ECONOMYNEXT – Sri Lanka ran a current account deficit in the last quarter of 2024, and reserves were run down to repay debt, official data shows, after large volumes of money were printed to push down interbank rates by a few basis points in the period.
Sri Lanka’s imports surged in December 2024 in particular, after three months of excess liquidity from being injected to bring to the middle of a policy corridor or single policy rate.
The liquidity was injected to push down interbank rates and undermine a scarce reserve regime as economic activities recovered.
The current account is a man-made accounting identity, which is a mirror image of the financial account in balance of payments accounting subject to errors and omissions.
Unless current account deficits are driven by open market operations, they simply mean that a country is depending on foreign savings for investment.
Foreign savings can be used for domestic investments be due to attractive conditions (like the US) or due to destruction of domestic capital by depreciation.
In the absence of money printing, any financial account inflows, invested domestically, also leads to imports, automatically triggering expansion of current account balance by increasing the availability of dollars from outside current inflows.
Reserve collecting central banks can run balance of payments deficits when printed money turns into credit and imports.
Countries can also be forced to repay debt by fresh borrowings or run down reserves including for imports themselves when interest rates incompatible with the BoP are maintained by ‘rate cuts’ enforced with inflationary open market operations.
Mercantilists believe that a current account or trade surplus (excess of excess of exports over imports) is required to repay debt. However, if money is printed, whatever the growth in exports is eclipsed by imports from central bank re-financed credit.
The confusion about the balance of payments emerged at the beginning of what is now called the ‘age of inflation’ coinciding with the invention of the policy rate and open market operations by the Federal Reserve in the 1920s which triggered he Great Depression.
Transfer Problem
Rejecting the founders of what is now called economics (political economy at the time) particularly Hume, Ricardo and Mill took place at Cambridge with John Maynard Keynes coming up with what was called the ‘transfer problem’.
The trend worsened after the Great Depression was created by Federal Reserve open market operations.
Keynes claimed that Germany was unable to make reparations payments because there was no trade surplus and there was a so-called transfer problem.
However classical economists pointed out that the trade deficit emerged from Reichsbank money printing and heavy foreign borrowings, which expanded domestic spending beyond available foreign exchange income.
Two prominent economists who tried to teach Keynes in the 1920s were Swedish economist Bertil Ohlin and French economist Jacques Rueff, who himself made the term ‘age of inflation’ popular later.
Three decades later Rueff fixed the French balance of payments problem under the Pinay-Rueff stabilization program, devising the New Franc, giving a strong and stable France to General de Gaulle.
READ MORE : Jacques Rueff: Statesman of Finance and “l’anti-Keynes”
Other German speaking economists also pointed out the Mercantilist fallacy of the current account deficit and transfer problem.
“The truth is that the maintenance of monetary stability and of a sound currency system has nothing whatever to do with the balance of payments or of trade,” explained Austrian economist Ludwig von Mises.
“There is only one thing that endangers monetary stability—inflation. If a country neither issues additional quantities of paper money nor expands credit, it will not have any monetary troubles.
“An excess of exports is not a prerequisite for the payment of reparations. The causation, rather, is the other way round. The fact that a nation makes such payments has the tendency to create such an excess of exports.”
“All the German political parties shared responsibility for the inflation. They all clung to the error that it was not the increase of bank credits but the unfavorable balance of payments that was devaluing the currency.”
Under inflationary rate cuts from 2011 Sri Lanka devalued the currency from 113 to 184 without a war.
From 2015 in particular under mid-corridor targeting running an excess reserve regime to do so, Sri Lanka borrowed heavily abroad as long as a credit rating was available to do so, eventually defaulting in 2022.
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The rupee then collapsed to 360 as float was sabotaged by a surrender rule and too low interest rates.
Since the third quarter of 2022 Sri Lanka’s central bank ran exceptional monetary policy operating a broadly deflationary scarce reserve regime until the third quarter of 2024 when net injections began.
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The central bank has run out of bills to operate deflationary policy easily but some of reverse repo deals were terminated from January running some deflationary policy.
The German trade deficit came in part from the heavy borrowings and FDI that Germany got (financial account inflows), Mises showed.
From 1924 to 1931, Germany paid reparations under Young and Dawes plans of 10,821 million Reichsmarks. In the same period Germany borrowed 20,500 million Reichsmarks and got 5,000 million as FDI, he pointed out.
What happened in the last quarter of 2024 in Sri Lanka is a dress rehearsal of what will happen under the single policy rate as private credit picks up and approved but undisbursed investment credit volumes go up. The credit slowdown in January has since stabilized events.
The last quarter of 2024 saw the debt restructuring (which required some extra repayments of debt), as well as budget support loans (financial account inflows) as well as early covering of imports ahead of vehicle imports re-opening on short term credit.
However the monetary regime must be resilience to all kinds of events, and these are relatively mild shocks in the overall scheme of things.
Sri Lanka’s central bank has a 5-7 percent deliberate statistical inflation target. Under the inflation target, its current policy rate of 8 percent is only real or positive by 1 percent under the upper limit.
If Sri Lanka does not run a scarce reserve regime at market interest rates, and instead adopts spurious statistical doctrines peddled by Western econometricians, the same drama that unfolded after the war will be re-enacted.
Up to 1930s no central bank had a policy rate or open market operations to indiscriminately inject money to all comers to defend a fixed pattern of interest rates.
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Among the first central banks that got overt open market operations were those in Latin America that whose original monetary laws were corrupted by Triffin-Prebisch missions after the setting up of the Argentina central bank.
Economics proper made a brief or partial comeback and briefly defeated Mercantilism in what was called the Monetary Approach to Balance of Payments (MAPB) including inside the IMF.
READ MORE: Monetary Approach to the Balance of Payments – IMF survey
But MAPB lacked the clarity of thought of the classicals (Hume’s price-specie-flow mechanism or Ricardo and the bullionists/currency school) and was hopelessly mired in statistics and was therefore unable cure BoP crises or external default permanently as some East Asian and GCC countries did.
Fiscal fixing is good and necessary, which will delay the onset of monetary instability, but no amount tax hikes, or even reductions in debt to GDP ratios can cure external default if money is not sound. (Colombo/Mar28/2025)
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