The sovereign default announced by Sri Lanka on 12 April 2022, was the cumulative result of fiscal folly over many years. This writer has attempted to uncover the root causes of our ‘sovereign predicament’ in a series of interviews with international media between January and July 2022; a curated version of which could be accessed online1.
Two in-depth studies by this writer published in 20162 and 20173 prognosticated what was clearly a looming disaster. These were published in academic journals in 2016 and 2017, they were orally presented at the Inaugural Nagalingam Balakrishnan Memorial Lecture4 in Colombo on 21 June 2014, and at an international conference organised by the Centre for Poverty Analysis5 (CEPA) in Colombo from 1 to 3 September 2014, respectively.
The purpose of this essay is to highlight the specific blunders by successive Governors of the Central Bank of Sri Lanka and members of the Monetary Board since 2006 that has led to the current crisis, and hold them accountable for their actions and/or inactions over a period of 16 years (July 2006-April 2022). Authority and power come with accountability and responsibility.
A couple of retired senior Central Bank staff (retired Deputy Governor of CBSL Dr. W.A. Wijewardena6, and retired Director of Statistics at CBSL Dr. S.S. Colombage7), independent Economists, and many other professionals (for example, Sanjeewa Jayaweera8) have repeatedly and publicly forewarned the Central Bank and the Treasury of Sri Lanka about their risky and wrongful policies since 2006 (if not before). Yet, successive Governors and Monetary Boards have not heeded saner counsel.
This study offers citations/references that amply demonstrate where the fault lines were and who was directly or indirectly responsible for patently risky and wrong policy decisions.
Global best practices in central banking in brief
The independence of the Central Bank is a foundational imperative in an open market-led economic/monetary system. As a corollary, there must be a strict separation of powers between the Treasury/Ministry of Finance and the Central Bank of a country. This demarcation is as important as the insulation of the judiciary from the executive and the legislature.
Countdown to sovereign bankruptcy in Sri Lanka
The very first breach of the independence of the Central Bank and its autonomy viz the Treasury occurred in the late-1990s when Sri Lanka graduated in to the lower middle-income country in 1997 and thereby gained access to borrowings in the private international capital markets. The Secretary to the Treasury was made an ex-officio member of the Monetary Board of the CBSL by the then President of Sri Lanka Chandrika Kumaratunga. A.S. Jayawardane was the then Governor of the Central Bank of Sri Lanka.
Although Sri Lanka was eligible to borrow from the private international capital markets in 1997, the very first such borrowing was in 2007 through the issuance of an International Sovereign Bond (ISB) to the value of $ 500 million. The then Opposition Leader and current President of Sri Lanka, Ranil Wickremesinghe9, wrote to the joint lead managers of the debut float (Barclays Capital, HSBC, & J.P. Morgan) in 2007 that a future government of his would dishonour repayment of the same.
After the election of Mahinda Rajapaksa as President in November 2005, Ajith Nivard Cabraal was appointed as the Governor of the Central Bank in July 2006. It has been the practice to appoint the senior-most Assistant/Deputy Governor to the post of Governor of the Central Bank since its inception in 1950 until President Premadasa appointed Dissanayaka as the Governor in 1992. Dissanayaka was a civil servant in the Ceylon Administrative Service (and its successor Sri Lanka Administrative Service) and was a Deputy Secretary to the Treasury prior to his appointment as the Governor of the Central Bank in 1992.
For the first time in the history of the CBSL a versatile book keeper assumed the role of Governor of the Central Bank in 2006. This appointment of a person who had scant regard for demonstrated and proven principles of central banking put the integrity of the Central Bank in peril.
The decline of the technical competence and integrity of this premier institution was apparent to all but the ruling crony class.
This writer learnt that there were deliberate actions taken by the newly appointed Governor to weaken the technical competence and integrity of the Central Bank by way of side-lining senior competent professional staff such as the then Head of Economic Research, Dr. H.N. Thenuwara, and the then Head of Statistics, Dr. Anila Dias Bandaranaike, among others. Such arbitrary, irrational acts of the new Governor resulted in the premature retirement/departure of Dr. H.N. Thenuwara, Dr. Anila Dias Bandaranaike, Rose Cooray, and the like from the Central Bank. Governor Cabraal wanted a compliant and subservient staff and a pliant Monetary Board as opposed to technically competent and upright senior staff with professional and personal integrity.
The year 2006 marked the beginning of severe politicisation of the CBSL never seen before in the history of the Central Bank since its establishment in 1950. It was not just the beginning of the politicisation of the Central Bank, it was also the beginning of the politicisation of the entire banking and financial sector including the private banks. The modus operandi of such politicisation was as follows. The CBSL under Cabraal utilised the EPF/ETF funds to purchase shares in the two largest private commercial banks. Commercial Bank of Ceylon (Com Bank) and the Hatton National Bank (HNB), and thereby secured memberships in the Board of Directors of such banks to park the retiring senior Central Bank officials such as Assistant/Deputy Governors. For example, Dr. Ranee Jayamaha (former Deputy Governor of CBSL) was appointed to the Board of Directors of the Hatton National Bank, and Dheerasinghe (former Deputy Governor of CBSL) was appointed to the Board of Directors of the Commercial Bank of Ceylon after their respective retirement from the CBSL. The foregoing appointments could have caused conflicts of interest (if not illegal). The justices of courts of law are barred from practicing law after retirement in order to prevent conflict of interest during their tenure as judges. In a similar vein, senior executive staff of a Central Bank should also be barred from working in the financial sector post retirement.
The aforementioned appointments in the largest private commercial banks were made to influence/encourage those banks to borrow foreign exchange from private international capital markets to lend to the Government for its ambitious prestige infrastructure projects, inter alia, for what former Central Bank Governor W.D. Lakshman called the “developmental state”. (See the justification for such politicisation of the entire banking and financial sector by Dr. Weligamage Don Lakshman, one of the successors to Governor Ajith Cabraal (July 2006-January 2015) and the predecessor to Governor Ajith Cabraal (October 2021-April 2022), in 2020. Lakshman, 202010
Similarly, the CBSL under Ajith Cabraal directed state-owned commercial banks such as the People’s Bank and the Bank of Ceylon (BoC), and the state-owned specialised bank, National Savings Bank (NSB), to borrow foreign exchange from private international capital markets to lend to the Government for its ambitious prestige infrastructure projects as well as to fund capital expenditures of the state-owned public utilities such as the Ceylon Electricity Board (CEB) and the National Water Supply and Drainage Board (NWSDB), a state-owned enterprise such as the SriLankan Airlines, and crude oil purchases of the state-owned Ceylon Petroleum Corporation (CPC). (See, Sarvananthan, 201411, for example)
Such Central Bank-directed external borrowings by state-owned banks, private commercial banks, and state-owned utilities/enterprises between 2006 and 2014, inter alia, have undermined the overall financial sector stability, increased the precarity/vulnerability of such semi-government and private financial enterprises, and contributed to the overall volatility of the external public debt portfolio of the country by way of underestimating the real total external liabilities of the Government.
Policy milieu of the CBSL during 2006-2022
The Government’s direct borrowings through the issuance of International Sovereign Bonds (ISBs) and indirect borrowings through state-owned banks (such as syndicated loans) and utilities/enterprises (with and without government guarantee) currently account for over 50% of the total external debt of Sri Lanka. The borrowings by the state-owned banks and utilities/enterprises on explicit government guarantee are called “contingent liabilities”12 of the government in fiscal parlance.
The ISBs bear the highest interest rates (between 5% and 9% in the international borrowings of Sri Lanka (see, for example, CBSL, 201213) among all the available external borrowing mechanisms (bilateral, multilateral, and private international capital market borrowings) to any country. Moreover, the repayments of ISBs are relatively short-term (5-10 years) without any grace period for the commencement of repayments. However, one advantage of ISBs is that borrower has to pay only the interest payment annually, and the entire capital is repayable only at maturity, which gives some breathing space for the borrower.
Between 2007 and 2019, borrowings in the private international capital markets were the primary mode of external borrowings for successive governments of Sri Lanka, in which borrowings do not require justification or do not come with strings attached (conditional upon economic policy reforms or political governance reforms).
Ironically, certain press releases of the CBSL during 2007-2008 explicitly acknowledged that the proceeds of the ISBs were not only utilised to pay for certain infrastructure projects (such as the Hambantota port and southern highway) but also to retire some of the then-existing domestic debt that bore very high-interest rates (between 15% and 20% or higher) (see a series of articles by this author in Montage14 (current affairs magazine) edited by Frederica Janz at that time for criticisms of such external borrowings of the government/CBSL (unfortunately, we could not access the press releases of the CBSL before 2012 on their website now).
In order to lessen the burden of short-term repayments of the ISBs, inter alia, successive Governors of the Central Bank have artificially kept the exchange rates quite stable thereby artificially overvaluing the domestic currency, the Sri Lankan rupee (LKR). This was the key policy blunder that led to the eventual sovereign default of the country in April-May 2022. The Central Bank’s frequent interventions in the foreign exchange market to prop up the rupee also contributed to heightened imports of consumption goods (including luxury motor vehicles, for example), especially during the period 2010-2019.
By keeping the value of the rupee artificially high by fixing the exchange rate/s for prolonged periods of time (years, not weeks or months) through frequent interventions in the foreign exchange market by the Central Bank, Sri Lanka’s exports were artificially overvalued (thereby undermining global competitiveness) in dollar terms, and earnings from tourism were suppressed. These were on top of the loss of the GSP+ facility for exports of goods and services to the European Union (EU) in the early 2010s. However, the GSP facility for Sri Lanka was restored in 2017 but is currently once again under intense review by the EU for the past couple of years.
The severe negative impact of the managed floating exchange rate system practiced by the CBSL (as opposed to free float) is reflected in the fact that the exports of goods and services as a percentage of the GDP in Sri Lanka, in US dollar terms, that was 39% in 2000 and 32% in 2005 fell to mere 17% in 2021 (second lowest since 1960 after just 15% in 2020 due to the pandemic)15.
Were the forgoing of exports and tourism earnings for white-elephant infrastructure projects and retiring of domestic debt rational and prudent management of the external finances of a country? To the best of the knowledge of this author, no sane government in any country would dare to borrow externally in the private international capital markets to retire its domestic debt in spite of the fact that domestic debt directly contributes to inflation.
In addition to the folly of wanton borrowings through ISBs, the then Central Bank Governor Cabraal, and the then members of the Monetary Board (all political appointees) were singularly responsible for the losses incurred on hedging for crude oil imports16 and investments in ill-fated Greek Bonds17. The then Governor and the members of the Monetary Board have never been made accountable, to date, for such losses to the country. These past impunities have contributed to continued irrational and imprudent policy decisions of the Monetary Board (all political appointees), the chairperson of which is the Governor, that eventually resulted in the sovereign default in April-May 2022.
By the time the Rajapaksa regime lost power in January 2015, Sri Lanka’s external debt position had already become precarious. The person who replaced Cabraal as the Governor of the CBSL in early 2015, Arjuna Mahendran, was once again from the international private sector though much more educated than Cabraal. However, Arjuna Mahendran also lacked professional and personal integrity like Cabraal, which resulted in the Central Bank of Sri Lanka bond scandal18. Arjuna Mahendran was removed from office in 2016 by the then President, Maithripala Sirisena, and replaced by Dr. Indrajit Coomaraswamy on 2 July 2016. Dr. Coomaraswamy possessed both educational qualifications and professional cum personal integrity to be the Governor of the Central Bank.
Whatever external borrowings made by the Government between 2015 and 2019 were almost entirely to make repayments of the external borrowings, especially ISBs, made during the period 2007 and 2014. The new President elected in November 2019 appointed “Emeritus Professor” W.D. Lakshman as the 15th Governor of the Central Bank effective from 24 December 2019. In spite of being a former “Professor of Economics” at the University of Colombo, Dr. Lakshman lacked the necessary exposure to the complex world of global commerce and the finer intricacies of international finance.
Dr. Lakshman was an ideologue of a forgotten era. He was a lifelong critic of international financial institutions such as the IMF. Unsuitable to head the Central Bank of an emerging lower-middle-income open economy. Dr. Lakshman was the third worst Governor, after Ajith Nivard Cabraal and Arjuna Mahendran, the Central Bank of Ceylon/Sri Lanka has had in its entire history, though the former is professionally an honest person as opposed to the latter two. Dr. Lakshman’s lifelong pathological aversion to the International Monetary Fund (IMF) played a critical role in Sri Lanka’s procrastination to seek an IMF bailout.
By the time Dr. Lakshman was appointed the Governor in the closing days of 2019, Sri Lanka was shut out of the private international capital markets because of the repeated negative reports about the precarity of Sri Lanka’s sovereign bonds by global credit rating agencies such as the Fitch Group, Moody’s, and Standard & Poor (S&P) Global Ratings. Therefore, since the beginning of 2020, the CBSL was forced to borrow only locally in addition to several ad-hoc short-term currency swaps with Bangladesh, China, and India, a few bilateral credit lines from China and India, and one-off loans from Japan and South Korea.
Money printing and Modern Monetary Theory (MMT)
Ironically, whereas a Central Bank’s role is to be a lender of ‘last resort’ to the government, under the governorship of Dr. Lakshman the CBSL became the lender of ‘first resort’ to the government by buying unprecedented levels of government securities, which literally meant printing money.
While the dogmatic/theoretical inspiration for printing unlimited money is drawn from the fallacious Modern Monetary Theory (MMT), the practical lessons Dr. Lakshman19 cites are from Japan and the Newly Industrialised Countries (NICs) such as South Korea and Taiwan in the aftermath of the World War II, which he dub as “developmental states”.
Dr. Lakshman, during his academic days, has publicly accepted corruption as a necessary evil during any country’s early stages of “take-off”, citing rampant corruption in Korea and Taiwan during their take-off period. I remember him juxtaposing corruption and successful developmental states as a classic chicken and egg conundrum at a public seminar held at the Dr. N.M. Perera Centre in Colombo several years ago, in which this author was a co-panellist.
It is true that Japan, Korea, and Taiwan were developmental states (as opposed to market-driven states) during the early stages of their “take-off”. However, the global political and economic context during the immediate and medium-term post-World War II (i.e. 1950s, 1960s, & 1970s) period wherein victorious western powers regarded the aforesaid countries as bulwarks against communism raging throughout East and South East Asia did play a pivotal role for the resurgence of Japan as an economic powerhouse and the emergence of the so-called tiger economies (ala Korea and Taiwan).
Hence, just because Korea and Taiwan were “developmental states”, Sri Lanka, for example, cannot emulate those “economic miracles”, through a developmental state. This author would argue that third world countries like Sri Lanka need what Prof. Rainer Kattel, et al, calls “entrepreneurial state”20.
Two underlying cardinal principles of MMT are that as long as the public debt is denominated in domestic currency, a government need not worry about unlimited domestic borrowings because domestic currency could always be printed thereby avoiding a public debt default (i.e. states have “monetary sovereignty”), and that unlimited money printing ‘does not’ cause inflation! Both are fallacious according to mainstream economic science in general, and monetary theory in particular. (See, for example, Coats, 201921; Drumetz and Pfister, 202122; Hartley, 202223; Palley, 202024; Prinz and Beck, 202125)
In his oration to mark the 70th anniversary of the establishment of the Central Bank of Ceylon/Sri Lanka on 28 August 2020, Governor W.D. Lakshman promotes the idea of developmental central banking, deviating from the core functions/objectives laid out in the Monetary Law Act of 1949 and amendments thereof made in 2002. Implicit in his 70th anniversary oration was the justification for unlimited printing of money. Dr. Lakshman has been strenuously denying publicly that the printing of money causes inflation. One of Dr. Lakshman’s former students at the University of Peradeniya and later a lecturer in political economy in the same university (long retired), Sumanasiri Liyanage26, has publicly supported the printing of money by the Central Bank in January 2021.
Ajith Cabraal27, who once again functioned as the Governor of the CBSL between October 2021 and April 2022, propagated the myth in April 2021 that money printing does not cause inflation parroting the then Governor Lakshman. During the previous stint of Governor Cabral (at the CBSL) between 2006 and 2014, Dr. Lakshman was an “Adviser” at the Ministry of Finance. Cabraal had a history of shouting/shooting down negative reports by international credit rating agencies28 on Sri Lanka’s creditworthiness since 2006 to date.
The over-stock of money in the market (as a result of money printing by the central banks worldwide), in the absence of a commensurate rise in production (primarily due to lack of demand), depreciates the domestic currencies resulting in hyper-inflation29 (including food inflation). In Sri Lanka, in the 21-month period between 1 January 2020, and 30 September 2021 (during Governor Lakshman’s tenure), due to excessive money printing30 by the Central Bank, the stock of money rose by 38% (i.e. by Rs. 2.9 trillion) whilst the GDP grew only by just 1%. This has caused inflation to rise to over 11%, and food inflation rose to over 18% in November 2021.
These have seen steady rises ever since; resulting in the overall inflation, in terms of Sri Lanka Consumer Price Index (SLCPI), at its peak 74% in September 2022, and the food inflation at its peak 86% in September 2022. During the last quarter of 2022, however, both the overall inflation as well as the food inflation have begun to decelerate.
Both Cabraal and Lakshman have unrepentantly deviated from the holy grail of central banking31, i.e. policy-making in the interest of the “public” as opposed to policy-making in the interest of the government in power or the politicians.
The poor performance of Dr. Lakshman as Governor of the Central Bank is emblematic of poor standard of economic professors in Sri Lanka in particular, and poor pedigree and pedagogical practices of Sri Lankan academics in general. The tertiary level economic curriculum in Sri Lanka requires urgent and substantial revision and upgrading from outdated and irrelevant contents.
Theories of physical sciences are not subject to political or social circumstances, contexts, situations, or territories; that is, the outcomes of physical sciences theories are universal. In contrast, the outcomes of macroeconomic policies/theories vary according to the political and social circumstances, contexts, situations, and territories. Thus, right macroeconomic policies should be adopted taking into consideration of the individual political and social circumstances, contexts, situations, and territories. Just because advanced industrial countries were printing unlimited money for prolonged periods during the pandemic, any developing country cannot afford to print unlimited money for an indefinite period of time to revive its pandemic-affected economy.
Lessons to be learned from sovereign bankruptcy in Sri Lanka
It is high-time the proposed new Monetary Law Act (MLA) in Sri Lanka explicitly and clearly define the qualifications and experiences required for the post of Governor of the Central Bank, members of the Monetary Board, and the members of the Stakeholder Engagement Committee (SEC). The SEC was established in July 2022 amalgamating the former Monetary Policy Consultative Committee (MPCC) and the Financial System Stability Consultative Committee (FSSCC). Moreover, the post of Governor and memberships in the Monetary Board and the Stakeholder Engagement Committee should be openly advertised and recruited and ‘not’ arbitrarily appointed by the President and/or the Governor (in the case of appointments to the Monetary Board & SEC).
While the independence of the Central Bank is sine qua non, there should be necessary checks and balances to prevent abuse of power, corruption, nepotism, and the like in the Central Bank of Sri Lanka in recruitment of staff, consultants, etc., and transparency in the policy-making and decision-making processes. Moreover, Central Bank’s frequent paternalistic diktats to the commercial and specialised banks (including to the private ones, let alone the state-owned banks) and unnecessary interferences in the financial sector in general (under the euphemism of “moral suasion”32) should be tamed (if not done away with) in the proposed new Monetary Law Act (MLA). Every single public authority (e.g., Central Bank Governor, Treasury Secretary, Monetary Board) in Sri Lanka should be made accountable and responsible not only to the parliament, government, and the executive in power, but more so to the general public as well.
Sri Lanka cannot emerge out the current economic quagmire without broader financial sector reforms such as divestiture of the state-owned commercial banks (People’s Bank and Bank of Ceylon) and specialised banks (National Savings Bank) which function as captive sources for funding public debt (both domestic and external) as well as funding perennially loss-making state-owned utilities (Ceylon Electricity Board (CEB), Ceylon Petroleum Corporation (CPC), National Water Supply and Drainage Board (NWSDB)) and enterprises (SriLankan Airlines, Sri Lanka Railways, Sri Lanka Transport Board, Road Development Authority, etc.).
According to a report of the Committee on Public Enterprises (COPE) of the parliament of Sri Lanka, state-owned banks (i.e. Bank of Ceylon and People’s Bank) have complained that they have been repeatedly ordered by the Central Bank to fund the CPC and CEB during 2020-2022. Moreover, in the investigations into the Central Bank of Sri Lanka bond scam of 2015, it was revealed how the CBSL coerced the People’s Bank to back off from bidding. The forensic audit report of the CBSL in the aftermath of the bond scam of 2015 is yet to be made public. This kind of non-transparency cannot assuage the domestic markets or potential foreign investors.
The state-owned banks have also become primary lenders to unscrupulous politicians from all political parties, especially members of parliament and deputy/ministers, who are involved in variety of businesses such as owning liquor shops and fuel stations throughout the country, and involved in construction projects (public works) for public and quasi-public authorities.
We understand that one of the conditions the IMF has put forward for its proposed bailout of Sri Lanka is enaction of a strong anticorruption legislation in parliament. This is just a cosmetic exercise. There are enough laws in Sri Lanka already to arrest corruption; what is lacking is the political and/or administrative WILL to enforce such laws or the law/s are applied only selectively to penalise the political opposition.
In addition to any new legislation, the IMF should insist that an international forensic audit of the personal finances (bank accounts, movable and immovable property, income tax filings, etc.) of each and every member of parliament (including both government and opposition) and their extended family members, and each and every public servant (especially executive grade) (including armed forces personnel) and their extended family members should be carried out and appropriate legal actions taken if their wealth and income cannot be accounted for or justified.
Even today, under a new Governor and management, some of the actions of the Central Bank of Sri Lanka smack of duplicity and double standards in law enforcement as reflected in the recent permanent “revocation” of the license of the Prasanna_Money_Exchange_Pvt_Ltd33 and merely a temporary “extension of the suspension” of the trading of Perpetual Treasuries Limited34, which was the executor of the Central Bank bond scam of 2015. It is important to note here that the Perpetual Treasuries is owned by the son-in-law of the then (2015) Governor of the Central Bank, Arjuna Mahendran.
If Angola35, where the Supreme Court in December 2022 ordered the seizure of $ 1 billion worth of assets of the daughter of the former President and freedom fighter Jose Eduardo dos Santos, and Mozambique36, where the Maputo City Court in November 2022 found a son of the former President and 18 other “high profile defendents” guilty of $ 2 billion illicit foreign loan with government guarantee that bankrupted the country could do it, why not Sri Lanka?
Although, in principle, we welcome the public appeal by 182 Economists worldwide37 on 8 January 2023, urging the hedge fund holders of International Sovereign Bonds (ISBs) of Sri Lanka in particular, and of all the third world countries in default in general, to cancel such debt, in practice any such debt cancellation initiative should be conditional upon barring all those politicians, bureaucrats, and professionals who were responsible for the sovereign default (by their actions or inactions) and who were directly or indirectly involved in the Central Bank bond scam and other mega corruption from holding any public office hereafter. If not, any unconditional and unilateral debt cancellations would become a moral hazard for countries such as Sri Lanka.