Fixing the Foreign Currency Front in Corona-hit Economies - Science against Myth
Structural Problem in Economics
The new global economic order has led developing countries to depend on imports for all activities of the economy as imports provide inputs for export industries as well as domestic economic activities in addition to the supply of many essential food items. As a result, many countries are compelled to manage with wide deficits on global trade financed by foreign debt/investments attracted through specific policies. As these investments comprise private funds in developed countries, they come on a short-term trade basis looking for quick portfolio gains, given the global competition and geopolitical risks underlying these funds.
Therefore, servicing of foreign debt/investments (interest, profit, repayment, etc.) has become the major burden on the economy through its balance of payment (BOP) where such servicing has become a roll-over basis. Given the red tapes involved in private sector dealings in foreign investments, government borrowing has become the dominant source of BOP financing and foreign reserves. Therefore, almost all currency tensions and crises are risks arising from this foreign servicing profile.
Macroeconomic Dependence on Foreign Currency
The direct dependence is very clear in funding the BOP deficit. However, indirect dependence of a country’s financial conditions is evident in the central bank balance sheet and inter-bank market liquidity. First, due to foreign reserve operations, the balance sheet of the central banks is 70-80% on foreign currency. As a result, money printing is directly connected to the changes in the foreign reserve.
Second, foreign currency flows directly affect the market liquidity, i.e., inflows raise the liquidity and outflows shrink it. As a result, the domestic currency market has got roots in the monetary policies of the US and Europe to which such foreign investment flows are linked. Therefore, central banks have lost monetary policies required for mobilization of domestic productive resources and operate still as de-facto Currency Boards.
Structural Problem of the Government
The global economic front of many countries since the 1980s has been the liberalization of trade of goods and services whereas capital trade has been largely controlled. Foreign investments into the stock market and government securities markets and private foreign borrowing have been permitted only under specific schemes subject to limits and close scrutiny. Therefore, private foreign investment inflow has not been sufficient and stable to finance the protracted BOP deficits. In this background, the exchange rate has to depreciate to clear the deficit over time.
However, the policy routine has been to suppress the exchange rate depreciation (Over-valued exchange rate) to prevent the cost-pushed inflation on higher costs of imports and the increase in domestic currency cost of government foreign debt service. Such exchange rate control requires the supply of foreign exchange to the market from the foreign reserve of the central bank.
Given the structural BOP deficits and excessive control of private capital flows, the maintenance of the foreign reserve to control the exchange rate at discretionary levels requires mobilization of foreign funds through official/government sources because the central bank does not seem to resort to monetary policy measures (Monetary Law Act and Foreign Exchange Act in Sri Lanka) for this purpose.
Therefore, the government acts to finance the BOP deficit of the private sector through the sovereign balance sheet although the exchange rate and reserve management are the statutory duties of central banks. This is the reason why BOP has been the structural problem confronted by the fiscal policy/national budget.
Official Funding Sources/Instruments
As central banks are the bankers and debt managers of the government, they resort to raise foreign borrowing for the government in order to fund their foreign reserve where central banks buy these proceeds and provide domestic currency to governments (printing money). International Sovereign Bonds (ISBs), Currency Swaps and IMF facilities have become routine sources with ambitious targets of the foreign reserve. In the past, the sale of state assets to foreign investors was also pursued, but national issues have suppressed this source at present.
ISBs have become a global routine to source foreign funds to governments through investment banking network in global financial markets. Such debt is raised in the guise of foreign borrowing to fund the public investments while their proceeds are bought by central banks for their foreign reserve. This new strategy has caused bilateral debt such as project loans to be gradually phased out.
Currency swaps arranged through private negotiations and dialogues have become the popular type of quick borrowing to fill the foreign reserve as and when needed. Although currency swaps are meant to be an exchange of two currencies with an agreement to reverse the exchange at an agreed future date, these swaps are operated mainly in two types. The first type is a short-term loan raised from a foreign bank at a specific interest rate, generally up to one year. Second is the purchase of foreign exchange with an agreement to sell it back on an agreed future date at the exchange rate agreed. This is similar to foreign exchange reverse repos which control the exchange risk of the foreign currency seller.
These currency swaps are arranged with local banks with the side objective of facilitating investments in government securities as a part of the promotion of foreign investments. In some instances, local banks are specifically permitted to borrow abroad beyond normal limits and channel the proceeds to these currency swaps. There are financially engineered currency swap products with unknown risks (for example, recent allegations in Lebanese Central Bank that has caused a forensic audit by labeling the Governor as a criminal).
The IMF comes as the lender of last resort in the function of BOP function and the foreign reserve in terms of the global financial protection system. IMF loans are medium-term conditional facilities that help countries to boost investor confidence. These conditions comprise of a package of economic policy reform to be implemented during the loan period in line with Western market economic principles.
Exchange rate flexibility, control of the budget deficit, enhancement of tax revenue, commercialization of state enterprises and foreign reserve targets based on purchase of foreign exchange from the market on real economic trades are major conditions. Loans are released on installments basis upon the assessment of conditions and added to the foreign reserve of the country.
Above sources have created a debt-reserve-spiral that policy authorities seek to rollover them to service existing debt. Therefore, such rollovers have become the corner stone of the macroeconomic management in many countries as the current account of the BOP struggles in deficits with inefficient volatile capital flows.
Quality of Foreign Reserve - Meaningless
In this background, some talks about the need to improve the quality of the foreign reserve. The foreign reserve has two sides, i.e., the source side (foreign liabilities) that comprises funding sources and the use side (foreign assets) that comprises investments of the foreign reserve in assets until funds are required. Therefore, the quality involves in managing risks on both sides. However, the mostly referred to quality is the volatile and short-term nature of sources of the foreign reserve. The reserve quality is regarded as high if it is built up through the BOP current account surplus and long-term foreign investment.
However, many countries never had such quality and cannot expect it any time in the future. The use side quality is not known as details of reserve assets including losses are not regularly disclosed. In the present context of the BOP and macroeconomic difficulties, what matters is the availability of any form of reserve at any cost to prevent default on foreign payments and, therefore, looking for the quality reserve is nothing but a myth.
Difficult Fix
Above fact-finding shows that foreign currency regulatory framework that funds the private BOP deficit through the sovereign balance sheet and budget is the cause of structural problem in many countries. Keeping economies open to global trade with a largely controlled capital account, non-compliance of central banks with their mandates of foreign reserve and exchange rate management and policy framework that has failed to sustain a manageable current account position in the BOP have been the key underlying culprits. As this has been a model of macroeconomic story in the past 2-3 decades, no easy fix is possible, given the historic shock of present Corona pandemic that has disrupted the global economy.
Therefore, policy motivations such as control of imports and foreign exchange, leaving out the global financial system to fund the economy, orientation to living in domestic economy and resorting to ad-hoc/non-transparent currency swap-based-foreign funds or cash exchanges are not helpful for fixing the above culprits, irrespective of rosy stories and numbers cited.
It is never late to start fixing the above culprits with serious worries as actual default on foreign payments is possible in not long future as experienced by many countries, given the current geopolitical risks on both local and global fronts. Instead, brave stories on the success of the macroeconomic management by citing the control of currency depreciation in the present manner of ad-hock arrangements is nothing but a myth.
The required fix is neither economic theory nor rocket science. What is required is to understand the root causes and resolve them. In that context, key policymaking grounds can be highlighted as follows.
- Separation of the BOP between the government and private sector,
- Letting the private sector to manage their currency flows with own risks largely through foreign sources,
- The government managing a separate foreign currency budget and balance sheet for fiscal operations independently,
- Central banks implementing the monetary policy for the domestic purposes including the exchange rate stability and maintenance of the foreign reserve independently from government foreign proceeds,
- Continuation with transparent international monetary system to raise the resolution finance (e.g., by end of July 2021, the IMF alone has granted nearly US$ 113 bn to 85 countries to recover from Corona-hit BOP difficulties that help boost private investments internationally)
This will prevent happening recent Turkey-Lebanon style foreign currency crises in the short-term. However, the long-term solution comes from the structure and stability of the macroeconomy as modern monetary economies operate in the global economy and thereby on the foreign currency front. That will take few decades and new market strategies, given the geopolitical issues and shocks. Meanwhile, as the IMF Managing Director recently pointed out, the US Fed has to maintain its monetary policy stability globally responsible manner without upsetting international capital flows.
Otherwise, in the current global context, the revival of old hypotheses (by those who do not know basic Economics) to manage the pandemic-hit economies closed from the global pool of resources (model followed in the 1970s) by heavy bureaucratic controls as the fix will no doubt end up in national and human disasters in few years to come. As the present form of monetary economies functions on debt, no one can escape from debt and debt-rollover.
Therefore, any attempt to control debt as the fix for foreign currency tension without considering the economic side of the public in modern monetary economies will be a mis-fix and cause a new round of global poverty that has already commenced as side effects of policies implemented by the governments to fight the Corona pandemic. Everybody knows the outcome of the bureaucracy. Unless the unregulated IT market became responsive promptly in the market mechanism, the whole world would have got into a deep human catastrophe due to the Corona pandemic.
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