Sri Lanka runs into frequent balance of payments crises due to contradictory exchange and monetary policy involving manipulating interest rates by the Central Bank in the wake of excessive state spending, usually to manipulate energy prices.
The IMF program which began with a BOP crisis ending in 2009, helped push growth to above 8.0 percent for two years and more importantly helped keep inflation to single digits until early 2011.
But a failure to tighten monetary policy in time, in the face of massive state spending to manipulate energy prices from mid 2011 plunged the country to another balance of payment crisis from around August 2011.
Policy Corrections
In February 2012 Sri Lanka's energy prices and interest rates were raised reducing damaging state interventions in the economy allowing markets to put the economy back on track, and a suspended IMF program resumed.
However the rupee fell due to the effect of money printed to sterilize foreign exchange sales, pushing up inflation, even as credit slowed.
"The current monetary policy stance is appropriate, and monetary conditions should remain firm in the near term given high headline inflation and possible second-round effects," IMF's deputy managing director Naoyuki Shinohara said in a statement.
"With a flexible exchange rate regime, monetary policy can increasingly focus on inflation control to achieve broader macroeconomic stability while allowing the exchange rate to act as a buffer for external shocks."
Sri Lanka has a so-called soft-pegged exchange rate regime where contradictory exchange and interest interventions are possible.The central bank triggers a balance of payments crisis when it intervenes in the foreign exchange market and off-sets its contractionary effect on the monetary base and banking system by printing money (a sterilized foreign exchange sale) through Treasuries purchases.
Until 1950 under a so-called currency board law, printing money by purchasing Treasury bills (to sterilize foreign exchange sales or monetize debt) was legally barred in Sri Lanka and the exchange rate was fixed and inflation was low.
Severe exchange troubles emerged within two years of creating the Central Bank, resulting in the enaction of a draconian exchange control law against the people in 1952.
Flexible Exchange rate
If money is printed, the exchange rate has to be allowed to fall (a floating exchange rate) to prevent balance of payments crises from developing.
Conversely if monetary policy is kept tight (open market operations are directed at withdrawing liquidity) the exchange rate will tend to appreciate.
Two weeks ago the Central Bank started to sterilize foreign exchange purchases, a practice if continued will rapidly strengthen the exchange rate, analysts say.
Sri Lanka lost more than two billion US dollars of reserves until February 2012 with more than 200 billion rupees of money printed from around August 2011.
From February foreign reserve losses started to tail off as sterilized foreign exchange sales reduced, though inflation rose due mainly to currency depreciation.
"Headline inflation has increased, but core inflation remains relatively stable, while tighter monetary and credit policies have begun slowing credit and import growth," Shinohara said.
"The external current account deficit is narrowing, and international reserves have stabilized."
"Foreign exchange market intervention should thus be limited to smoothing excessive volatility, and steps should be taken to gradually deepen the foreign exchange market."
Sri Lanka cut overnight open forex positions of banks, reducing the depth of the forex market making the exchange rate extremely volatile.
Such practices - which also forces dollars to be converted to rupees by sales to the monetary authority creating more liquidity and putting further downward pressure on pegs - are prevalent is most balance of payments prone countries.
Budget Gap
IMF said the budget gap is widening, partly due to higher interest payments, but authorities are committed to keeping the budget gap to a planned 6.2 percent of gross domestic product.
Last year a central government budget gap of 7.0 percent of GDP gap was kept by making state enterprises, particularly energy enterprises run a 1.5 percent of GDP deficit mainly using bank credit, helping trigger the balance of payments crisis.
This year revenues are hit by slowing imports. The state also hit an own goal by imposing prohibitive taxes on vehicle imports (an indirect exchange control), in a misguided effort to cure a monetary problem with real economy restrictions.
"The slowdown in economic activity and declining imports are adversely affecting fiscal revenues, while interest payments on government debt are higher than budgeted," Shinohara said.
"The authorities are committed to meeting their 2012 deficit target by restraining expenditure, but a redoubling of effort to strengthen revenue administration is needed.
"Furthermore, continued structural reforms are required to put state-owned energy enterprises on a sound financial footing."
Analysts have called for a transparent pricing formula for energy to prevent arbitrary ruler interventions from triggering balance of payments crises, high inflation and currency depreciation and eventually even a banking crisis if high rates persist.
Going Forward
The IMF said an ongoing financial sector assessment program is looking at potential problems in the banking sector.
"The authorities should remain vigilant for systemic risks, and recommendations in the update can be used to strengthen the financial system further," Shinohara said.
"The Sri Lankan authorities have undertaken substantial macroeconomic policy adjustments to stabilize reserves.
IMF said it is looking at a follow up program. Sri Lankan authorities have also said they would like to have a surveillance program after the current program ends.
Rating agencies which give Sri Lanka a 'BB' level credit, slightly below investment grade are also expecting an IMF program to spending and inflation in line.
"It will be important to continue macroeconomic stabilization and structural reforms efforts, in particular maintaining exchange rate flexibility while building international reserves, given the uncertain global outlook," Shihonara said.
"A successor arrangement with the Fund would provide valuable support to the authorities in these endeavors."
The IMF was a useful confident booster to prevent foreign capital from fleeing as authorities were forced to take corrective action to stabilize the economy and thereby protect the people from further harm coming from energy price interventions.
Fleeing foreign capital can transform an energy price manipulation driven crisis, which is essentially confined to the current account, to a capital account problem. When capital flees extremely steep economic downturns are triggered.
Update III
