difficulty in preventing the flight from short-term Treasury instruments (it is worth asking the question whether the recent Bank of Ceylon $500 million bond issue would have been as successful without an IMF arrangement being in place). The consequences would be severe for the people of the country.

Good politics: Pragmatism not dogma In assessing the merits of an IMF agreement, it is important to be pragmatic and avoid dogma and ideology or allow manipulative and rent seeking behavior to set the agenda. It is also important to recognize that the character of the IMF is evolving as the G20 supersedes the G8 as the premier forum for international economic decision-making. Large emerging counties like Brazil, China and India are having an increasing voice in running the institution. It is noteworthy that China decided to channel its support for Europe through the IMF. One should also remember that the IMF agreed to release the Stand-by financing in 2009, despite opposition from some major countries, due to the positive intervention of India. Even if the authorities determine that additional borrowing from the IMF is not required (even if the costs would be less than half that demanded by international capital markets) it is possible to have a IMF Board or Staff monitored arrangement which would provide comfort to investors, while not adding to Sri Lankas external liabilities

Economy - overview Sri Lanka continues to experience strong economic growth, driven by large-scale reconstruction and development projects following the end of the 26-year conflict with the LTTE. Sri Lanka is pursuing a combination of government directed policies, private investment, both foreign and domestic, to spur growth in disadvantaged areas, develop small and medium enterprises, and increase agricultural productivity. The government struggles with high debt interest payments, a bloated civil service, and historically high budget deficits. However recent reforms to the tax code have resulted in higher revenue and lower budget deficits in recent years. The 2008-09 global financial crisis and recession exposed Sri Lanka's economic vulnerabilities and nearly caused a balance of payments crisis. Growth slowed to 3.5% in 2009. Economic activity rebounded strongly with the end of the war and an IMF agreement, resulting in two straight years of high growth in 2010 and 2011. Per capita income of $5,600 on a purchasing power parity basis is among the highest in the region. GDP (purchasing power parity) $116.2 billion (2011 est.) $107.6 billion (2010 est.) $99.55 billion (2009 est.) note: data are in 2011 US dollars GDP (official exchange rate) $58.8 billion (2011 est.) GDP - real growth rate 8% (2011 est.) 8% (2010 est.) 3.5% (2009 est.) GDP - per capita (PPP) $5,600 (2011 est.) $5,300 (2010 est.) $4,900 (2009 est.) note: data are in 2011 US dollars

GDP - composition by sector agriculture: 13% industry: 29.6% services: 57.4% (2011 est.) Population below poverty line 8.9% (2009 est.) Labor force 8.307 million (2011 est.) Labor force - by occupation agriculture: 32.7% industry: 24.2% services: 43.1% (December 2010 est.) Unemployment rate 4.2% (2011 est.) 4.9% (2010 est.) Unemployment, youth ages 15-24 total: 21.3% male: 17.1% female: 27.9% (2009) Household income or consumption by percentage share lowest 10%: 1.7% highest 10%: 36.8% (2009) Distribution of family income - Gini index 49 (2009) 46 (1995)

Investment (gross fixed) 27.3% of GDP (2011 est.) Budget revenues: $8.495 billion expenditures: $12.63 billion (2011 est.) Taxes and other revenues 14.2% of GDP (2011 est.) Budget surplus (+) or deficit (-) -7.3% of GDP (2011 est.) Public debt 78.5% of GDP (2011 est.) 81.9% of GDP (2010 est.) note: covers central government debt, and excludes debt instruments directly owned by government entities other than the treasury (e.g. commercial bank borrowings of a government corporation); the data includes treasury debt held by foreign entities as well as intragovernmental debt; intra-governmental debt consists of treasury borrowings from surpluses in the social funds, such as for retirement; sub-national entities are usually not permitted to sell debt instruments Inflation rate (consumer prices) 6.9% (2011 est.) 5.9% (2010 est.) Central bank discount rate 7% (31 December 2011 est.) 7.25% (31 December 2010) Commercial bank prime lending rate 10.77% (31 December 2011 est.) 9.29% (31 December 2010 est.)

Stock of money $2.462 billion (31 December 2008) $2.465 billion (31 December 2007) Stock of narrow money $4.136 billion (31 December 2011 est.) $3.579 billion (31 December 2010 est.) Stock of quasi money $11.01 billion (31 December 2008) $10.46 billion (31 December 2007) Stock of broad money $22.52 billion (31 December 2011 est.) $19.72 billion (31 December 2010 est.) Stock of domestic credit $25.67 billion (30 November 2011 est.) $20.39 billion (31 December 2010 est.) Market value of publicly traded shares $19.48 billion (31 December 2011) $19.92 billion (31 December 2010) $9.55 billion (31 December 2009) Agriculture - products rice, sugarcane, grains, pulses, oilseed, spices, vegetables, fruit, tea, rubber, coconuts; milk, eggs, hides, beef; fish Industries processing of rubber, tea, coconuts, tobacco and other agricultural commodities; telecommunications, insurance, banking; tourism, shipping; clothing, textiles; cement, petroleum refining, information technology services, construction

Industrial production growth rate 10.1% (2011 est.) Electricity - production 10.71 billion kWh (2010 est.) Electricity - production by source fossil fuel: 51.7% hydro: 48.3% nuclear: 0% other: 0% (2001) Electricity - consumption 9.268 billion kWh (2010 est.) Electricity - exports 0 kWh (2009 est.) Electricity - imports 0 kWh (2009 est.) Oil - production 636.5 bbl/day (2010 est.) Oil - consumption 92,000 bbl/day (2010 est.) Oil - exports 0 bbl/day (2009 est.) Oil - imports 84,730 bbl/day (2009 est.)

Oil - proved reserves 0 bbl (1 January 2011 est.) Natural gas - production 0 cu m (2009 est.) Natural gas - consumption 0 cu m (2009 est.) Natural gas - exports 0 cu m (2009 est.) Natural gas - proved reserves 0 cu m (1 January 2011 est.) Current Account Balance -$4 billion (2011 est.) -$1.418 billion (2010 est.) Exports $10.89 billion (2011 est.) $8.307 billion (2010 est.) Exports - commodities textiles and apparel, tea and spices; rubber manufactures; precious stones; coconut products, fish Exports - partners US 19.6%, UK 10.4%, Italy 5.1%, India 4.9%, Germany 4.9%, Belgium 4.1% (2009) Imports $20.02 billion (2011 est.) $13.45 billion (2010 est.)

Imports - commodities petroleum, textiles, machinery and transportation equipment, building materials, mineral products, foodstuffs Imports - partners India 19.4%, China 15.1%, Singapore 9.1%, Iran 7%, Japan 4.9% (2009) Reserves of foreign exchange and gold $8.4 billion (31 December 2011 est.) $7.197 billion (31 December 2010 est.) Debt - external $21.74 billion (31 December 2011 est.) $21.43 billion (31 December 2010 est.) Stock of direct foreign investment - at home $NA Stock of direct foreign investment - abroad $NA Exchange rates Sri Lankan rupees (LKR) per US dollar 112 (2011 est.) 113.06 (2010 est.) 114.95 (2009) 108.33 (2008) 110.78 (2007)