(This article is one of a multi-part series exploring the global monetary system - starting from its past, and hopefully exploring its future. The first piece - on the dollar’s 8 decade hegemony is here. While some ideas are reflective of standard monetary history, the framing of others are ones that might be a bit new. While I’m sure others have come across similar framing of their own, what I put here is mine - so any errors mine. I have referred to others wherever possible.)

It’s almost become the mainstream view, that the world’s economic order is changing. Looking back, one might argue that this has been happening for a while, though this was slow and gradual enough that the prophets of orthodoxy could claim otherwise. Now, with the rapid shifts happening alongside the new Trump administration, even the most hardened critics of change will have to agree that things are moving pretty dramatically.

What does this change look like? One aspect is that of the monetary system itself. In a previous article, I spoke through why I think the dollar’s dominance over the last 80 years can be understood as a function of the depth of USD markets, but that the cost of ths is the credit expansion and deficits that follow the use of these markets. That was what I see as having underpinned the USD as the global reserve currency.

However, although the USD has been the reserve currency for at least the last 8 decades, the monetary system underpinning this has changed in my view. The obvious part of this is the Bretton-Woods system and the post-Bretton-Woods world order, but I think its better understand as three, roughly 25 year periods instead.

1. The Bretton-Woods monetary order

The first monetary order of the modern dollar was under the Bretton-Woods. In short, this was where the currencies of the world would peg against the USD, and the USD would peg against gold. There are plenty of reasons behind this decision, but I think for this story, the critical one is that the world wanted to avoid competition in exchange rates and the capital flow speculations that followed. By setting a globally agreed system in place, you can avoid countries competing against each other to attract foreign capital through devaluation of their currencies.

Of course, this system only worked as long as the US held the ability to maintain parity with gold. If the global system wanted a roughly constant amount of dollars, or if the amount of gold held by the US rose alongside any new USD demand, this would work. But in reality, the “strength” of the USD, backed up at the start by plenty of gold, meant countries, businesses, and individuals started racking up USD-based liabilities. These future requirements for USD meant that the US slowly had to give more USD than it could currently create parity for, to the world.

As long as the US had spare dollars of its own, built up by external surpluses, this was fine. The US would be able to lend these dollars to anyone who wanted them. But countries that got these dollars now had to do something with them. Some, like Italy, spent it more on consuming the products of American production than in creating their own production. For others, the benefits of having extra USD meant they invested in their own production. Now, they have their own ability to produce, and need someone to buy their products. The US, with its strong economy, was the obvious choice. They could easily fund that consumption through credit as well - after all, countries that now had surplus dollars could lend to the US anyway. In the chart below sourced from CEPR, you can see how dollar liabilities exceed the American gold stock in the early 60s - the point at which this changed.

But this meant the US had to keep running deficits AND other countries needed to keep running similar surpluses to lend to keep the US running. This was the Bretton Woods monetary order in a nutshell - cycling USD between the US and the rest of the world, all the while keeping the (increasingly nominal) peg to gold. Running so many deficits then means that conventionally, the system should eventually “fail”. Debt rises faster than growth, and eventually, the likelihood that either the US has enough dollars or the world produces enough products to finance the US both fall.

2. Post-Bretton Woods multi-surplus monetary order

Eventually, the Bretton-Woods system collapsed as the demand for dollars exceeded the ability of the US to maintain parity with gold. After a 1971 devaluation of the dollar, the US managed to stabilize its external accounts for just a tiny bit, before rising oil prices and then later, offshore credit growth meant the US returned to even larger deficits.

Rising oil prices could even be understood (somewhat controversially) as a result of the US devaluation. The shock it created across the world could easily have affected supply dynamics in the Middle East. Regardless of whether this was the case, rising oil prices meant massive surpluses by the petrostates of the Middle East. What could they do with this money, but park it somewhere?

The outcome of this - both directly through the petrocurrency agreements of the 70s and indirectly by boosting liquidity across the world from the 80s - was that you had a lot of money willing to lend into the US. The US borrowing this money, using it domestically to buy foreign goods and services, that money being accumulated by trade partners that relent it to the US was the core part of this part of the monetary system.

This cycling of money might sound similar to Bretton Woods but the major difference was that global currencies were no longer fixed. They moved dramatically if needed, but even steadily otherwise. This movement meant that across this period, you had varied countries and varied players combined lending into the US. There was no singular counterparty to the US deficits across this period. In the 70s, the petrostates covered most of it. The early 80s had rising Japanese surpluses, and the late 80s had the European surpluses really kicking up, and then East Asia rising across the 90s.

This multi-surplus monetary order had one big consequence - money rushing in and out across the players. At varied points, even countries with small surpluses mattered more to the overall balance - so capital moved all over. The cost of this was visible in the massive currency flows out of Latin America in the 80s in particular, and Asia in the late 90s. But by the late 90s, one player became increasingly and clearly the counterparty to the large deficits and started changing this multi-surplus monetary order to a more straightforward uni-surplus order - China’s integration into world trade.

3. The US-deficit and China-surplus monetary order

The monetary order that was clearly visible in the early 2000s but likely was starting to be in play from the mid to late 90s, was when East Asia, and particularly China started to run massive surpluses on their external account and using the proceeds of these to financing the deficits in the US. The mechanism here was the same as in the previous monetary orders, but with a single counterparty to the large deficits of the US, the dynamics were different.

This single counterparty status didn’t really materialize until around the mid-2000s, but the trend was starting from the mid 90s anyway. As East Asia rapidly industrialized, they started gathering larger and larger FX surpluses. For countries that were still, largely poor, the deployment of these surpluses had to go somewhere - and eventually ended up in the US deficit.

However, as China became the main player in this story, the dynamics change. It is no longer varied countries with varied domestic and international priorities, and exposed to varied volatilities that provided this surplus. It was China, singular and consistent. As opposed to the volatilities of the multi-surplus system, you had some level of stability. As long as the system functioned, the system was largely stable. The US ran deficits, paid China to produce goods, which then invested that money back in US treasuries. The chart below from Brad Setser’s shows how this has evolved.

This translation of Chinese surpluses to US deficits doesn’t need to be direct. Since the mid 2010s, China has actually been reducing it’s holdings of US treasuries. This has only accelerated since the pandemic. Yet American deficits grow as do Chinese surpluses. How? Through intermediaries (who might not even know they’re acting as such!). As long as the two end up meeting each other at some point, the two balance against each other.

Yet even uni-surpluses have large impacts. As opposed to the relatively more local impacts of a multi-surplus order, the uni-surplus system builds up to much larger levels. At those points, any shifts can be pretty dramatic in their impacts. These could be local too - China’s rapid rise as a cheap industrial power clearly hit Germanic Europe’s production power negatively. But the bigger impacts that matter are global. What happens when the system keeps going and both sides end up having far too much pressure to go on?

What will the next monetary order be?

If we assume that roughly 25 year cycles exist for monetary orders, we’re right around the cusp of another shift. Visibly, that seems obvious too. American trade contraction and European rearmament are the obvious and visible parts of this. But China has continued to struggle on its consumption boom, other than the success of moving low-consumption rural Chinese to less-low-consumption urban Chinese.

But what will this next shift look like? Here, I think we can go even deeper into the way these monetary orders have worked in the past. Each of these orders have had what feels like specific periods within that are distinct. Perhaps this can help us figure out the changing world.

(There’s a lot going on in the global economy right now. Entire systems themselves might be changing. This is something I’ve been trying to write on for a good year now, but things have moved too fast for me to sit down and put something together. This article is therefore written as one part of many exploring just one aspect of the global monetary system. This first part explores an overall framing of this story - on the dollar’s status as the global reserve - before future parts will go into smaller and smaller time periods. Enough of these views are unorthodox enough that I have to place usual disclaimers on these being personal views, stronger than usual as well.)

Over the last few years, the calls of de-dollarization has started to sound a little louder than before. Regardless of whether it’s realistic or not, the idea of a world without a dollar is something that more and more and people are beginning to explore - and others to call for. Yet the dollar’s role in the global system isn’t an accident of history. Over decades, it has wrought itself to where it is today - through massive turmoil and pretty remarkable periods of stability too.

Looking at how the dollar evolved to its modern form can help frame the contemporary point a bit better. The story of the dollar in this approach is the story of the global monetary order and how it has moved and changed over time. Whether this movement will continue in the same way or whether it will change how it moves is a pretty important point in the end.

80 years of the dollar as the reserve currency of the world

Formally with the Bretton-Woods arrangements of 1944/5, but informally from at least partway through WW2. the USD was increasingly being used as the major international currency. Since then, despite all the narratives around the USSR, the Japanese, the Europeans, and now the Chinese, the dollar has reigned supreme.

What supported this? The strength of the US economy is undoubtedly a factor here - the US has been the world’s largest economy since at least the mid-1930s. For such a large economy, it has also maintained impressive enough growth rates - growing to be 50% larger than the EU despite being roughly the same size in the 1970s (although admittedly, almost all of this overperformance is since the Euro crisis).

Beyond this, there are all the softer reasons provided for the USD’s dominance. There are the military arguments, the argument that the US can maintain parity against a commodity (gold at one point, time and trust right now), and even the arguments on US soft power across the world. No doubt these have at least some impact as well. I would argue they are more consequences rather than reasons for the dollar’s dominance, but they almost definitely have at least a partial mutual impact too.

Deep USD markets almost definitely allowed the dollar to remain the global reserve

The key reason I would point to, would probably be the depth and liquidity in the US’ financial markets. The use of the USD in global transactions is itself probably the measure here that best illustrates it. Other indicators follow - since the 70s, the US has the largest amount of portfolio flows, debt flows, and even credit flows across its borders. Not just within the US, but the depth of the US markets are accessible to foreigners as well. To be a global currency, one that the rest of the world works on, this feels to me the most important. Everyone needs to have easy access to the USD for it to be a global unit of account.

This is part of what allowed the US to actually continue running this system itself. Given how much of the overall system is driven by varied financial market flows, including credit, there is a pretty huge demand and supply for USD based financing. For the US, this gives two massive opportunities. By changing local financial conditions, they have a powerful lever to move the rest of the world. But the rest of the world also has so much financial depth in the US’ own currency, that they can finance themselves regardless of what happens. The idea of the “exorbitant privilege” that being the global reserve currency, to me, is from this lens.

The “exorbitant burden” of being the global reserve currency

But the cost of having a currency that anyone can access? Being vulnerable to either the trade or currency (or both) impacts that people moving money across your borders will have. As people use the USD, they build up contracts of credit and otherwise, that requires them to have access to further USD to meet. This means USD flowing out of the US. Where does the US find the USD to send out? Either it has to use the results of its own production, running down its external surpluses. If they don’t have this, they need to create new USD or at least allow for new USD to be created. This means credit - which then boosts local consumption - and takes external balances into deficit. To pay down said credit, the US also now needs USD. The cycle continues until it doesn’t.

Across the 80 years since Bretton-Woods, the US has been gradually expanding its consumption in this way - first by running down its surpluses, and then by expanding deficits. The chart from the St. Louis Fed shows how this has moved on the trade account. This is the consequence of being the reserve currency - being whipped by the emotions of capital flows. Where will this go from here?

This is part of what different parties aligned with the Trump administration (I don’t think anyone can say there is anyone more than “allied” with Trump and global trade decisions!) have called the “exorbitant burden” of running the global reserve currency. This isn’t a concept that’s widely accepted - former RBI governor/IMF Chief Economist Raghuram Rajan recently wrote against this entire economic concept for example.

What keeps this system going, in my view, is not just the global capital story but how this interacts with the local econopolitical dynamics in the US and other countries. Part of this is how the credit that flows into the US isn’t simply a one to one transaction but rather mediated across many other parties in between. All this creates incentives - in the US to push domestic spending and consumption, and in counterparties to do the opposite.

At varied points in history, these incentives have led to what I consider different underlying monetary orders that have underpinned the dollar’s reserve status. We see to be in a similar place once again. Will it be a change that changes the system but keeps the dollar ascendant? Or will the mighty dollar itself start retreating this time around?

The next part of this series of essays can be found here -

(This article is part of a series exploring South Asia’s economic story as a distinct economic phenomenon. You can read the first article in this series here. Usual disclaimers apply).

Over the last few decades, central banks across the world have gradually moved towards some form or the other of inflation targeting. This has broadly gone alongside currency control generally going the other way. After the collapse of Bretton Woods and then after WTO rules came about, I think it’s fair to say that the world has had a bias towards flexible exchange rates. Exchange rate control tends to be seen with at least some level of skepticism and there are enough cases of currency manipulation accusations being thrown around. Instead, focusing on managing inflation through adjusting interest rates has increasingly become the primary policy prescription across monetary regimes aross.

Without getting into the specific histories of each country, the same gradual move towards inflation targeting regimes is true for South Asia as well. The legal strength of the inflation targeting regimes in South Asia vary, but even when it is not a strict target, these central banks have anyway tended to have a push towards managing inflation.

South Asia’s economic makeup ties its inflation closely to currency moves

This context of the economic structure of South Asia is one that has general FX deficits on trade and income. This then means that in order to bridge this, South Asia requires constant capital inflows. Where these inflows fail or change, that can then necessitate some amount of depreciation or use of FX reserves of the central bank to defend the currency. Often, this has been a combination with central bank activity mostly during changes in capital movements and currency movements during underlying changes in the economies themselves.

Does this currency depreciation then affect local inflation? In two forms, it can. One is through the fuel import side. Given South Asia is a net importer of fuel at a substantial rate, this then means that any currency pressure directly translates through to the local economy through the price of fuel. Given the direct political cost of rising fuel in the region, this also likely ties into how fiscal support for fuel imports and fuel pricing has been a constant and recurrent factor in South Asia.

The other mechanism is through the angle of food. While South Asia produces a significant amount of its food, it still has a substantial import cost as well as the cost of fertilizer, machinery and other inputs needed for the agricultural sector. To simplify, we can simply show that imports of food and fertilizer alone accounted for around 1% of GDP in 2019. Given the large amount of consumption in these economies. Again, this likely creates strong fiscal incentives towards supporting food, fertilizer, and agriculture.

Whenever the fiscal space for these protective measures exist, South Asia can manage price changes that happen from currency moves. But when the fiscal space is less strong (South Asia also has relatively weak revenue bases), the direct impact of currency movements onto the inflation dynamics is pretty straightforward.

Do South Asian Central Banks end up having implied exchange rate targets for inflation control reasons?

Even if this is not explicitly a target, there can be a bit of an implied target. Lets use a hypothetical currency and inflation story to showcase this. Lets assume a currency starts at 100 rupees (I’m going to be bold and call this currency the South Asian Rupee - SRP) per USD, and assume a defacto inflation target at 2%. Lets assume that for the local inflation index, about 30% is directly tied to the price of imports. Let’s assume the pass through of currency movements to inflation happens where the direct import goods (30%) is immediately inflated, and the rest of the economy that depends on these imported goods (60%) is inflated in 2 stages across 2 quarters. These may not be realistic assumptions, but I’m taking them to show the issue illustratively.

Here, if we assume the exchange rate depreciates by 1% in each quarter, we would see inflation pickup to 3% by Q6, and not really fall to the target after that. This then is a clear breach of the 2% defacto target. If the central bank wants to bring inflation back to 2% here, they would then have to act.

However, lets see what happens if the exchange rate actually depreciates at a slower rate. For whatever reason or the other, lets assume that instead of 1 SRP depreciation per quarter, there is only a 0.7 SRP depreciation instead. In such a context, the inflation rate is significantly less and doesn’t go much beyond the defacto 2% target.

Here, a simple and clear point comes about. If the central bank is meant to maintain exchange rate flexibility, then that can act against their inflation target in some cases. If the exchange rate naturally wants to go weaker, then that can easily cause inflation to go out of target. The same is true the other way, if the exchange rate sees only slight depreciation (or even appreciation), then that adds a strong disinflationary force that can take inflation the other way around as well.

Fundamentally, given the struture of South Asia’s economy, this then means that there is actually an implied “range” of exchange rate movement that can work for the economy’s inflation targets. In this illustrative example, if the exchange rate depreciates above about 0.7% per quarter, that pushes inflation too high. If the exchange rate depreciates below about 0.4% per quarter, that pushes inflation too low. For this economy then, there is an implied exchange rate depreciation range of 0.4-0.7% per quarter, or roughly 1.5% to 3% a year.

How do South Asia’s inflation regimes tie into its economic structure?

The move towards greater inflation targeting often involves greater and greater use of the monetary lever. In effect, adjusting interest rates often occurs where central banks try to maintain a particular interest rate level. In technical terms, this is a price target or price control on interest rates and credit that affects the supply of credit and thereby, affects demand. In simple terms, expensive loans=expensive business activity=slower growth=slower demand.

The issue is that in additional to an interest rate target that modern inflation targeting measures call upon, South Asia’s central banks might also have an implied exchange rate target for the same inflation targeting reason. These are not necessarily contrary goals - a particular level of interest rate and credit growth might be exactly in line with the exchange rate target for example, especially when inflation is driven by domestic demand forces.

The question comes when depreciation occurs for reasons outside domestic demand. Primarily, this would be capital flows but it could also be demand forces outside of the central bank’s jurisdiction. Given South Asia is a net importer of oil, the oil price is one clear way that this can come through.

This itself is once again, not too much of a problem in a “free market” sense. You can still adjust the interest rate to account for this, and although it might be a much tougher job given the speed of interest rate mechanisms compared to that of capital flows, its not impossible. Domestic demand will need to contract by a bigger margin that otherwise, but its still technically possible.

The issue comes with the structure of the economy, which then affects the social and political structure of the region as well. The fiscal incentives, the electoral incentives, can actually run counter to the measures needed to maintain inflation in such a context. These are not factors a central bank can, or even should in my view, get involved with.

My personal view here is that South Asia needs to have a long hard conversation of what sort of economy it wants to have, and what kind of policy measures can support that. In such a context, I think whether some amount of depreciation is okay or not is then part of a much bigger conversation. Once that economic conversation has gathered more steam, I think the question on what sort of way to support an inflation target takes a different form. If the economy decides that it wants to move towards a production-export economy for example, demand might anyway need to be weak enough that disinflation rather than inflation becomes the problem. If the economy decides it wants to run on a consumption based growth pathway, such a pathway might need to grapple on the inflationary consequences this necessitates.

In either of these context or any other, I think it becomes important to consider these varied systematic incentives that can be at play. They can push varied policy in varied directions, even if intentions remain clear and strong. Recognizing these incentives, and the fact that South Asia probably already has implied exchange rate targets to meet their inflation needs, can help understand the economy better.

(This piece is meant to touch on some of the unique features of the region as an economic actor. For simplicity, I’m only using limited data. Any opinions here are my own and don’t reflect anyone else’s.)

South Asia has long been considered more a geopolitical region than an economic one. Historically, this does make sense, being halfway between the sea trade lines between the East and the West. Yet this itself points towards a more economic role as well, and one that affects South Asia overall different compared to other regions.

Yet the idea of South Asia as economically distinct is still not the most common one. It is so uncommon, that even defining what makes South Asia economically distinct itself is hard to pinpoint. In this piece, I’m attempting to lay out a few specific aspects that I feel makes South Asia’s economy unique and a little bit of hypothesizing about this as well.

South Asia’s massive (yet small) consuming population

Arguably the most important point here in my view is that South Asia has a massive population, even if it is not a population that is as large as that of East Asia. India, Pakistan, Bangladesh, and Sri Lanka combined hold only around 1.8 bn people, where China, Indonesia, Japan, and the Philippines alone can match that. But it is quite large nevertheless.

However, the difference between these two regions, is that South Asia’s people consume more than they produce, while the opposite is true for East Asia. South Asian households consume 64% of GDP, while East Asian households only consume 45% of GDP. In fact, South Asia’s consumption is more comparable to the US and the UK - high consumer economies, whereas East Asia is more comparable to the production centres of the Euro Area.

Despite this, South Asia is still substantially poorer than all of these regions. While it overperforms in terms of how much consumption it does compared to the size of its population, at the end of the day, it remains quite poor.

South Asia’s continuous external deficits

This then extends into your FX requirements. In 2019, for the countries above, you had approximately USD 100 per capita more in net exports and income in East Asia compared to South Asia. The specific balances are different, and not all countries fit the regional structure perfectly, but the overall story still remains.

This is even more true when you look at net trade and income as a proportion of these countries’ GDP - South Asia’s deficit is as large a component of its economy as East Asia’s surplus.

Alongside this, South Asia has very few commodity exports - which puts it apart from Latin America, Sub Saharan Africa, and even East Asia. We can see part of this by looking at fuel imports from the two regions against their GDP. South Asia imports more than twice the fuel that East Asia does as a % of its GDP. The region is also a net importer of fuel at twice the rate that East Asia is.

South Asia’s weak fiscal base

(South Asia’s fiscal picture is a much bigger story I want to expand in the future, so I’m keeping this relatively short here)

Part of which allows for all this consumption and external imports, is that South Asia’s governments have moved towards smaller and smaller tax collection over time. Tax collection has been below 13% of GDP for India and Bangladesh for a while, while Sri Lanka and Pakistan has seen consistent falls in its tax receipts. Overall revenue is only slightly better than this.

In fact, by 2019, South Asia’s tax revenue numbers looked closer to East Asia’s (where low taxes and low expenditure have gone alongside a production economy) or even lower, and were lower than most of Sub-Saharan Africa’s (commodity exporters with a significantly portioned off export sector). For how low South Asia’s tax numbers were, it should have been a pretty decent production centre but fundamentally wasn’t. Ironically, when South Asia was much poorer, 60-70 years ago, it didn’t show the same trend.

Despite this weak tax base, the region has continued to have seasonal and sometimes continuous fiscal needs. Local agricultural cycles are extremely seasonal and this has meant both a historical tradition and modern mechanism of both fiscal and credit support. The end result? Government expenditure is largely constrained outside of these needs, meaning South Asia actually has a relatively small state sector compared to most regions in the world. It then spends less on human capital than many other parts of the world, with government education expenditure only reaching global averages in India, and massively underspending across the region in government healthcare.

Yet despite this, South Asia’s human capital remains some of its most valuable resources. Personal remittances account for a much larger portion of South Asia’s GDP than most of the world, and at a smaller scale, the same is true for ICT service exports as well. While a lot of this has specific reasons - historical ties to the Middle East on remittances being a key story here - it doesn’t detract from the overall story that despite weak human capital investment, the consumption side of the economy has supported human capital growth nevertheless.

What makes South Asia?

Very few of what I discussed above on its own, is unique to South Asia. Plenty of regions and countries have low taxes, have strong human capital, have high FX needs, are oil importers, have high consumption, have high populations. Yet all of this together? That’s where South Asia becomes unique. Not just at these topline factors but even within these, the combination of all of these working together seems quite distinct to South Asia.

Why is this the case? Perhaps some combination of its cultural, social, and economic history is at play. The specific historical role that the local caste system has played, how it played a critical role in pre-modern and continues to do so in modern trade, the impacts of colonialism, the shape of post-colonial democracy, the constant seasonal impact of the monsoons, all likely played at least somewhat of a role. At this stage, I’m not going to spend too much time exploring these reasons, but merely establishing the distinctness of South Asia as an economic region.

With all of these factors, there are some changes that might be undergoing. Compared to the data at 2019, the post-Covid world seems to have reduced South Asia’s deficits considerably. Global trade is anyway at an interesting place, with at least some changes liely over the next few years. In the meantime, South Asia is getting increasingly interconnected financially. As we go ahead, I think South Asia becomes increasingly and visibly more distinct as an economic region. If South Asia pulls ahead in its GDP growth, its impact on the world will very likely increase markedly. In such a world, figuring out what South Asia is, and how it is distinct will matter.

(This piece is written as an introduction into the ideas within and to serve as a starting point for this newsletter. It thereby, lays out the purpose of this - to argue on the interdisciplinary (and beyond) nature of a lot of knowledge, and the need to continuously try and fail in exploring this.

I’ve separated this newsletter out from my economics content, primarily to facilitate any who would rather read that alone and not this side of my thoughts. While I will keep these separate for now, I very much see a lot of overlap at some point in the future, and I do expect to crosspollinate heavily as well.

UPDATE: For ease of organization, I’m moving this newsletter to its own domain)

TLDR - The nature of the real world feels highly multifaceted and complex. Yet specialization has been a cornerstone of how the modern world progressed. These provide two contrasting ways to engage with knowledge. While things could be moving towards interlinkages and generalization again, taking both approaches could allow to avoid the pitfalls of both, at least until better “techniques” are developed could be one way to engage with knowledg. But taking both approaches probably means failing in one approach while succeeding in the other. Being okay to fail, being okay to try and apply both the specific and the general, is what I’m terming “forseeking” and is the basis of splitting this newsletter out.

There’s this quote of John Maynard Keynes (being an economist, it is hard to escape the man) that talks about how being a good economist requires one to be well-rounded. This isn’t a rare idea by any means. Most people would have heard someone somewhere talk about the benefits of being such a “jack of all trades”. If you’re from a part of the world that has a cricket culture, the term “all-rounder” might even have entered your vocabulary.

Yet this is not always the most common framing. The very frame of a “jack of all trades” involves being a “master of none”. Instead, increasing specialization, both in the economic framing but also in the scientific framing, has been more or less the way that the world has worked for at least a few hundred years. Whereas earlier (centuries earlier in some parts of the world, decades earlier in others), a general Bachelor of Arts would make you among the most educated thinkers of your generation. Now, even a PhD (ironically, a title suggesting generalization) might need post-doctoral studies to “establish your niche”.

But this is not a simple one-way development. Keynes himself spoke of this well before the current hyperspecialization of the world was underway. We’ve had similar arguments on the benefits of generalization over specialization made recently as well - David Epstein’s “Range” is probably the most popularly accessible version of this argument. Between the two, there was also a famous (infamous?) quote by the sci-fi author Robert Heinlein that took a bit of an exaggerated framing on the issue as well.

A human being should be able to change a diaper, plan an invasion, butcher a hog, conn a ship, design a building, write a sonnet, balance accounts, build a wall, set a bone, comfort the dying, take orders, give orders, cooperate, act alone, solve equations, analyse a new problem, pitch manure, program a computer, cook a tasty meal, fight efficiently, die gallantly. Specialization is for insects.

- Robert Heinlein in Time Enough for Love

Across the years, this tension between generalist and specialist approaches has continued in its varied forms. Regardless of how important this tension itself was in the past, it existed then, and it exists now. How do we engage with this situation? How do we engage with the world itself? How do we understand reality around us and crucially, how do we take steps to move forward with it?

Reality as multi-influenced, complex, and interconnected

I don’t think it’s a stretch to say that society is increasingly aware and increasingly accepting of the pretty intuitive and obvious fact that the world around us is quite complex. I don’t mean this in the technical meaning of the word used in “complexity theory” (which ironically, uses a precise definition alone on the concept) but rather in the general meaning of the word. A simple “proof” of this is to look at the trends between the frequency of the words “complex" and "simple" in Google's database of books.

I would argue that outside of general “complexity” in the way that the world works, there’s also an almost inherent multi-influenced mechanism at play as well. Again, for most, this would probably be obvious enough. Obviously, things are affected by more than one thing at the same time, or at least by more than one type of thing. If we take a simple situation like an economy’s growth trajectory, of course it’s affected by many things! Politics matters. Economic decisions matter. Investment matters. Social trends matter. All of these and more will obviously affect the way the economy works.

Where it might be less appreciated, but still at least on some level, obvious, is where this also applies to things that feel “bounded”. Lets take the individual human for example. They’re an individual of course. We talk of them as such, we give them a name, we talk to them individually. Yet for no person do they exist without the biological genetic makeup they get from their parents. Noone exists outside of the social context of their upbringing. Your cultural background IS a part of you, regardless of whether you agree with the culture or not. It becomes hard to consider people as pure and isolated individuals. They’re connected, they are understood different by different people, and they exist differently from one moment to the next. In similar ways, most things we consider “isolated” can in many ways be considered pretty complex, interconnected, and multifaceted. I doubt many will disagree with the fact that there is at least influence on this level.

Knowledge as deep, specialized, and siloed

Despite all of this increasingly “obvious” points, the other side has also been visibly true as well. Even for us as individuals, we prefer to think of things as “discrete” and “bounded” categories. We list things out, we put them in buckets, and slap labels on each bucket as well. Despite people being very much an interconnected creature, we still consider them individuals in the end. In practice, dealing with a nicely packaged idea that’s neatly defined is much easier than dealing with a purely nebulous idea. Even this very piece of writing is split into sections, sections in paragraphs, paragraphs into sentences, sentences into words, words into letters. I could just get rid of every bit of separation there and take everything together, but that would just be a massive darkened block, not particularly interesting.

This has not just been on an individual basis, but the very foundation upon which the modern science-based world is built. Looking at the history of how different “fields” or “disciplines” came to be shows this quite well. Most knowledge fell under just a few headings in the past - of knowledge itself, and at most split between worldly and spiritual matters. Over time, as each aspect developed itself further, this has nested itself into greater and greater specialization. There are many different ways we can map this, but just one is reproduced below - of Immanuel Wallerstein’s view of how different “world systems” came to be (a bigger story for another time). From a religion driven, to a split into secular philosophy, then into sciences, then into further division until a point we end up having hyper specific specializations (which then have even more specific areas that individual practitioners go in greater depth into).

While I may sound a little irreverent of this development into specialization, it is undoubtedly the engine that drove everything the modern world is about. There is no question whatsoever that it has driven massive change, massive growth, and massive explosion of deep knowledge. Yet interestingly enough, this very specialization has now started to increasingly become cross-fertilized. Whereas one might specialize in a hyperspecific area alone, it has become SO hyperspecialized that it’s infact much easier to specialize by combining two (or more) previously different fields. To use my own economic thought as an example, one might be one economist among million. But if one is an economist specializing in quantum application? Rare indeed. While most of these interdisciplinary contexts have been less dramatic than that example, they’re increasingly becoming more and more of what new knowledge is made by and made in.

Forseeking as an interdisciplinary approach to engage with knowledge

Across this entire story, what we’re seeing in my view, is two broad methods that have both been quite useful across human history (or at least, the relatively short period I spoke of here). How do we deal with both of these approaches? One feels more relevant to what the world is “really like” but the other has brought a lot of progress in a more practical sense. Then again, both worlds seem to be colliding as well right now. How do we engage with this situation?

My answer is to engage in both. By taking the multifaceted and interconnected side of things, we are able to recognize and engage with a lot of the “actual” aspects of reality that we might otherwise miss out on. By taking the specific and precise side of things, we are able to develop ideas and bring forth actual results in a much more practical sense. Both have their pitfalls of course, but both also have their great successes.

But a big part of this “combined” method likely involves failing in one way or the other. By taking one approach, you are almost by definition failing on the other approach. The opposite is true as well. Thereby, any form of engaging with the two approaches probably require that sort of “openness to fail”. There may even be new “techniques” and “methods” that allow this sort of dual approach to work, but until such gets developed, this “continous failing” feels likely to be at least one way that one can engage with it. That can look like directly trying to apply different disciplines but also different techniques and different approaches altogether.

A tangent - that’s the main reason behind me splitting this blog into two newsletters as well. The interdisciplinary nature of things I want to explore will probably be substantially “wrong”, especially as measured from the perspective of the economics content I have a bit more of a “specialist” expertise in (though ironically, that expertise comes from a sort of interdisciplinary background in the first place). This newsletter, Forseeking, is meant to be a place to explore these “wrong” ideas. The word itself is one I’ve coined, a protologism for now, that relates to this overall idea of exploring wrong ideas with a view to understand more things later. The other newsletter continues for now, but as I write on both sides, I do expect them to be pretty significantly interlinked in the future.

Regardless of that personal diatribe, I do see an increasing likelihood that knowledge will become more and more interdisciplinary in the future. Whether this actually reverts to the totality of the past, or whether it reverts back to specialization, or even if it oscillates between the two extremes is one I don’t have a great answer to - though my bias is that we will end up in some totality of knowledge before oscillating back. But in the meantime, it’s a moment where I DO see at least some level of change in the way we engage with knowledge in the world. How do we engage with it? I feel we need to keep trying and keep failing, but the paradox is - if I am right, then I am wrong as well. That paradox is a question for another time.

T

(This piece is written as part of a potential multi-part series exploring Colombo as an economic region, arguably distinct from the rest of Sri Lanka. There’s obviously a lot of history behind the idea, but this one is to take a relatively simple approach to “measure” how “rich” Colombo potentially could be. The methods I’m using here are not those I personally find very credible, but as an initial exploration, I am starting here nevertheless).

There’s no question that Colombo is richer than the rest of Sri Lanka. Most Sri Lankans (and many others who’ve listened to a Sri Lankan) have probably also heard the apocryphal story of Lee Kwan Yew, Singapore, and Colombo. But how rich is Colombo really? Is it potentially, a rich city in and of itself?

Before we start - What IS Colombo?

One question here is what “Colombo” really is. Officially, that would be the Colombo Municipal Council. But this comes against the fact that Sri Lanka’s urban definitions are really weak - and has resulted in many “urban” areas being classified as rural. For example, Wattala, Ja-Ela, Gampaha are all classified as rural areas, purely due to the fact that they’re under Pradeshiya Sabha, as opposed to Municipal or Urban councils. There are other definitions thereby, that we can take, but defining what “Colombo” is will probably still be quite nebulous. Is it based on governance? Economic connectivity? Distance? All of these? None of these?

In order to move past this, and since we’re not really aiming for some precise number on Colombo itself, lets take a few approaches. Lets move from the biggest definitions we can and move in, and see what it implies on Colombo itself. That is, let’s first look at the Western Province, the Old Colombo District, the Colombo District, and one additional external definition. Despite my disagreements with GDP, and particularly GDP in PPP terms, I’ll still use this as a comparative to place each of these different “Colombo”s in a global context - in per capita terms of course.

How rich is the Western Province or the “Colombo Metropolitan Region”?

There are at least some, and some of these being semi-official, definitions that take the entire Western Province as the “Colombo Metropolitan Region”. So let’s start there. Thankfully, provincial GDP is something we DO have, though in imperfect and delayed terms. We can use this, and then put a wide error margin, to see if this gives us a sense.

In 2023, the Western Province had nominal GDP of around LKR 12.1 tn. The average USD/LKR exchange rate across 2023 was around 327 LKR/USD, so that puts the USD GDP at around USD 36.8 bn. While we don’t yet have an up-to-date population measure for the Western Province, the most recent estimates put it around 6.1 mn people. If we take a 5% margin around this number to reflect internal migration, we get a population of 5.8-6.4 mn people. That puts GDP per capita at USD 5700-6400 - about 50-60% higher than Sri Lanka’s overall GDP per capita of around USD 3800-3900. On this basis, where Sri Lanka is in the 130th rank for GDP capita for countries, the Western Province jumps to somewhere near the 100th to 110th rank.

But this is all on nominal basis. All of this has to be converted to some sort of inflation and purchasing power adjustment. Here, we don’t have a very good way to do it other than the PPP factor conversion - where you compare the ability to purchase a certain basket of goods in one country vs others. Sri Lanka’s GDP per capita in PPP terms would be around USD 13000-15000. If we apply the same ratio for the Western Province, that takes it to USD 21000-25000. Since in practice, the ratio would probably be different, lets do a 5% margin around this as well to get USD 19000 to 26000 in per capita GDP in PPP terms.

This makes a significant difference. Compared to the nominal per capita rankings of around 130th for Sri Lanka, and 100-110 for Western Province, the PPP per capita for Sri Lanka is itself around the 110th ranking. The newly estimated GDP per capita in PPP for the Western Province goes substantially higher, now ranking somewhere in the 90th to 75th rank!

How rich is the Colombo District?

Another approach we can try, is to take the Colombo district. Here, I’m actually going to start with the Old Colombo district - that is before the partition into Gampaha and Colombo. That is, can we see how rich “Colombo and Gampaha together” is - what I will call Old Colombo?

This is much harder since we don’t really have good data or even proxies at this level. The attempt I will use is to take the total “expenditure” by household in the three districts in the Western Province according to 2019 data, and then see what the “proportion” of this is held by the Gampaha and Colombo Districts, and use this to create a proxy GDP for the two.

This tells us that Colombo District has 48% of all expenditure in the Province, Gampaha has 37%, and 15% for Kalutara. Thereby, the combined Old Colombo has around 85% of expenditure. Taking this as 80-90% as a range, this tells us that of the USD 36.8 bn in GDP in the Western Province, USD 29-33 bn is in Old Colombo. With a combined population of around 4.9 mn people, this puts nominal GDP per capita in Old Colombo at USD 5900-6700 . In PPP terms at the same ratio as before, that makes it USD 21000-27000, about 80th to 70th ranked in the world.

But what if we dial down onto Colombo district itself? The same approach gives us a nominal USD GDP of USD 16-19bn, a per capita GDP of USD 6500-7700, and a PPP adjusted per capita GDP of USD 23000-30000, now somewhere near the 75th to 65th ranked country.

Can we get even closer?

Any further and we move pretty heavily into the realm of speculation. Not only are there no strong economic indicators for something like the CMC, nor are there population estimates. Hopefully, after the new census is done we have a little bit more visibility, but other than that the only real option is to use proxies.

Until we do that, another view we can take here is what the Harvard Growth Lab’s Metroverse has estimated as Colombo’s GDP per capita. Their definition of the city is a bit different to any we’ve taken here, but with a definition that extends the city from Negombo to Beruwala, and a few suburban corridors as well, they give a GDP per capita of somewhere in the USD 16000-17000 range - highest so far that we’ve gotten. It’s not fully clear whether this is PPP terms or not, but the “comparative cities” they have given have nominal per capita in this range. However, the total “GDP” we get from this is arguably too high for Sri Lanka, but population and GDP per capita is “calculated” very differently so they might not be comparable anyway.

If we consider this as a nominal GDP data point, and convert this to PPP terms at the same ratio gives us USD 57000-67000, which puts this definition of Colombo at the 30th to 20th rank. This fits the trend so far of getting richer and richer, the closer we get to the economic heart of what “Colombo” is. If we try to verify this by taking a rough view of “Colombo” as comprising half of Colombo District’s GDP, but across only a million people, we can get somewhere nearby as well - and I would feel that the city generates well more than half of the district’s GDP.

But are these values too high? Particularly given the question of whether the datapoint is nominal or not is not very clear to me, it could very well be. I will leave that question open for now and return to it later with an amenities approach, since it likely relates to the relatively uncommon nature of inequality in Colombo.

All of this is only an exploratory question - numbers alone don’t make a country rich

The biggest question with all of these is does it really ring true? Does Colombo feel like such a rich city? For many people, I suspect the answer is no. There is no real narrative, no real story that Colombo holds that it is truly a rich city. Richer than the rest of the country, sure, but the dominant narrative feels closer to it being the richest city in a poor country.

What these numbers tell us, and other explorations outside of this can as well, is that there is a potential story that Colombo has missed. Missed, in the decades of dreams and despair, missed in crisis after crisis, missed in the grinds of daily life, but missed in the end. Part of it might even be the cyclical nature of South Asian economies that prevent such a narrative from properly taking hold. But in the end, I think we will eventually have to think of and grapple with this narrative as well.

I don’t expect this narrative to immediately take hold. But we can’t forget the fact that since 2018, Sri Lanka, and especially Colombo, has been facing pretty strong contractionary and tightening forces (outside small exceptions). Will this continue? If the overall story of the economy changes significantly enough, Colombo could be looking at a big change in its story as well. This doesn’t have to be a purely positive story of course, but a big change nevertheless. My gut tells me we have to be ready to deal with what a “rich Colombo” means as a story and as a reality.

Disclaimer: This piece is written purely as personal opinion and analysis, and not meant to be a “forecast” of Sri Lanka’s future - rather, an exploration of the factors underlying the current debt situation of the country in a series of possible hypotheticals. This doesn’t reflect the work done at Frontier Research, which has anyway tended to be more specific in its expectations of the future.

There’s no question that Sri Lanka’s debt crisis is still ongoing. Despite strong improvements on key macroeconomic measures including the primary balance, inflation, and the currency, the economy is still barely sputtering along. While the potential for improvement very much exists, sociopolitical realities on the ground continue to be a reminder of the pain that has continued to exist alongside the topline improvements, particularly in an election year that is bound to add complexity to everything going on..

However, while domestically the focus has very much been on these domestic factors, the fact of Sri Lanka’s external debt crisis still remains unresolved. Sri Lanka is making progress with varied aspects of its debt restructuring, most recently reaching an Agreement in Principle with its official creditors, though there is more to go. However, plenty has been said and likely will continue to be needed to said about how Sri Lanka’s overall debt story can go in the future.

What factors drive Sri Lanka’s debt restructuring requirements?

The IMF’s DSA effectively restricts Sri Lanka’s debt deal only under a few targets, which I WILL repeat here for ease of reference. 

1. First, is that during the IMF programme, a certain amount of external financing is needed to close financing gaps (US$ 17 bn) - this largely comes from the fact that any debt deal is expected to provide either relief or new funding to this extent (this becomes important in a bit). 

2. Second, the public debt stock is required to fall to 95% of GDP by 2032 and decline afterwards - in the first 2 years, this is mostly through nominal growth and afterwards through a primary surplus and real growth

3. Third, central government gross financing needs should be lower than 13% on average between 2027-2032 - this is a whole other problem I’ve talked about before, so will only roughly relate to this here.

4. Fourth, FX payments are required to be limited to 4.5% of GDP across 2027-2032

In an Alphaville piece a few months ago, Brad Setser and Theo Maret have argued on the leniency of these IMF targets for Sri Lanka (more to do with the MAC DSA than on any Sri Lanka specific point) and I’ll extend my point from that foundation. In short, Brad and Theo give the following point - 

Complex models should not trump common sense: countries that dedicate more than a third of projected revenue to interest payment are not likely to be sustainable and regain market access. 

- Brad Setser and Theo Maret

Fundamentally, the problem here is that the IMF’s DSA for Sri Lanka puts it under a whole different set of conditions and features than for countries like Zambia, and this create a whole lot of space for Sri Lanka to “maintain” higher debt and payments and still be considered. Brad later takes up an extension of the same argument on how the IMF’s DSA can easily sidestep the specific issues that countries face (external debt in SL’s case) and end up justifying sustainability on a series of not particularly realistic assumption.

I will not rehash much of what Brad and Theo have said and recommend both excellent articles be read instead. However, what I will try to do is put some additional context, both historical and hypothetical, on how I would see Sri Lanka’s debt deal looking like. For this, I’ll assume Sri Lanka will not go Zambia’s way and see another year or so of delay before a finalization and somehow that there will be a deal confirmed soon enough.

What sort of external debt deal will Sri Lanka end up with?

As Brad and Theo have said, Sri Lanka’s debt targets allow for a pretty lenient debt deal to come through - one that relies a lot on multilateral support to meet the programme period debt relief, bilaterals to handle decent maturity extensions, and for haircuts on commercial credit likely to be compensated with varied mechanisms.

That last point bears a second review, given that all the talk of GDP warrants, innovative new contingent clauses, and upfront payments like in Zambia’s case can all reasonably fall within the IMF’s targets (I’m not too sure how alternate scenarios within contingent scenarios get captured in the main DSA and whether it’s possible to actually squeeze even more out of Sri Lanka by structuring the warrants in a particular way). In any case, Sri Lanka has shown SOME awareness of this - rejecting pretty directly the proposal for a macro-linked bond proposed by a group of bondholders. However, there may still be a lot of space to pay more than Sri Lanka could/should.

In any case, a deal that is less than favourable to Sri Lanka’s medium to longer term debt sustainability doesn’t necessarily affect a lot of things too negatively in the short-term. As long as comparability questions don’t come up too strongly (big ask, of course) even an unfavourable debt deal shouldn’t be too problematic immediately. One factor that CAN affect this even in the short-term is the size of any upfront payments - the MLB proposal had for example, 40% of past due interest paid upfront (though this has to be balanced against the programme period relief which is again, part of the challenge that can possibly affect CoT as well).

A strong positive here is how much domestic (and seemingly international financial) sentiment has become tied up in Sri Lanka as a positive story, particularly on a macroeconomic front and especially compared to the chaos of 2022. Once final data of Sri Lanka’s likely incredible primary surplus in 2023 comes out (personally think this could be as much as a 1.5 bn USD overperformance, driven both by a late pickup in revenue and curtailment of expenditure both recurrent and capital), that could again add to this story. The optimism that a finalized debt deal will bring out can easily help sustain the short-term positively EVEN IF upfront payments are higher than expected.

What can Sri Lanka’s historical debt sustainability tell us?

Brad argues clearly that Sri Lanka’s debt won’t be sustainable in the future - a country like Sri Lanka shouldn’t be considered sustainable at public debt at 95% of GDP in 2032. I’ll offer a few alternative ideas to this - ways that Sri Lanka’s debt could still continue at a high level, even if not actually sustainable, even with the weak targets and a lack of focus on external debt, and all the problems made possible by both of these.

Here, taking a look at Sri Lanka’s past gives an interesting starting point. Sri Lanka has actually been able to maintain quite high debt as a % of GDP for quite some time. This has both been during periods of market access as well as prior to this when Sri Lana’s debt was quite concessional. Exploring some of these periods could give some sense of how the future could hypothetically go.

Across the periods in which debt was higher than 90%, this is not particularly driven by one factor alone. Large external inflows (mostly bilateral and multilateral) continuing to disburse into Sri Lanka, an increasingly large domestic debt market (including at points, monetization by the CBSL) - which included generally high rates from the domestic market at many points - kept the debt levels high. Nominal growth and paydown of central bank debt have generally coincided with periods of the debt ratio falling.

The key points here are the external rollovers being possible - driven more by the presence of low-cost bilateral and multilateral debt than by any underlying “sustainability” - and the strength and place of the domestic market in creating space for debt. For me, both these facts meant space for the economy to continue on an unsustainable fiscal path, since the costs were sidestepped - which then also helped some of the costs by bringing in periodic bouts of inflation driving nominal growth. 

How will Sri Lanka’s engagement with the global financial system go?

I framed this article on the perspective of the global financial architecture on the basis that it is one that Sri Lanka might not have a lot of power (though it has more power to do so now than ever before) to change. Here, the question is will Sri Lanka’s debt be sustainable alongside however the global system evolves over the next decade or so.

One possible pathway for Sri Lanka is one of continued external rollovers, that allow Sri Lanka to see either real or nominal growth that brings down the debt ratios. Whether this happens through an improvement in global financial conditions injecting liquidity into the basket case of Sri Lanka, even at a high cost, or whether it’s supported by Sri Lanka maintaining tight fiscal policy and thereby, forcing external surpluses is less critical than the fact there are a few pathways towards external rollover that don’t create sustainability, but are allowed by some other mechanism. This is in essence, the post-GFC pathway for Sri Lanka resuming.

Another possible pathway for Sri Lanka is one where the domestic market overall continues to hold up more and more of the burden, but does so in a way that goes alongside the fiscal performance. Strong fiscal performance and primary surpluses to bring down domestic interest costs, lower rates to spur real growth, and the impact of the fiscal pathway reducing inflationary pressures. One possible pathway here is where the financial system borrows and onlends to the government - allowing for the government to remain locked out of markets but still access it at a reasonable enough cost. Parts of this pathway have been active since the 90s in particular, so there is some precedence for the Sri Lankan system trying this - though this time with fiscal performance driven external surpluses taking the place of extra external financing.

A third pathway for Sri Lanka is one driven more by nominal growth than real growth. This is admittedly fanciful given the newly inflation-targeting CBSL, but in the context of an inflation target that is slightly higher than the currently mandated 5% (lets say closer to 7%), nominal growth should be able to both push down existing debt stocks in real terms and also encourage the development of external surpluses by creating incentives towards it. This pathway has existed during some short periods post-2001 so again, there is some precedent.

I think the way to think of the IMF pathway is a combination of 1 and 2 - but where instead of external surpluses, Sri Lanka maintains external deficits financed through new debt. This is for me, where the seriously unsustainable scenario comes into play most directly. Sri Lanka definitely does have a bias towards consumption-led growth it has maintained in the past, so has enough time and restructuring happened to reverse this? My gut says that the system will seriously resist a move towards an investment-led growth model at varied levels.

Sri Lanka will probably see bouts of boom and crawl, but could a new paradigm be here?

However, none of these pathways are straightforward. As with Sri Lanka’s past, all of these pathways are probably possible in varied points. What all of this would mean is that the Sri Lankan system would likely remain fragile and shaky, even at points where the situation on the ground is both booming and when its crawling. My gut tells me that Sri Lanka will likely see shakiness this year particularly with the election worries and the comparability question on debt, improvement afterwards, and shakiness again in a few years. 

However, how much this really hurts the long-term story very much depends on the continuance of the fiscal pathway as well as how the external balances move. If Sri Lanka actually maintains its twin surpluses for a few years, then all bets are on IMO - it’ll definitely be a wholly new paradigm. The question for me, is then what helps this continue. What creates enough buffers and what creates enough incentives (both being somewhat contradictory points). I have no real answers to this, but on the long-term, my positivity hinges on the fact that I continue to hold that Sri Lanka’s pathway so far has looked more like those others in Asia that pulled out of crisis and less like those in the Americas that didn’t. Perhaps time will prove me wrong, but so far, I’m hopeful.

Disclaimer: This piece is written very much from a place of personal opinion on discussion, narratives, and discourse about economics, and how I see this playing out in an electorally and political charged period. I very much recognize the inherent bias here and will attempt to address this. A big part of this also comes from my personal belief that 9 times out of 10, the political future for Sri Lanka will effectively end up with the same broad socioeconomic outcomes regardless of the actual electoral outcome.)

There is little doubt that public conversation in 2024 will skew towards the partisan and political - after all, it is an election year. For Sri Lanka, this electoral moment is obviously a monumental one, being the first election after the crisis and a very significant one as well. For a country reeling with and recovering from an economic crisis, this can easily create a moment of discourse that is volatile, partisan, and pretty disagreeable. How do we deal with such a moment when we continue to need to have an economic discussion, and ideally one that acknowledges, but moves past the partisan nature present in this moment? For me, this has to be through a process of aggressive neutrality, with all the bias that such an approach comes with as well.

Economics is still and will still be a factor of the Sri Lankan story 

Why do we need to have a discussion about economics at all? Why not focus largely on the social side of things, the political side of things, or some varied other aspect of the Sri Lankan story now that the depth of the economic crisis is done with? This is a point that I feel is a bit circular, but in short - Sri Lanka’s crisis was deeply economic in my view, and will thereby continue to need an economic discussion for much longer as well.

Of course, economic doesn’t merely mean macroeconomic. The socioeconomic story is a key part of the economic discussion, as is the interplay between the political and economic spheres. Regardless of whether one holds a view of the primacy of corruption or social inequality or macroeconomic policy handling, the interactions across these sorts of spheres, not just one affecting the other but then the other affecting the one yet again -  coevolving with each other - is a key aspect I think is critical to keep front and centre of mind. Thereby, I do continue to believe that these discussions cannot happen in isolation, and need to be closely integrated with the overall economic discussion in all its elements.

This continued integrated discussion is critical in my view, since this overall economic story will not be something that disappears anytime soon. For years more to come, possibly even longer, the economic story is one that will in all likelihood, continue to be one that is shaky and volatile, even if it does well, and broadly on an upward trajectory, even if it does badly. This is both from the direct Sri Lankan side, but in many cases will also be from the clearly shifting global economic landscapes as well. Continuing to proactively engage with all this is an important tool in my view, for Sri Lanka to maintain and build a pathway towards a better country and for everyone involved to try and make sense of the pathway we will be on.

Underlying narratives matter and are a key part of navigating this moment

A pretty obvious development of the story so far is that the public discourse around the economic crisis has become incredibly partisan. I’ve talked (complained) about this before, but let me try to set out how I see this having happened over the last few years.

I think there have been broadly three types of economic messages/narratives in Sri Lanka for a while. One has been that of “growth will fix us, and better for it to be national” - I will call this the National Growth narrative. Another has been that of “we need macroeconomic reform and better policy” - I will call this the Reform narrative. The third has been that of “Sri Lanka has been wasteful and corrupt” - I will call this the Corruption narrative. The National Growth narrative was very much the kind of nationalist-centric argument that came in with the 2019 election, and continued as the major narrative until the crisis itself. There, the other two narratives took hold and have been tussling ever since.

How can we think through these narratives? For me, its absolutely critical to think of the incentives that led towards these being adopted and the biases that keep them going. The fact that the Reform narrative took hold when the country was in the depths of its worst economic pain - of shortages and galloping inflation (and the causes and costs of both) - is quite clear. If the current situation is not working, obviously there needs to be a reform of the current system. I believe the absolute intensity of the pain here meant that ideological or partisan messages against economic reform in particular, were very hard to fully take hold. It’s difficult to argue that with a country with immediate economic crisis, that economic reform is not needed.

However, this is not to argue that the Corruption narrative wasn’t present - it very much was. However, I don’t think it was in conflict outright with the Reform narrative during most of 2022, simply because there was enough space for both to be present. But as the worst aspects of the crisis started to be resolved and left behind us, the incentive to hold the Reform narrative on a wider level slowly petered out, and the cost of the reform pathway meant that there was now also an underlying incentive to reject it. I believe the strength of the Corruption narrative after 2022 can be understood at least partly from such a perspective.

These shifting narratives put us in an interesting place moving into 2024. In the traditional story of the macroeconomy, there has been lots of improvement on the topline variables - which strengthens the power of the Reform narrative. On the other hand, the pain of this Reform continues to weaken it at least on some level. On the other hand, the continued pain that exists despite the overall improvement in the economy, especially the pain on the ground for many people across the country, also strengthens the hand of the Corruption narrative as an alternative. Where will this story go?

The incentives and biases within the narratives cannot be ignored

Today, these two narratives are playing out not just from an ideological basis, but also from a partisan one. This creates a specific challenge - how do we engage with any specific idea in the current moment, without getting overly tied in with either angle?

Here, attempting to be “unbiased” and “objective” can be the straightforward answer, but I would still be very cautious about this myself. More than any other reason, such language itself has in Sri Lanka’s case and in many other cases, also been coopted by varied aspects of the partisan spectrum (traditionally by the “neoliberal” but very much also by those who claim to know the “truth” on the ground). Neutrality itself holds baggage, and it’s very easy for anyone claiming it, to also claim no incentives and biases. Obviously, this isn’t true. I think direct engagement with all the incentives and biases present in the moment can help somewhat, and here I will try to lay out a few I see playing into the partisan narratives overall but also those that prevent specific action happening one way or the other. 

There are three “truths” I would like to bring out that I believe and hope most and almost all Sri Lankans would agree with. First, that there is at least some level of unfairness and abuse in the Sri Lankan economic system. Second, that in the presence of personal pain, most people would want to avoid it. Third, that for many people if not almost all, things have worsened since 2021, even if things have remained “good” for some. The specific extent to which these three truths matter, I will not explore, except the fact that I think most people will agree with these at least partially. These three truths create a series of incentives in my view both towards the Corruption narrative and towards the Reform narrative. 

The truth on the unfairness of the system easily means BOTH that there is a lack of general faith in the system and thereby, an incentive against it, but also as importantly, a strong resistance by the beneficiaries of this system towards the system continuing. This is not just the politicians or the cronies, but everyone who directly or importantly, indirectly benefitted from the system - including burecrats and even general citizens who benefited from some aspect of the system. This is thereby, the same pain by the second truth of pain that most people would want to avoid, and the third truth that relates to their lot having worsened and seeing it as unfair. While the overall system’s continuance isn’t what this results in, it does and can mean that specific aspects of the system’s reform are resisted - and especially when people don’t see it as part of the system itself. All this applies not just to the economic reform, but also to the integration of the social and political dimensions as well - incentives for and against all aspects here.

There are varied additional ways this can manifest as. Those with ideological baggage one way or the other can easily tie their ideological story into these truths. Those with partisan messages one way or the other can tie their preferred political party into these as well. For both of these, there are incentives - sometimes personal (hope to get some money, status, popularity, grants, research funding) and sometimes larger than that (power in parliament, bigger place for your organization, potential for future). These incentives aren’t BAD in my view, everyone will have incentives of their own, but I do think we must be aware of these and the very fact that people ARE driven by these incentives and thereby, the “neutrality” of their action must always be questioned.

Aggressive neutrality is needed despite all this for Sri Lanka’s future

In my view, the current moment will likely be one where the partisan nature of the election year, in all likelihood, dominates the discourse of the year (not just relevant for Sri Lanka, but for all the other countries going through elections this year). Driven by incentives both personal and beyond, these stories will push forward and the biases that keep them fuelled might not necessarily be seen.

One positive aspect of this situation, is that very opposing ideas will very likely be easily seen. In Sri Lanka’s context, both the Reform narrative (now increasingly tied to incumbency) and the Corruption narrative (now increasingly tied to opposition) will have loud, strong, and at least in some cases, well argued proponents. The back and forth between these camps are visible in some places though not in all. Both of those angles I think, are quite well covered in the current moment in Sri Lanka, and personally I believe should be made - a case for why the movement of reform is needed and a case for those that are left behind. 

What remains broadly underserved as an area, is the story that can be feasibly called neutral or at the very least, non-partisan. There are some who are in this space, but for obvious reasons (lack of incentive being the main one, but also for being caught in the existing crossfire) this isn’t a particularly populated space. Given the strong and powerful narratives at play and the incentives that guide and keep them going, I would feel that this middle space becomes additionally important in an election year - both for a welcome reprieve from the toxicity that partisanship can bring but also importantly, the bridge some gaps therein. I generally would believe that it provides better arguments, better space, and better options that people in general can arm themselves with more understanding and better navigate the partisan landscape itself.

This is not to say that anyone in this middle space is unbiased, objective, and fully neutral. I don’t think these are possibilities in the full sense of those words. What could be possible, however, is being open and aware of these, and engaging directly with whatever biases present. In many cases, the ability to be within this space itself is an incentive as can many others that stem from the benefit of occupying this space as well as the costs of avoiding it. These aren’t points that can be ignored in my view, but someone in this space, by definition should be able to tackle that better.

In the end though, even if this isn’t perfectly done, I do genuinely believe it’ll be a positive addition to Sri Lanka’s economic story moving ahead. The path ahead will be long and the need for a continued dialogue on economics in all its aspects will definitely be needed. Aggressive neutrality has a clear part, to me, in making sure this dialogue continues to take place. All this will still mean the future of the country is a long slog, but even long slogs can end in better places eventually.

(This piece is being written as a general followup to https://www.lankaecon.com/p/sri-lankas-fiscal-future-a-tightrope and https://www.themorning.lk/articles/DUxuO7UmvvRDpknk2q3L , as part of exploring Sri Lanka’s economic pathway. Everything here is my own view and opinion and doesn’t reflect the thoughts and views at Frontier Research - though any data and facts would still come from the same sources, Frontier takes a far more diverse set of views than one person’s alone) 

At the risk of sounding repetitive, it is clear that Sri Lanka will have an absolutely critical 2024. Nowhere is this more obvious than in the upcoming election and whatever changes or lack thereof it brings. Given the overwhelming backdrop of the economic crisis, there’s no question that the elections will very much focus on this question. In many ways, this has already begun (and in even more ways, was always a part of the crisis as well), not only in terms of policy and political debate, but also in how sharply partisan public discourse has become.

Lets attempt to sidestep the landmines of partisan rhetoric here and attempt to talk through some of the economics for 2024 and beyond. Let's not try to be so bold as to claim unique or otherwise success in this goal, but rather hope that some additional context can still be placed on how one can be both optimistic about Sri Lanka’s long term (expecting things to be quite good) and still “pessimistic” (or rather, expecting a lot of pain) in the short-term. However, doing so will require a sidestep into the past once again. Although it is a story that has kept being repeated, it might be worth visiting it again in the context of where we are today.

A critical part of Sri Lanka’s past - growth driven by deficits

The technical explanation for Sri Lanka’s crisis (and one I myself have made in the past) is one of “twin-deficits” - at risk of oversimplification, spending more rupees than the government earns, spending more dollars than the country earns, and bridging these two gaps with rupee and dollar debt. There maybe plenty of disagreement on who is to blame, but I think there’s broad agreement on the broad story.

If we take these 3 aspects - rupee deficits, dollar deficits, and debt - we can see that the structure of the Sri Lankan economy was one where these two deficits were able to be run and where debt was readily available. I personally don’t think it’s necessarily very accurate to blame one factor over the others - if there was no debt to be had, the deficits might not have been run but if the deficits were not run, perhaps the debt might not have been available as well - but the end result is an economic structure where all three of these combine. This combination results in a situation where economic decisions are all made in a context where deficits continue to be run and debt continues to keep the system going. 

What does it mean for the deficits to keep running? On the rupee side, it effectively means higher incomes for many (if we consider the state service and the indirect employment impact of infrastructure development as a politically-biased form of welfare towards a big chunk of the working population) as well as reduced costs (both in terms of direct subsidies but also through the use of the state banking system to keep prices of utilities low and hence, anything else that depends on it the use of utilities). On the dollar side, it is both about having access to more and more imports (both for direct and indirect consumption - where fuel is the single biggest item) and having cheaper costs for all of these as well (through keeping exchange rates suppressed).

Such an economic structure can have powerful “positive” effects (I’m keeping positive in quotes since the temporary nature of these can make the label a little suspect). One direct impact is that incomes can end up higher and thereby, consumption can be too. Any inflationary pressures can be kept at bay by direct and indirect price controls (and shortages can be prevented by the government essentially paying the gap - energy is a good example here) and this can further feed into consumption. One other point is that all this can combine with the reduced cost of production to help businesses as well.  All this also means that many people can have a significantly better quality of life than otherwise - and this can be true across the socioeconomic spectrum. In my view, it is this model that allowed for the expansion of electrification, for the lowering of Sri Lanka’s poverty rates over time, and for many other socially and economically desirable objectives. Essentially, the deficits can be considered an “injection” into Sri Lanka’s economy.

However, there’s one issue (outside of the obvious - where the money comes from) here that I see - all of this encourages consumption and imports (given Sri Lanka directly or indirectly imports most of its consumption). This can give a powerful incentive for individuals, businesses, and politicians to align themselves with this same trend. For individuals, it can make more sense to work in an industry that benefits from this consumption. For businesses, it can make more sense to take business decisions that allow them to benefit from the consumption. For politicians, it can make more sense to push more of this economic pattern as well as tie themselves closer to these policies as well. This can then strengthen the pattern once more. I personally feel that this is a key reason why Sri Lanka’s export growth has been poor - there have simply been very few incentives towards it and very strong incentives away from it.

Without debt, this growth pathway was always doomed to failure

The only way this system can keep going however, is if there is money to keep it going. It doesn’t matter how “good” it is, if there is no money to finance it, it simply cannot be done. Here, there was one overall factor that really helped Sri Lanka keep going with these deficits in my view, and that was the expansion of global liquidity since the late 80s that led to huge amounts of money pouring into developing countries. Why invest in a developed country if returns are low, when you can borrow at cheap rates and invest in a developing country for a great return? This pattern expanded in the aftermath of the Global Financial Crisis as global rates were at effectively zero - there’s no coincidence that Sri Lanka’s golden age of sovereign debt was post-GFC as well.

However, Sri Lanka took the deficits too far. So much so, that the country even failed to see a proper post-conflict growth boom as is common for many others. Sri Lanka’s growth peaked in 2012 and slowed down ever since, as the size of the deficits started becoming way too large even for the highly liquid global markets to keep financing at the same rate (incidentally, Sri Lanka’s growth rate slowing sharply from 2013 is a point that rarely gets noticed - the growth slowdown actually started under the second MR regime itself).

At its most simple level, if there’s a leak in your boat, you try to patch it first. Sri Lanka attempted to do this, and there was some broad success from 2013 to 2019 - though there were many missteps along the way with the global liquidity still being sloshy enough to allow these mistakes to continue unpunished. However, the slowdown in growth combined with the sociopolitical backlash following the Easter Sunday attacks (and undoubtedly many other factors) and we ended up with a new government by end-2019.

Many pages have been written about how the tax cuts took a country which was running on debt and took away one of the few sources of non-debt money it had, so there’s probably no need to repeat too much just yet. The pandemic also meant that tourism didn’t really recover after 2020 (2020’s fall wasn’t too problematic since imports also fell during 2020, but imports recovered in 2021 although tourism and critically, remittances didn’t). However, on the dollar side the bigger factor was probably Sri Lanka losing access to the cheap money that we had lived on - and being limited to just a little being given by China (and later India) - enough to barely survive, but definitely not to run a functioning economy with.

The recovery from the crash - the rise itself in reverse

The immediate impact of the lack of debt was that the deficits can’t exist at the same rate, and they have to basically contract. This means that the “injection” we saw into the economy slows down and overall can even reverse - a “withdrawal” from the economy instead to pay back at least a tiny bit of the cost of the injections. Raising revenue through tax increases and containing expenditure will be how the rupee deficit falls, while the adjustment of prices that allowed the dollar deficit to be subsidized will be how the dollar deficit falls.

Of course, the problem is that this doesn’t happen in a vacuum. Reversing the injections means first that the benefits of the injections themselves start to reverse, and then that the negatives of the withdrawals start to be felt. The benefits of the rupee deficit - the higher incomes, the growth in consumption, the reduced prices all go away. The benefits of the dollar deficit - more and cheaper imports and the quality of life improvements afforded by them, all go away as well. 

This is of course, likely an inevitable overall consequence of this pathway. If we had benefits financed through debt, the lack of the debt means the benefits themselves no longer can exist in the same way as well. This is why the short-term still likely remains quite painful in my view, though less painful than the crash of 2022 - especially since there are still other aspects that compensate somewhat.

While one could theoretically argue away consumption by calling it “excess”, some of the benefits were also far more socioeconomically beneficial as well. The pain would also be on those benefits too. For example, Sri Lanka’s rapid electrification would be affected by the utility pricing adjustments - which would undoubtedly affect quality of life substantially (though the specifics will take time to be seen - data points like disconnections are still not significantly higher than past years despite media attention).

Thereby, the disagreement on the pain probably shouldn’t (at least in my opinion) on whether the costs are needed, but rather the pain can be better distributed. Broadly, I think there is a lot of pain being put on the biggest absolute beneficiaries of the old economic structure -the rich - but there is also a lot of pain being put on the small in absolute but relatively significant beneficiaries too - the poor. The fact then, that the poor are suffering is undoubtedly a key part of how we must understand the crisis and its recovery (though we probably shouldn’t overplay it either - “reduced calorie intake” is quite bad, but it's still different from absolute starvation). I have previously argued it's more a reflection of the unsustainability of the past pathway than the recovery from the crash that’s to blame, but in the end, the justification doesn’t really matter but the pathway forward.

What does the pathway forward look like?

Probably the biggest flashpoint on the pathway forward is the increase of VAT rates and the removal of many VAT exemptions. Even if some of the outrage on “essentials” being taxed is a little overblown in my view - many essential food items are still VAT exempt, though a few could be argued to be essentials will now be charged VAT - there’s no doubt that this isn’t a particularly progressive change to the tax policy (though VAT is probably not as regressive as immediately visible given how unequal Sri Lanka’s consumption is, because VAT replacing a more opaque tariff system is probably better, and because of how VAT can act to improve tax base widening outside of the VAT itself too). 

However, I don’t think we can take this VAT change in isolation. This is not a change that is being done in a vacuum, but rather in the context of an economy that has begun economic expansion once again, albeit slowly. With local credit recovering, remittances remaining strong, and tourism growing quite well, some of the drivers of local growth are starting slowly. It’s entirely possible that these, combined with the powerful impact of the public salary hikes of 2024, more than offset the OVERALL impact of the tax changes for 2024 (there’s also the reduction of PAL on many of the newly VAT imposed items too - which again reduces the net impact). This doesn’t mean NO impact onto the economy, but rather something closer to “slower recovery” (The question of VAT likely can’t be addressed in its entirety here - I will likely return to it later).

Once again though, even if the overall impact is mitigated, that doesn’t necessarily mean the same for the equality of the change. Here, we must be generally cautious in my view - this is not an area with a whole lot of data on, and it's easy to get caught by anecdotes - both the positive and the negative. What data we DO have (the recent DCS survey results on the impacts of the economic crisis are useful here both in what it reveals and what it doesn’t - for example, overall household indebtedness has actually fallen from 2019, though number being indebted for food reasons has increased), suggests that the impacts of VAT changes are likely to be felt by the poor, but the continuation of some exemptions do limit the likelihood of an absolute disaster (limit, not entirely prevent). Overall, it feels like there will be pain that continues, and at least for some part of society, might even increase as well (though it may not be a clear consistent increase in pain even there). Obviously, questions of fairness aren’t answered well here - if the poor even have a CHANCE of their pain increasing, that isn’t a fair outcome in my view.

But is the pain “worth it” still? Does it lead to a “sustainable” economic pathway? Perhaps, but with a big caveat. Let's first look at how it CAN work before looking at the caveat.

Earlier, we went through how the structure of the economy in the past was that of deficits financed through debt. The pain we’re talking of can be thought of as an inevitable consequence (the overall pain, not necessarily in how it's distributed) of these deficits reducing, thereby it also then goes alongside the improvement of the underlying conditions. This can extend beyond the simple macroeconomic as well - an easy example is how the amount of graft and theft that would have happened through infrastructure development likely fell dramatically, simply due to the inability to finance large-scale infrastructure. The restructuring of our existing debt that happens parallelly to all this also can help create space for these reduced deficits (more accurately, surpluses by now) to accumulate in more long-term sustainability as well.

As there is short-term necessity to address these deficits (simply because there’s no other way to), one change that additionally comes into being would be the structural legislative changes alongside it. Some of these may be directly related to the deficits themselves - for example, the Parliamentary Budget Office Act - while others may be more about adjusting around the deficits to improve other aspects - for example, the Anti-Corruption Act. These two are particularly important ones to look out for - since the establishment and empowerment of strong independent institutions has the potential to be very impactful. The example of the Central Bank being defacto independent since April 2022 (and legally so since September 2023) is a great testament to the power of such institutions - even if one may disagree with the direction. Of course, the PBO and the new CIABOC aren’t functional yet, but looking out to see how they become established within the Sri Lankan system can have powerful long-term implications as well.

I personally believe that there is another important factor underlying as well, and that is that the structural incentives in the economy has likely changed, with the past structure of the economy now serving as a disincentive. The risk of “80% depreciation” or “70% inflation” is not something that will be forgotten completely, and I would feel this encourages more and more businesses, large and small, particularly small, to look at more export oriented avenues. In Sri Lanka’s current context, this can both serve as a more sustainable structure for the economy, that both allows the dollar deficits to be lower but also reduces the incentives of politicians to take policies to encourage consumption, and hence reduces the incentive for the rupee deficit to expand too.

The major caveat to this pathway is that it's quite some distance away still (and it's not necessarily the only way the long term pathway can materialize - service growth, remittance growth, agriculture growth, partial improvement in global liquidity are all factors that can go alongside this as well). This means that to get to the promise of this eventual pathway, the short-term pain and unfairness has to be borne.

Steeling through the pain towards the promise - will it happen?

Here, the responsibility lies squarely upon policymakers in my view. I don’t think merely telling people that the future can be good, or merely recognizing that the burden very much remains on the people achieves this purpose. The circumstances to achieve this must be set out by policymakers in varied ways.

One way is to find other ways to compensate people for economic pain. Whether this is through structural reform that helps or whether it's through finding places to reduce costs when possible is besides the picture. The easiest yet hardest solution here is probably taking strong anti-corruption measures - easy because it isn’t particularly expensive in financial terms, hard because the beneficiaries of corruption (not just at the top) will heavily resist it, making it quite expensive in sociopolitical and even administrative terms. The new CIABOC will have a huge role to play here.

Here, taking symbolic steps are useful as well as avoiding actions that look terrible. For example, the VAT increase going alongside a tax exemption for a project as Special Development Project looks terrible (even though the actual functioning of the specific exemption might take a few years to really matter, the timing is terrible regardless). Ironically, a change in governance would probably make it much easier to run the exact same policies as now, though intentions of course, can still differ.

I don’t think it’s realistic to expect massive change in governance structures given the continued forces that would oppose them, so I would be realistic on what actual results we can expect anytime soon. However, that doesn’t mean that there aren’t changes that can still be made. The Aswesuma programme is a good example - both in the goals being commendable, the rollout being very weak and messy, and some of the solutions including empowering the Welfare Benefits Board being something that steps CAN be taken towards, even if not easily.

All of this is also alongside a particularly fragile period for the Sri Lankan economy. The inability to run deficits also means that any short-term shocks aren’t able to be tided over - the increase in tariffs in 2023 are a good example here. With many local and global factors - debt, liquidity, credit, climate, geopolitics being probably the more alarming in the short-term - still looming over the country, it becomes especially important to build up as much space as possible in the system. Given that deficits are no longer possible, then this must come from other aspects.

Overall, I’m not going to expect a lot of the pain for 2024 to be adequately avoided. This isn’t a positive message for sure, but I also don’t see this mismanagement being something that is overly harmful for the long-run, though it would very much be quite damaging to those that would face it directly. I would still expect things to gradually improve, even for the poorest (though again, the immediate impact of VAT would still be felt), and for Sri Lanka to move towards its promise. That promise, I am still quite confident will be reached. If I look back at countries across history, it is difficult to find countries that don’t do well over long-term horizons, except in incredibly unique circumstances. Of course, the ideal is that it doesn’t take so long, and that the journey itself is painfree. However, I would be less utopian about Sri Lanka’s journey towards promise. It’ll be a painful journey, but the promise can still and hopefully still, compensate for the pain in between.

(Most of this remains personal opinion, though the facts and figures of the past are very much driven by work at Frontier Research. Outside of those, thoughts given here are very much my own and don't reflect Frontier which doesn't do this sort of policy thoughts. What I’m explaining is also an oversimplification, so please bear with this.)

As Sri Lanka continues its gradual recovery from the worst of 2022, some aspects of the economy are now starting to look towards a stronger recovery in the future - though many others are still crawling along. What choices the government makes on the fiscal front will likely be a key part of how this story turns out. Although I’m writing this on the eve of the budget for 2024, I will focus far more on the overall future of the fiscal trajectory and largely leave the impending budget aside for later.

Sri Lanka’s fiscal past - Growth financed through borrowing

It is largely undeniable that the root cause of Sri Lanka’s crisis stemmed from fiscal mismanagement. Of course, views may differ on whether this was revenue-related (which is largely consensus but has a few detractors), expenditure-related (which is more commonly held in urban centres than outside), or more driven by theft-corruption (general economic consensus is that this was not the case, but it is a powerful and attractive argument nevertheless for many across the country). I will touch on the theft-corruption angle later, but outside of this, the key message is that as long as these fiscal issues remain, it will mean the government’s ability to directly push growth is limited.

However, these fiscal constraints aren’t new. Sri Lanka has had weak and falling revenue for ages and our government sector employment numbers have been rising for ages. But despite this, GDP grew at a compound rate of around 5.2% from 1958 to 2021. Though these are not absolutely stellar numbers, they still account for a pretty decent level of growth. We can break this period down into many more, but I will refrain from doing so too much to keep this piece a bit short. I will just note that if we take the 2001 to 2018 period, growth is even faster, compounding at around 5.8%. There are always issues with comparing growth rates across such a long period, especially given how hazy GDP as an indicator is, but the broad message should still remain - Sri Lanka managed to see at least decent growth despite fiscal issues.

How was this done? Overall, through borrowing to hide the fiscal issue or at least, to side-step it. This was from varied sources, but we can simplify it down to being primarily from the CBSL (money printing) and external borrowing, and secondarily from local (relatively) captive sources of capital. These essentially meant that although domestic fiscal conditions should have necessitated fiscal consolidation, successive governments were able to avoid this reality by borrowing to fund growth. The rise in growth since the late 80s along with falling revenues as a % of GDP is a great indicator of this. I won’t place all the data here, but may follow up later with some of this.

Constrained fiscal space - How can growth be financed?

One key difference that shapes Sri Lanka’s post-crisis fiscal environment, is that both the primary sources of financing are significantly lower than in the past. Given the new CBSL Act, “money printing” won’t be possible unless there are circumstances that cause the Act to change (which would need a strong majority in Parliament that wants to print money). Given the default, raising large amount of external finance will also be constrained for a while. Here, global liquidity conditions matter even more than local in a way, since tight global conditions would mean costlier and fewer funding coming into Sri Lanka.

This leaves local sources alone to finance the government’s deficit - which is where the government is moving towards a primary surplus (though the overall balance remains in deficit, and is currently being increasingly rolled over causing a rise in interest). The current framework for the primary surplus is that through revenue growth and expenditure rationalization. Although there can be different views on HOW the balance between revenue and expenditure can be handled, and what measures are best within each, I don’t think there’s much disagreement on whether SOME measures are needed.

The issue with whatever measure is taken, is that it will constrain that growth pathway we saw in the past, because the mechanism to sidestep that growth constraints are likely going to be limited. Tax measures would constrain consumption, expenditure measures would do the same. Tax measures can additionally constrain production and investment in the economy as well. External borrowing and money printing could theoretically have mitigated some of the growth impacts of these, but as we have seen they have their own costs - arguably worse. Of course, the alternative of taking no measures would very likely be worse too in that huge deficits remaining unfunded would likely necessitate either sharp inflation to reduce the value of these deficits or outright default. In all of these outcomes, weak growth leads to weaker quality of life, weaker health and education outcomes, and weaker upward mobility than in the past. This is, of course, heightened for the poorest but not at all limited to that level. The fact that this is a relative change (things are still growing and improving, but at a weaker level, and it will take time to reach pre-crisis levels) is quite likely to lead to high levels of dissatisfaction at varied levels of society.

What this is likely to mean, is that the “costs” that are being felt by the economy and society are unlikely to be purely temporary, and that society is likely to have to face higher costs than in pre-crisis Sri Lanka for much longer.

Avoiding a growth trap - are there any options?

Given these constraints and the need to try and address these, the only real way to “boost growth” seems to be financing from abroad. What form this takes, whether it is tourism, remittances, foreign investment, foreign inflows into our securities, or even “repatriation of stolen money” is not particularly important in my view - since I feel they all fall into the same few traps.

The first trap is that although the topline numbers for all of these are “inflows”, the actual effect is rarely as straightforward. Inflows that result in direct growth of individual incomes (tourism and remittances) have a direct impact on the amount of imports that are consumed - leading to a new outflow that coincides with the new inflow. Foreign investment and inflows also have an outflow baked in - projects often have direct import requirements, and both investments and inflows have an obvious repatriation need. This is not to say that none of these inflows matter and they are negative. They are still positive in that it allows consumption-led growth to some extent AND it doesn’t require new debt to finance this. Rather, it is to say we can’t consider these purely as “free money” and that there ARE costs, sometimes quite immediate, that moderate their positivity. Even if it allows some “new growth” to happen, whether it is enough to finance the “existing growth” is a question I don’t think gets a full-hearted yes.

The second trap is more subtle, and relates to the external finances more. Sri Lanka will still have external debt payments to make after the restructuring is complete, which will mean a need for USD to be generated to pay these off. This requires an obvious thing to happen - for our USD income to grow faster than our USD expenditures. However, a key problem with inflows alone is that they can cause the LKR to stay strong and even appreciate (though in the short term, the CBSL’s desire to grow reserves can absorb these inflows and delay what I’m explaining below). Why is this a problem? This means that the incentive towards growth of the export sector (through decreasing the income on exports), the key USD income earner, will be severely constrained leading to weak export growth (I personally feel this is the key reason for weak export growth in Sri Lanka, a relatively controlled exchange rate). Additionally, the incentive towards growth of the import sector (through decreasing the price of imports), the key USD expenditure, will be strongly supported. These two factors can combine to create a situation where Sri Lanka has a constant deficit in the USD trade balance, hence leading to a net outflow of USD. Combining with our debt repayment need, this will mean one of two things - either we need to borrow more to meet these two deficits (trade and debt), or we act to constrain the economy again and improve the trade balance - what happened in 2022 for example.

To me, this means a whole bunch of factors that add a huge amount of complexity. None of this means that a particular inflow is bad or a particular outflow is good. The balance between these factors will vary in all sorts of ways. For some, one balance will be really good while it will be completely different for another. On the whole, however, it seems difficult for me to argue that one approach is purely completely better than the others in the short-term. Of course, I do still believe that in the long-term, even short-term pain will be worth it and will lead to a great outcome, but the question is whether we then actually reach the long-term.

The tightrope to walk on - How can a government handle all of this?

What all of this means, is that there are no easy answers for the government. If it chooses to prioritize growth, it will need to finance it one way or the other and the lack of reasonable options can lead to further issues. If it chooses to prioritize stabilization, it will need to deal with the real and perceived impacts of lower growth. So far, it has had a benefit that the costs of 2022 were so high that stabilization measures were still an “improvement” on growth, but this dividend is fast fading.

All this is very much part of the fiscal future of the country. The social impacts of lower growth can’t be ignored nor can the social impacts of debt-financed growth. It is not just something that matters outside of economics, or something that affects the economics, but in my view is a part of the economic trajectory as well. Both from the socioeconomic as well as the political angle, each approach will have detractors and supporters. Their incentives, lobbying, support, and narratives will be a core part of what shapes the economic story in my view. They cannot be excluded from the economic equation and considered separate.

A future that includes SOME pain doesn’t seem particularly easy to avoid for me, whatever the path taken, though the shape and colour of this might be. This pain is likely going to cause further instability that affects the macroeconomic story at some point, whether it is in 2024, 2025, or beyond (I don’t mean public unrest, but varied social, political, and even economic responses that prevent a particular macroeconomic pathway). For me, this means that economic stabilization cannot be limited to the macroeconomic indicators, but must also extend to other aspects as well.

This is not to say that we must “sacrifice” the macroeconomic performance for the other aspects - stabilization measures that ignore the macroeconomic reality are doomed to fail. Rather, it is that reasons that cause non-economic instability must also be addressed directly and indirectly. These are, of course, not just public responses. Stabilizing not just the social impacts on wider society, but the political responses of lobbying groups, political parties, external actors and even ideological narratives will be a core part of Sri Lanka’s future. All of this stems from the fiscal pathway and the constraints coming from it, and will likely need measures from that pathway as well - essentially that macroeconomic measures that ignore the wider stabilization needs are also doomed to fail.

Will Sri Lanka go down this road? It is difficult to say, but there seems to be rising multi-partisan consensus on the need of the purely macroeconomic stabilization pathway at the least. Political parties are of course, only one part of the picture, with small and large businesses, the media, and even average citizens all having the ability to influence, at varied levels, the amount of stability and instability in the system. My hope, however, is that any emerging political consensus also leads to political parties taking measures that ensure that other forms of instability are also addressed across society, and particularly that they won’t be pushed to add instability into the system. In the long-term, I think the economy and society will adjust, I struggle to think of countries where it hasn’t. However, I think there is space to make things less painful in the short-term as well, and that we all have a part to play here.

This piece is part 3 of a multi-part series going into the role of money and inflation in Sri Lanka. The first two parts can be found here and here. This piece will focus on how I understand and see credit in the economy, and what it means. This piece is meant to be a precursor to a more detailed dive into how credit works in Sri Lanka, but explaining some ideas behind it in more detail felt easier than cramming everything into one piece alone.

Credit IS the lifeblood of the economy - and I don’t exaggerate when I say this. But that doesn’t make credit a simple good that must always be given - Sri Lanka’s own experience with catastrophic inflation is a good example here. Too much blood in your veins doesn’t help keep you alive in the end.

Understanding the role of credit, in my view, is a critical part of understanding the workings of the economy, and in particular, how inflation moves. For a country going through a period of high inflation (though thankfully, inflation which is slowing down), this becomes especially important.

What exactly do I mean by credit?

Very simply, I mean the amount of loans and debt taken on by the economy overall. This is not just limited to loans taken by individuals, loans taken by the private sector, but also very much includes loans taken by the government and government institutions as well. Credit also includes beyond just simple loan contracts, but also includes tradeable debt like bonds and commercial paper, but also any repo/reverse repo contracts on top of those as well. Of course, the further you go into the financial system and the more derivative credit becomes, the more and more complicated the situation becomes. Thankfully for our purposes, the Sri Lankan system isn’t heavy on the derivative side so anything beyond repos become quite small, and small enough to not be a major factor (at least just yet).

How does credit work - is the theory realistic?

The textbook definition of lending is where a bank or another licensed financial institution takes money in as a deposit (or money from shareholders it keeps as capital), and then lends that money to the economy (after keeping a certain % of the deposit in reserve), and the process repeats. 

For example, if a bank has a reserve requirement of 10% and receives a deposit of Rs 1.11 m, it is required to keep Rs 0.11 m in reserve and can lend out the remaining Rs 1 m to other borrowers. The borrowers then deposit that Rs 1 m into another bank, which is also required to keep a fraction of that deposit in reserve and can lend out the rest. This process can continue, leading to a multiplier effect in which the initial deposit can result in many times its original amount being loaned out.

This is the textbook definition of how bank lending works - known as the fractional-reserve theory. I personally believe this remains theoretical only, and that the practical reality of how banks lend is different. In practice, I don’t think it’s accurate that banks loan out money that they have direct deposits for. I’ll give two explanations to show this.

In both of these explanations, lets think of what happens when you go to the bank to get a loan. Assume that the bank has a reserve requirement of 10% and you’ve asked for a Rs 1 m loan to be repaid in 7 years. Lets also assume, of course, that you are creditworthy, the bank has done due diligence, and has decided that YOU are worth giving a loan to. The only thing now they have to deal with is actually giving you the loan. 

Firstly, according to the theory, due to the need to match deposits, in order to give this sort of loan, the bank will need Rs 1.11 m (since they can only lend 90% of the deposit amount) in a 7 year deposit (since they’ll have the pay the deposit back in full once the loan is fully paid off). In practice though, will the loan officer start calling around frantically, asking if such a specific deposit was made somewhere, so that they could lend Rs 1 m to you? The simple answer is no. The loan officer isn’t practically matching the deposit to your lending need, at least not at that immediate moment.

Okay, but this could be because the bank already has extra cash so they don’t need to directly match everything. But surely they’re still looking at reserve requirements in close detail? I would argue not immediately.

For the second explanation then. In order to meet reserve requirements in practice, the bank branch you are getting your loan from would need to thereby know the exact amount of reserves and cash held by the bank overall, as well as the total value of loan contracts that has been signed up until that moment. Is it realistic that even a branch manager has direct access to all the most up to date information that the bank’s treasury has, and that they make lending decisions based off that information? I would argue no.

My argument here is that it’s not really practical to strictly follow reserve requirements and deposit matching in a continuous way for every lending transaction as theory suggests, at least not as a factor that the actual bank officers consider before making each and every single lending decision. Of course, reserve requirements still need to be met for sure - so how does this happen?

Credit creation in practice - creating money now, dealing with issues later

My view is that the reality of how credit creation works in many countries of the world, including Sri Lanka, is one where the reserve requirements and deposit matching needs happen in aggregate later, and any short-term needs are met by the banks themselves borrowing from others. Let's explore this view, and use a few diagrams to illustrate this.

When a bank first extends a loan, what would happen is that they would both see an increase in their loans (an asset since a loan is something that gets paid back to the bank later) AND an increase in deposits (a liability for the bank, since it can be withdrawn as cash or transferred to another account) as the bank puts the loaned money into your bank account. Since in practice, the reserve requirements don’t have to be (and practically can’t) be met every second for every transaction throughout the day, it’s perfectly possible for the bank to essentially create the reserve requirement it needs on their own. This first part is probably the least intuitive - how come a bank creates money out of nowhere? But practically, this is my view on how it works.

However this is only a short term thing. While it’s technically possible for the bank to just issue a loan, put the loaned money in your account, and then when the loan is due, just take the money back (accounting for interest of course), in reality, you’re not going to leave the money in the account for ever. Most people take loans to use the money, and for that, the money can leave the banks accounts - meaning the increased deposit falls, meaning that in order to meet the reserve requirement, the bank NOW needs some more money.

There are two ways this can happen. First, is by NOW getting a new deposit in (or a sum of deposits that fit the reserve requirement). Second, is for the BANK to take some short-term debt to get some cash and fill the reserve requirement. In practice, my view is that both of these happen - in the short-term, the bank can use short-term borrowings to meet this (for example, borrowing some money from the central bank or from other banks at the end of the day) until they get enough deposits later on. However, if we’re at a place where the bank already has excess reserves, then the need to do new short-term borrowing is limited.

The reality of credit creation affects what causes loans to be extended

Understanding this practical reality is important because it changes whether lending can happen or not. Whereas according to theory, the presence or absence of deposits is a main factor to whether a loan can be given, in this practical framework that isn’t as critical anymore - or at least, isn’t as critical NOW. What’s more critical, is whether short-term borrowings are possible, and at what rate. The more money is available in short-term borrowings and the easier it is to borrow that money, the longer a bank can sustain itself without needing to take on new deposits. Of course, eventually they definitely do - but until that happens, banks have some leeway in practice (the presence of repo markets and derivatives markets help delay that even further, but in countries like Sri Lanka, derivatives in particular aren’t as large a deal, and private repo markets are generally dwarfed by central bank facilities. The process is also a lot more complicated than what I explained, but the simple explanation can be approximated through considering all of these as simple “short-term borrowings” as well).

Beyond this, where the specific credit goes also matters. For example, extending a loan that is used to buy machinery to produce exported textiles is different to a loan that is used to build a house which is different to a loan that is used to buy a Treasury bill with. The first and third will both produce income, though the first is more longer-term and uncertain than the third. The second is very much a consumption decision, so the ability to repay will be different - though if housing prices are rising, someone could build the house, sell it off, and then easily repay the loan. These types of differences also directly (in terms of repayment ability) but also indirectly affect how credit is created (in terms of overall amount of money in the economy that is used to both meet the deposit requirements but also short-term borrowing ability of banks).

This story and explanation then affects how inflation can work. Instead of needing to strictly match deposits, banks can create more credit since the short-term reserve requirements can be met through short-term borrowing, and then the bank can get deposits later (often, because the initial loan given could create additional income in the economy, which can return to the bank as a deposit later). If the credit created was used for consumption, then there is a greater inflationary effect in the economy than otherwise possible. On the other hand, if the credit created was for production, then there could be a greater deflationary effect than otherwise possible.

The whole story for countries like Sri Lanka also depend on the role of depreciation, given the large import dependency. This story ties in from the credit angle, so that’s what we’ll go into next - how credit has expanded depreciation tendencies in the Sri Lankan economy.

This piece is following on from a previous piece that went into some theories of money - where I noted that I was splitting an article explaining Sri Lankan inflation into two, and writing a more technical piece on . However, this explanation of money is taking on a life of its own, and morphing into what is likely to end up as a series of articles exploring money and inflation in Sri Lanka instead of just two. This current article will only expand on some of the basic ideas behind money and inflation for now - though going into a bit more technical points, it will still be quite straightforward in a way. This also means my explanation of money here is going to be overly simplistic, so please do bear with that. Future articles will likely slowly go into more detail and specifics about the Sri Lankan story.

Inflation is always a monetary phenomenon. That was Milton Friedman’s declaration and one that has been a powerful part of the global monetary story. The same was referred to once again in Sri Lanka, when the country went through its sharpest inflationary periods in recent history. But how true is this statement and in what contexts does it really matter? The short answer - in many cases, it is very true, but the mechanism of action could be very different (and possibly counterintuitive).

What does the theory of monetary inflation tell us?

I’ll use the same “chocolate” example as in the previous piece for continuity’s sake to explain both how the monetarist view on inflation is both right but also not necessarily relevant in Sri Lanka’s case.

The basic explanation is that ceteris paribus (in simple English, if everything else remains the same - I guess economists felt left out when lawyers used Latin phrases to sound sophisticated), if there is an increase of money, then prices will rise. 

Lets use the chocolate example to assume that you have only Rs. 100, and there is only 1 bar of chocolate, and nothing else in the world. In this context, the price of chocolate is Rs. 100.

If there is a Rs. 100 injection of money, then the price of chocolate will rise to Rs. 200. Money supply has gone up by 100% and inflation is 100% as well.

Reality is more complicated than a simple example - but the relationship still holds broadly

This is the classic monetarist example, but reality is more complicated (you’ll hear me say this many times throughout this piece, please bear with me). Lets assume that you decide to save Rs. 20 of the new Rs. 100 you get, leaving you Rs. 180 to buy chocolate with. Now, though the money supply has increased by 100%, the price of chocolate has only increased by 80%.

Lets go one step further. Lets assume that the entire increase in the money supply doesn’t come to you alone, but only Rs. 80 comes to you, and Rs. 20 actually goes to the chocolate seller (who saves it). You also save Rs. 20. Now, the total money left to buy chocolate with is Rs. 160, which means money supply goes up by 100% but inflation only rises by 60%.

These examples, although resulting in less than a 1 to 1 relationship, still very strongly suggest that an increase in the money supply definitely does result in an increase in inflation. However, when we started to think about other uses of money outside of goods consumption (for example, how saving in the bank reduces the reality of money available for consumption), we start to see the first inklings of how chocolate prices COULD theoretically, not rise as much as theory suggests.

Money doesn’t always get consumed or saved alone - production can grow too

To take this into more contexts, lets take one more step. Lets assume that the Rs. 20 the chocolate seller gets is instead used to increase productive capacity, and now there is actually 1.2 bars of chocolate. The total amount of money left to buy chocolate is still Rs. 160 (original Rs 100 + Rs 80 you got - Rs 20 you saved), but you’re splitting it over 1.2 bars instead. The price of a chocolate bar is now actually Rs 133.3. Although the money supply has increased by 100%, inflation is only 33.3%.

This is of course, a pretty significant difference from where we started off from, although directionally things are still the same. 33% inflation is still high, but I’d argue it means something completely different to the doubling in prices (100% inflation) that the original 1 to 1 relationship suggested. We see this more clearly if we assume this is annual inflation - a 33% annual inflation rate is high, but still in the realm of controllable. 100% annual inflation on the other hand, is bordering on a spill into hyperinflationary territory.

The role of credit in the story of inflation

All our examples so far have involved direct transactions - nothing has been leveraged yet. Lets take another step beyond this to add some credit.

Lets assume that the Rs. 20 you saved is directly lent out by the bank, equally to you and to the chocolate seller (assume no interest). The chocolate seller uses it to expand production even further, to get 1.3 bars of chocolate in the end. For simplicity’s sake, let’s say you decide to use the Rs 10 in credit to buy chocolate as well. Now, the price of chocolate is Rs 130.7 per bar. However, the total money supply has gone up by MORE than 100%, since there is also an extra increase in money due to the credit given by the bank (this expansion in money from credit is a critical point we’ll touch later in this piece, but in more detail another time). Once you factor in the fact that there is an extra Rs 20 due to credit, the relationship between the money supply increase (120% increase) and inflation (30.7%) becomes a little bit less strong again.

This shows a critical point that can be easy to miss when you don’t take this deep-dive. The presence of credit in the economy can THEORETICALLY lead to a situation where inflation FALLS rather than rises, despite an overall increase in the money supply. However, this is contingent on the credit flowing into productive parts of the economy as opposed to the consumption side alone. Lets take 2 examples to show this effect.

In both these examples, lets assume that instead of only lending out the Rs. 20 that was deposited, the bank decides to lend out a total of Rs 100 (for simplicity’s sake, lets say this is based off money the bank had previously). In these examples, the increase in the money supply is therefore, 200%  - Rs. 100 from the initial injection of money, then another Rs 100 in credit from the bank, which adds on to the original Rs 100 you had.

In the first version of this example, the bank decides to lend only Rs. 10 to you (like in the previous example, you use it to buy chocolate again) but Rs 90 goes to the chocolate seller, who uses it to along with the Rs 20 injection to increase production (for simplicity’s sake, lets assume production capacity increases at the same rate as before), and is able to produce 2.1 chocolate bars in total.

Now, for the first time in our examples, we have an actual case of deflation! The money supply has in fact, tripled, but prices have actually fallen instead of rising sharply! Truly a lucky day for the dentist next door. What caused this, however, was that although the money supply increased sharply, a big chunk of the increase went into production, which actually increased the supply of good instead. This isn’t contrary to the monetary theory (which of course, was always ceteris paribus), but it does show how there can be an alternate pathway to how money impacts the system

What about the other example? In the second version of the example we see how the effect of money on inflation is amplified instead. Here, lets see what happens if the bank decides to lend the entirety of the Rs 100 to you to buy chocolate with, lets say because you have land you can show as collateral, and the chocolate seller doesn’t have the same sort of relationship with the bank.

Here, we start to see the powerful impacts of how an increase in money supply can result in sky high inflation. Since the chocolate seller still gets Rs 20 in an injection, production still expands to create 1.2 chocolate bars, but now, you have Rs. 250 to buy it with. Inflation is now higher than 100%. If this stays up, chocolate will soon be unaffordable, and dentists will be out of work too.

The real world is even more complex still - which tilts the balance towards inflation again

All of this could seem to imply that there is a big chance that the inflationary impacts of money can easily be handled, if not prevented altogether. In a highly simple scenario like what we explored (yes, even that was highly simple, even in just the context of the chocolate purchase), that may be true. But again, the real world is far far more complex. Lets explore one final example, the most complex one yet, to show how even in the context of chocolate alone, the real world is far more complicated. 

To do this, lets introduce a surprise to the story - you were the chocolate seller all along as well! (i.e. lets assume the chocolate seller is a firm that you have, that you are separately, as a consumer, buying chocolate from). Lets add another twist, and say that you are, in fact, an employee of the bank as well, and thereby, get a salary from the bank too. Finally, instead of the loan being zero interest, lets add a 10% interest rate to the loan, and assume that half of that goes to you as your bank employee salary.

This is a complicated diagram for sure. What’s important is this - due to the second-order effects of the system, consumption rose much more than production. This is because, despite there being an extra Rs 60 going into production (Rs 20 injection+Rs 50 credit-Rs 5 chocolate seller salary-Rs 5 interest), which increased production by 60%, there was an extra Rs. 115 going into consumption (Rs 80 injection+Rs 5 chocolate seller salary+Rs 5 bank employee salary+Rs 50 credit-Rs 20 deposit-Rs 5 interest), which increased consumption much more than the increase in production.

Since the real world is even more complicated than this, this is still just a very basic example for what goes on when money supply increases. But this should still show an important part of the story - when the supply of money rises, prices tend to rise, but this rise CAN be mitigated IF production can also increase. Since investing in productive capacity is a far harder project that just throwing money AND it’s often a longer-term return, the fact that prices can rise in the short-term still rings true.

Lets step outside of theory for just a moment, and look at some actual data that shows that the increase in money supply is very much tied to inflation in reality. The following chart shows Sri Lanka’s money supply against inflation twelve months afterwards. 

By and large, this chart shows that a rise in money has gone alongside a corresponding inflation increase across the following 12 months. However, the effect isn’t as large as it is implied after 2007 - where inflation didn’t rise beyond 10% despite pretty large expansions in money. This is partly explained by some of the credit factors we discussed, but the far bigger driver that mitigated this, in my opinion, is the movement (or lack thereof) of both the USD and the LKR, which is a story we’ll explore later. Overall, I don’t think it’s unfair to say that Milton Friedman is at least partly vindicated.

Inflation is monetary in the end, but a complicated monetary in many cases

Going through the examples like this also starts to show the absolutely critical role the credit system plays in the inflation story. Governments, which do the direct injections, often have an incentive to give money for consumption (the more people get money, the more votes for the next election - whereas improving production is a more long-term dividend instead). This makes the direct relationship between money supply and inflation much stronger. However, the credit system doesn’t necessarily have that same incentive. What incentives drive the creation of credit in the economy, thereby, can have pretty powerful impacts on inflation, and this is true even when the government itself isn’t directly “printing money” to expand the money supply.

For countries like Sri Lanka, there is an additional channel to all of this - depreciation. Depreciation can causes prices of imported goods to rise (so imported chocolate is more expensive, leading to chocolate inflation again), and the ability of the economy to behave in a way that encourages depreciation also has close ties to credit. This fact is also true when considering that expanding productive capacity doesn’t happen out of the blue, and often involves importing machinery and capacity from abroad, meaning that the deflationary impact of production gain is also reduced in a context like Sri Lanka.

In the end, all of this shows why money, money printing, and inflation aren’t simple stories with simple explanations. There ARE overall narratives that make sense and are broadly correct (inflation being monetary is one of them), but these have many qualifiers, footnotes, and asterisks on top of them. Understanding at least part of the monetary story underneath can therefore help navigate the inflation story for countries like Sri Lanka - and perhaps, make a few more conscious decisions about buying chocolate bars too.

(Thanks to anyone who helped with the story of money so far, particularly with whom I've been discussing the presentation of this topic for a while)

I started writing this as an explainer into money printing and how to understand it in the context of Sri Lanka’s crisis and recovery. However, the introductory part of that piece that explained different types of money ended up being longer and longer. Instead of having one super-long article (even this one is quite long), I’ve instead split the article into two. This first piece will focus on the basic explanations of money focused at a non-technical audience, while the second will look at money printing in Sri Lanka from a more technical viewpoint. The second piece is likely to be over at so give that a follow to keep up.

Despite taking some of the first steps in what is likely to be a long road for recovery for Sri Lanka, money is one of the many things that Sri Lankans still do not have in full. We can see this in the amounts of items bought, in the amount of loans that are renewed, and the wallets that are both thicker but also more empty at the same time.

But what exactly is this “money” and how does it work?

The basic definition - it’s boring and abstract, let’s bring some chocolate into it

Of course, there are a hundred and one “fun” definitions for money (freedom, wisdom, belief, hope, goodness, credit, enterprise, respect, time, and too many others) - which all have some degree of truth in them. The traditional definition of money however is something like the below definition from Encyclopaedia Britannica:

“Money is a commodity accepted by general consent as a medium of economic exchange. It is the medium in which prices and values are expressed. It circulates from person to person and country to country, facilitating trade, and it is the principal measure of wealth.”

This is boring, but other than putting this in simple language, there’s not much we can do.

Let’s try and understand money in an easier way though, and that gives a good enough sense of what it is in Sri Lanka.

Probably the simplest way to understand money is as something that can be easily used to buy (or sell) something else. This can also tie into the popular understanding of money as cash - the 500 rupee note in your wallet can be used to buy something that is priced at 500 rupees. For the sake of simplicity, and for some levity, let’s assume that you’re trying to buy chocolate.

Money, then, is whatever allows you to easily buy chocolate.

What makes something money - levels of “chocolate moneyness”

When we’re talking about a 500 rupee note, it’s clear that this is money - you can use it to buy the chocolate for sure. It’s extremely unlikely for someone to say no, I can’t accept 500 rupees for this 500 rupee chocolate

But what about a 500 rupee gift voucher at a supermarket? Is that money?

Within the context of the supermarket, it basically is. It can be used to buy anything in the supermarket that is worth 500 rupees. So in the context of the supermarket, it behaves basically like a 500 rupee note would. That is, the 500 rupee gift voucher has high “moneyness” (or you can easily use it to buy things). Since what we’re trying to buy is chocolate, it has high “chocolate moneyness” in the supermarket.

How about a gift voucher for a chocolate shop instead? In the context of the chocolate shop, again it behaves as money, and has high moneyness, and has high “chocolate moneyness”.

Outside these specific locations, however, can the gift vouchers be considered chocolate money? Clearly, not everywhere, but by how much is it lower? That’s hard to measure of course, but if the supermarket is a widely visited supermarket, perhaps someone might be happy enough to accept the gift voucher (as long as they can verify it) as worth 500 rupees. But since at least some people will not accept it, I think it’s fair to say that the supermarket voucher has lower chocolate moneyness than a 500 rupee note - i.e. people would prefer to hold 500 rupees in cash in order to buy their chocolate as opposed to holding a supermarket gift voucher. 

Since there are likely more branches of the supermarket than the chocolate shop, I think it’s fair to say that chocolate moneyness is higher in the supermarket voucher compared to the chocolate shop - but not as high as in the 500 rupee note which can be used to buy chocolate from anywhere (not limited to the supermarket or the chocolate shop).

All that is nice and interesting in the context of gift vouchers, but (chocolate) moneyness matters outside of this situation as well. For that, let’s take a move into the financial system.

Your money in the financial system - different levels of chocolate moneyness

As explained previously, cash clearly has very high levels of chocolate moneyness (ability to buy chocolate using it) - we can definitely buy 500 rupees of chocolate using that. However, what if the 500 rupees is in a savings account? As long as you can use a debit card to access the 500 rupees in savings, then the moneyness remains high. But you can’t pay using a debit card EVERYWHERE in Sri Lanka - some places will only take physical cash (like say if you are buying chocolate at a roadside stall). This means, that in order to use the 500 rupees in the savings account, there needs to be a “translation” - you need to withdraw the money from the bank into physical cash. Since this is by definition harder than not doing it, the chocolate moneyness of 500 rupees in a savings account in Sri Lanka is lower than the chocolate moneyness of 500 rupees in physical cash -  though not by a lot.

Using this same idea, if your 500 rupees is in a fixed deposit, there are additional steps needed to use the 500 rupees to buy the chocolate with. You need to close the FD, then take it into your savings, then withdraw it and finally buy the chocolate. Thereby, the moneyness is once again lower - and this time, more significantly.

Once you move further into the financial system, however, moneyness reduces even further. Let’s say you buy a Treasury Bill issued by the government with your cash. Now, in order to buy chocolate, you can’t just give the chocolate seller a T-bill over the counter. There is more of a process in order to do so, which means T-bills don’t have very high chocolate moneyness. What if in addition to the T-bill, you get a loan against the T-bill? Can you use the loan contract to buy chocolate with? No - you’ll have to translate it across the system before you have access to physical cash to pay the chocolate seller with - either by repaying the loan, and selling the t-bill, or by using the money from the loan directly (but now you’re in chocolate debt!).

All of this, however, is about money you have access to since it's yours. Let’s look then at money that you don’t have but is in the financial system anyway.

Bank money - out of sight and out of mind?

Of course, banks also have money of other people that is not your own money, and let’s assume that these people don’t want to buy chocolate just now. For simplicity’s sake, let’s assume that banks can do one of 3 things only with this other people’s money (and the bank is at the edge of its regulatory requirements so they can’t multiply the money). They can either lend the money out to you, they can put it in a T-bill, or they can just keep it without doing anything

How much “chocolate moneyness” is in each of these options?

The first option has the most chocolate moneyness in a way - once the money is lent to you, now you have 500 rupees, either in a savings account or if you withdrew the money, as physical cash. So if you want to go buy chocolate, you are able to do so.

This point is pretty critical - if money is lent out, then that money can be used in the real economy to buy things. This is a key way that money enters the economy (more on this in the next piece), and thereby can cause inflation (more money chasing the same amount of chocolate).

The second option has lower levels of chocolate moneyness than the first. By putting the money in a T-bill, the bank can now use only the T-bill for any of their own (non-chocolate related) money needs. If you wants to borrow from the bank, the bank can’t give the T-bill to you directly to buy chocolate with, but maybe it could use the T-bill as collateral to borrow some money from another bank, and give that borrowed money to you as a loan. Alternatively, if the money that the bank used to buy the T-bill is now with the government (ie, if the government doesn’t use the money to pay back some other loan), then the government can give you some chocolate money (let’s call it a chocolate salary). In either of these ways, you can go and buy your chocolate, but because there are additional steps needed (and unless you have an understanding of the financials already, you’l probably feel how complex it is), the chocolate moneyness is lower than in the first option.

The third option has the least amount of chocolate moneyness compared to the others. By “not doing anything” a bank would essentially keep the (non-chocolate related) money as “bank reserves”, mostly in a deposit at the central bank. In practice, depending on how much of these reserves are mandatory, banks might earn some interest on this deposit facility (for example, extra reserves might be deposited in the overnight deposit facility of the central bank which would earn interest). Especially if we’re talking about the mandatory reserves, then you can’t use them to buy chocolate. No banker can go to a supermarket and say, hey, I have 500 rupees in bank reserves, give me chocolate. In order to buy chocolate, the bank will need extra reserves, which it has to then choose to either lend out or invest in t-bills (assuming those are the only 2 options), and then the processes in option 1 and 2 come into play, and only at the end of all that can you buy your chocolate. There’s a lot of translation needed to get there. The chocolate moneyness of bank reserves is quite low that way.

Of course, in this explanation, we’re talking about chocolate moneyness. If we’re talking about moneyness from the point of view of buying T-bills (T-bill moneyness?), the moneyness levels change. If we’re talking about moneyness from the point of view of maintaining bank reserves (bank reserve moneyness?), it changes again.

Different types of money behave in different ways - this matters for inflation

Understanding how different types of money affects inflation can change how you think of inflation. To start with, lets take as a fact, that when everything else remains the same (which is a tall ask, but let’s make believe), when the amount of money rises, prices rise. In the context of the chocolate, if you have 500 rupees and the seller only has 1 bar of chocolate, and you are the only person who will ever buy chocolate (remember, everyone else is just keeping their money in the bank), the chocolate will be worth 500 rupees as well. But if you now have 1000 rupees, this suddenly makes the chocolate worth 1000 rupees.

But what happens in each of the different scenarios we talked of? If you have 500 rupees in cash, but 500 more rupees in savings, as long as the money stays in the bank, the price of the chocolate remains at 500 rupees. But because the translation from savings to cash isn’t very difficult, and you can relatively easily take it out as physical cash, then once that happens, the price of the chocolate will rise to 1000 again.

These 2 types of money (physical cash and savings account money), therefore, have a pretty high ability to cause inflationary pressures. We can call this chocolate money since we can easily use it to buy chocolate. Increases in chocolate money is what causes inflation in the price of chocolate (assuming the amount of chocolate remains the same). This is a simple yet critical thing to understand.

What about fixed deposits (and other similar deposits)? Deposits are a bit harder to convert into physical cash, but it’s easier than say - bank reserves or maybe even T-bills (given regulatory constraints). Deposits are less inflationary than chocolate money because it’s harder to take deposits out, and this impact is even stronger if there are non-monetary reasons why people would rather keep their money in the fixed deposit (for example, people know in 1 year’s time, there’s a bunch of special chocolate that’s coming into the country, and they want to save up to buy that later). Because of this, let’s call the money in deposits “maybe-chocolate money” - it CAN be used for chocolate if someone wants, but it isn’t as straightforward. T-bills count as maybe-chocolate money too, but they’re a bit less maybe than deposits due to the regulatory factors mentioned.

Now, bank reserves in particular, ie money that banks have access to that they’re not really doing anything with, doesn’t immediately translate to being chocolate money as explained earlier - there are so many steps to make it chocolate money. Let’s call this none-chocolate money. 

Now, none-chocolate money can still be used to buy other things - for example, if there aren’t any regulatory requirements that prevent it, a bank can use their none-chocolate money to buy a T-bill. As long as the none-chocolate money the government gets in return for the T-bill is not used to give people chocolate salaries like earlier (i.e. as long as the government doesn’t convert none-chocolate money into chocolate money), then the amount of chocolate money in the economy won’t rise. 

This is another critical point that we will explore in detail later, but the essence is this: You can have a huge increase in none-chocolate money (or even in maybe-chocolate money), and as long as it doesn’t convert into chocolate money (either through the government or through the banks lending to you), the price of chocolate stays exactly the same - 500 rupees. 

However, this doesn’t mean that none-chocolate money has no impact on prices. If the none-chocolate money is used to buy, for example, T-bills as described earlier, the price of T-bills will rise (which means the interest rate on the T-bills will fall). As long as lending into the economy from that point is contained, any inflation which happens is limited to T-bills. The impact this has on financial markets is an important area to explore, but not here. For now, chocolate remains uninflated.

Money is complex, but so is chocolate

All of what we discussed was in a very simplistic breakdown - and even still, the money story is complicated. The reality is even more complicated - for example, there is more than 1 person wanting to buy chocolate, and the chocolate seller might also be able to expand instead of staying static. There are also many different types of chocolate that all behave differently. I’ve also simplified the entire financial system to just T-bills and loans, and reality is more complicated. All of this affects how the economy works, and how prices work.

Money printing then comes on top of this complicated situation. Part of the complexity is because there is no simple definition for it, or a simple definition for money either - different types of money behave differently in different contexts, and money printing is a whole new context as well.

But hopefully, this piece gives an introductory story into how money works - and can help with a better understanding of the subject (though ideally it doesn’t affect your relationship with chocolate too much!). In the next piece, we’ll take a look at how this ties into money printing and what that means for Sri Lanka.

A mere 6 months after the last tariff increase, the CEB has increased electricity tariffs yet again.

For a country already battered by a series of price hikes in 2022, for a country reeling from massive shortages across 2022 (and even now, in the pharmaceutical sector), for a country still mired in a terrible economic crisis, this additional tariff hike feels quite hard. The increase looks especially bad, given the relative increases at different levels. It’s painful, especially coming after a period of relative consistency in prices. But was it necessary?

In a previous article, I spoke about the numbers behind the CEB, and how the CEB was in a cashflow crisis. The main thesis from that is mentioned below in a few extracts:

From end-2021 to end-2022, Sri Lanka’s energy costs have skyrocketed, primarily driven by the rise in global energy prices adding on top of the depreciation of the local currency. 

What this data shows, is that despite the personnel costs being quite large in absolute terms (around 3-3.5 bn LKR per month!), they’re only a relatively small component in context of the overall costs of the CEB, which are primarily driven by costs related to generation (between 70-90% depending on what is included within this category). That makes it clear that the primary cost issue that the CEB is facing has more to do with direct generation costs rather than high administrative costs.

As long as the CEB was in a negative cashflow position, especially given it would have been a significantly worse position than in the past, meeting these requirements would have been barely possible. In the context that the CEB was not able to make the LKR payments needed to purchase the USD for coal imports, it’s quite likely that the coal supply would have been hindered. This would have been similarly true for other petroleum payments, and there was some allusion made to this point as well in local media. The CEB, despite being a monopoly provider of energy, could simply have been forced into massive blackouts again, simply on a cashflow basis.

So don’t worry about the non-generation expenditure? Shouldn’t we restructure the CEB?

Not at all. I think the salary and inefficiencies side is critical EVEN IF it doesn’t matter too m uch on the numbers. Given that there is a strong narrative that the there is a lot of wastage and corruption (which of course is true I feel), then taking steps towards that is absolutely critical to build confidence. How can the people be asked to take a sharper hike if the CEB is getting off scott-free?

But this isn’t really where it has to stop. While these numbers are so bad this year for the reasons I laid out earlier, it doesn’t take away the fact that smaller, yet significant, losses have been building up for years before that. This I feel is very much tied to the corruption in the sector (though there is ALSO a lot of complexity in addition to corruption IMO). It’s also quite likely that this is a part of the reason why we have remained in this power mix where we are forced to use so much expensive thermal power and why we haven’t invested as much in renewables in the past.

This mess is part of the reason why something like “restructuring the CEB” is a difficult task as well. If you want to privatize the CEB for example, any firm that comes in will want to avoid significant negative cash flow too - and end up doing a tariff revision as well. There’s also all the legacy debt, the complex organization structure of the CEB and its subsidiaries, and all the technical complexities in the way we’ve set up our grid as well - we can’t really move forward and implement a great renewable energy plan in such a financial and operational environment. 

GIven all that, I don’t think a quick restructuring is realistic. However, these facts need to be put out, publicisized and explained - and a credible time-bound plan put out that can inspire some level of confidence that there is SOMETHING that is in the works. Put simply, I shouldn’t need to write these articles at all! While there is clearly something in the works, in order to inspire confidence that it is actually a proactive measure being taken, an easy first step would be to publicise the committee report on CEB restructuring recommendations, with any sensitive information being redacted as necessary.

Beyond this, there may be some medium term solutions possible as part of the restructuring exercise. Two such possibilities I mentioned in my previous piece would be ringfencing the CEB’s liabilities (and possibly taking over past debt to the treasury - which seems to have at least partly happened in 4Q 2022) and looking into the use of blended finance in partnership with multilaterals to finance renewable investment.

While these factors don’t immediately create any short-term relief, it will continue to be a critical part of making sure that any future costs are managed and of the government being able to move towards cheaper electrification for all. With Sri Lanka’s power generation being so skewed towards expensive diesel and secondarily coal, unless there’s a sustainable plan to move away from these, the costs will only continue to rise in the future. Restructuring the CEB is an absolutely critical part of being able to invest in cheaper energy in the future, since the current structure really isn’t conducive to this.

So what can we do for the CEB and the energy sector?

What happens after a reasonably successful restructuring is underway? Then we need to actually move away from the current expensive-generation mix towards cheaper and self-generated sources, ideally renewable. The issue is that this will likely take time - setting up solar farms, wind farms, connecting our grid to India are all things than can and should be done IMO (done well of course), but won’t happen in a few months. A clear plan, consistently communicated, can help inspire confidence until this takes place, but that won’t stop the pain. What could be done in the meantime?

This is a tough one. A key limiting factor is money - the capital costs of renewable energy is still quite high, and possibly could remain high in the current global environment. Getting past this will either require more credit from our partners, bilateral and multilateral, or further depreciation of the rupee to buy dollars for capital investment (running the risk of higher costs in the meantime!).

There are 3 short-term solutions I can think of that can reduce the pain on the energy sector directly. However, the problem here is that realistic implementation might make most of these into medium term solutions only. 

The first is to provide an urgent expansion of cash transfers to low-usage consumers, possibly expanding on the welfare system currently being implemented. The proposed increase in the electricity tariffs seem to come to around 2000-3000 LKR per low-income family, and accounting for the knock-on increases, perhaps giving a 5000 extra cash transfer to the bottom 2 mn households would be a price worth paying. For simplicity’s sake, we could also explore providing this transfer to the CEB itself in the future, so that the tariffs don’t have to rise for said households - though once again, with inefficiencies and corruption, whether that’s a fair process isn’t clear. I’m more biased to suggest a direct transfer for now alongside the existing welfare process, and then in the future move towards a subsidy to CEB.

A second option might be seriously considering the subsidizing of solar capacity for industry. Industrial tariffs still remain heavily subsidized and as a category, is likely equal to the deficit from residential users. Here, setting up solar energy seems far more practical than setting it up for low-usage consumers - the poorer you are, the harder it will be to access credit, payments, and even something as basic as physical safety for a solar system (the per unit cost is also higher for a low-usage consumer, since the fixed cost will be spread over a relatively smaller number of units). Setting up solar systems for industry will likely be a tough task and an expensive one, but I feel this is one place where if we can convince some investment/credit to come in, will be net beneficial for Sri Lanka overall, despite the increased cost of said credit. If this is self-financed, and the regulatory stifling is relaxed, that could also be an avenue through which this could happen. Overall, this also creates space for the CEB to cross-subsidize low-usage consumers in the future again.

Third, I think it can be made easier for individuals to set up their own renewable system. This would reduce prices for them but increase for everyone else, since it would mean a high paying consumer is no longer on the grid, which actually worsens the cashflow deficit for the CEB. This option, therefore, is less about the cashflow directly, but more about managing public sentiment. I’m more biased to not prioritizing this option too much given the financial costs seem overall negative - but move towards improving this in the future instead.

No easy way out in the end - but many things we can still do

All I’ve looked into the CEB and the energy sector overall, suggests that there are no easy options here. It does really look like we’re stuck between the proverbial rock and hard place. However, just because things are difficult, doesn’t mean there is nothing that can be done.

I believe that the way to help people deal with this is to make their lives easier in other ways. That requires of course, a strong level of coordination in government, but it’s not impossible to imagine SOMETHING happening. For example, for low usage consumers who are disproportionately poor as well, this rise in cost could perhaps be mitigated by better welfare support, better labour support, and better access to food and medicine - things that we are struggling with at some levels not because of a lack of USD anymore, but rather due to terrible processes including that of procurement (the pharmaceutical chaos is the best example for this). If the overall economic environment improves alongside this, that too could be one way that the situation can be  made more bearable. The current appreciation of the USD is one way this can pass through to consumers, especially if prices adjust downwards at least for a short while.

For the rich and the middle class, the improvement could be by making processes work faster and smoother, show a serious commitment to listening to their demands for state sector reform, and even something as simple as making it easier to engage with the energy sector when needed (anyone who’s tried to talk to the CEB about setting up any system knows this). For businesses, especially export businesses, giving regulatory reform including moving on land and other factor reform, I feel can be a critical tool to make things better operationally, even as some aspects like the cost of energy get worse.

Of course, the point is that all of this won’t happen alone. I think the energy crisis is in a sad way, an opportunity for the people to use the pain to force this reform in turn. This can look like public conversations, this can look like lobbying, this can look like engaging with different organizations that do these things - but this moment is one of action I feel. Without that action, I fear that we’ll be leaving things up to the government. The last time we left the energy sector up to the government, we had 13 hours without power and we stood in fuel queues for literal weeks. This time, I think we can shine at least part of the light ourselves.