Reform of exchange controls: There is a need, but do it correctly – Part I

The first Ceylonese Governor of the newly-established Central Bank N.U. Jayawardena

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Proposal to reform exchange controls without giving details

Prime Minister Ranil Wickremesinghe, in announcing the economic policy statement of his Government in November 2015, proclaimed that “the task of managing exchange processes” would be taken out of the purview of the Central Bank. This is an important policy reform which his Government had decided to introduce to create an environment conducive for investment. 

However, no mention about this reform item had been made in his second economic policy statement delivered to Parliament a year later in October 2016. Instead, the latter policy statement had referred to another policy reform which had been connected to exchange controls, namely, the repeal of the age-old import and export control regime in the country. 

This would be done, according to the PM, by introducing a new legislation in the style of Singapore’s Regulation of Imports and Exports Act which still maintains licensing of both exporters and importers.

Expectation was that the country would introduce a foreign exchange management system 

The new import and export control system to be set up in the country is to be guided by the system in Singapore. But regarding the reform of exchange controls, no details have been pronounced as to how it would be done. 

In this connection, Sri Lanka could go for major reform – in the style of a big bang reform – introduced by the UK’s Margaret Thatcher Government in 1979 by abolishing exchange controls overnight. Or else, Sri Lanka could go for a midway reform like the reform introduced by India in 1999 by repealing its Foreign Exchange Regulation Act or FERA and enacting in its place a Foreign Exchange Management Act or FEMA. 

The previous Ranil Wickremesinghe Government of 2002-2004 attempted to introduce a law similar to FEMA of India. But that attempt was aborted after the Supreme Court determined that some sections, unless revised, needed a special procedure for its enactment. 

Consultative process adopted when drafting first FEMA

The aborted FEMA was drafted after a wide and lengthy consultation with banks, business chambers, bureaucrats and professionals. It was done by a special financial sector reform committee set up in the Central Bank under the Chairmanship of Governor A.S. Jayawardena. This writer was a member of that committee and, therefore, has first hand information how it worked. 

The committee got a continuous feedback from the Government by reporting its deliberations to a Cabinet Sub-committee on Economic Affairs via R. Paskaralingam, the PM’s special envoy to the committee. Thus, a fruitful multilogue was established in the process with the Government, on one side, and the Central Bank, commercial banks, business chambers and professionals, on the other. 

It was adherence at its best to the principles of economic policy governance and economic democracy at a time when they were unknown ideals in the country. The final outcome was thus signed off by everyone because it had been produced through a consensual consultation process. 

New ECA appears to be an office desk job

Nearly one and a half years after the pronouncement by the PM in Parliament, a draft Exchange Control Act or ECA has been gazetted by the Government to repeal the existing ECA and introduce a new format of ECA. 

It has surprised many because the expectation was that the Government would introduce a law similar to FEMA. There is no evidence that it has been done after consulting the stakeholders involved. Hence, at its best, it would have been an office desk product of one or two consultants hired by the Government for that purpose. 

The draft ECA has been gazetted as a Bill to satisfy the constitutional requirements. But its surprise appearance and the rush to enact it are being read in the marketplace as a devious attempt at pushing it through the throat of people, including Parliamentarians. This process is in contrast to the principles of good economic policy governance and economic democracy to which the present Government is committed. 

Need for examining the exchange control system

Hence, it is appropriate at this stage to examine the history of exchange control in Sri Lanka as well as in other parts of the world and analyse how the proposed ECA departs from the existing ECA and what implications it would bring to the economy. In the first of the series of articles, let’s look at the history of exchange controls in Sri Lanka. 

Historically, Lanka was a free country

Sri Lanka did not have any control over imports, exports or payment for same during its long history. In fact, the ancient Sri Lankan kings not only promoted international trade, but also used it as a major source of revenue for the Treasury. Trade was free and was undertaken by foreign traders, specifically by those of Arabic origin, under the command of the king. 

The country functioned as an entrepot trading centre on the maritime Silk Road that connected the East with the West. Coins – or in other words, foreign exchange – of many different nations were used as the mode of payment. 

This practice was continued even during the colonial period until the onset of World War II. Then, the colonial administration introduced exchange controls following the control measures put in place by the British Government as a war strategy.

Wartime temporary introduction of exchange controls

Accordingly, in 1939, Defence (Finance) Regulations were promulgated by the colonial administration introducing exchange controls for the first time to the country. The colonial administration did not have to reinvent the wheel in this instance. In fact, they were concomitant with the Defence (Finance) Regulations introduced by the British government earlier in 1939. 

The objective of exchange controls was to prevent the foreign exchange reserves of Ceylon from falling into the hand of the enemy, in this case, the Germans and the Japanese. 

Accordingly, exchange controls were applicable only to financial transactions with countries outside Sterling Area Countries – the group of British dominions and colonies which had used the Sterling Pound as their currency or used it as a reserve asset. 

As such, it was only a wartime measure and expected to be lifted once the war was over. But the destiny of Ceylon since the end of the war in 1945 proved otherwise. 

The use of controls to suppress demand 

Ceylon had accumulated a substantial amount of foreign reserves during the war period due mainly to higher rubber prices, on the one hand, and strict import controls that were in force during the war period, on the other. 

As such, when the country became independent in 1948, foreign reserves were at such a high level that they were sufficient for financing 17 months of future imports – a popular index of measuring foreign reserve adequacy for a country. 

However, as B.B. Dasgupta, a professor of economics at the University of Ceylon at that time, had noted in 1949 in a short economic survey of Ceylon, these high foreign reserves were misleading since they could at any time flow out of the country when the country would revert to its normal import flows. Hence, the country was destined to continue with exchange controls. And it had a moral justification for doing so, because Great Britain too had strengthened exchange controls after the war by enacting the Exchange Control Act in 1947. India, Ceylon’s closest neighbour too, had strict exchange controls at that time. 

Hence, the popular economic wisdom at that time was not to use the market mechanism to eliminate the excess demand for foreign exchange but to use the powerful arm of the Government to pressurise the market to cut down the demand according to the availability of funds. Thus, exchange controls were further strengthened and expanded to cover all the transactions with even those in the Sterling Area as well.

Exchange controls were introduced without public debate

This was against Ceylon’s tradition of being a free economy from time immemorial. Exchange controls were a costly market intervention by the Government. The costs were borne by the Government which suffered from inefficiency, taxpayers who had to bear the cost of exchange controls future generations which had to bear with virtual economic stagnation and business sector which had to resort to unethical practices in order to get over artificial bottlenecks created by controls.

Furthermore, as the Columbia University economist Jagdish Bhagwati had noted with respect to India, such control systems would breed unproductive economic activities in the form of finding ways of circumventing the impeding controls. 

Yet there was no any public discussion over the unsoundness of the policy being pursued. The opposition parties were all for Government intervention in the economy. When the pro-private sector ruling party endorsed Government intervention through exchange controls, it did not have any opponents.

N.U. Jayawardena, Controller of Exchange but a fan of F.A. Hayek

At the time Ceylon gained independence, the Controller of Exchange was the late N.U. Jayawardena, known as NU, who later became the first Deputy Governor and finally first Ceylonese Governor of the newly established Central Bank. He was a pro-market man having been indoctrinated into that ideology when he followed lectures for a Master’s degree in Business Administration at the London School of Economics in late 1930s. 

As his biographers, Kumari Jayawardena and Jennifer Moragoda have dug out from his personal records, he had gravitated toward the free market viewpoints of a very influential economist of the day who had written extensively on the folly of Government interventions in the economy. 

That was Friedrich A. Hayek, who had just migrated to Britain to take up appointment at LSE. Yet, it appears that NU could not convince the political masters of the day that they were playing with fire by resorting to exchange controls during peace times. 

Multification of bureaucracy

As quoted by his biographers, it appears that NU has indirectly made known his apprehensions about exchange controls which to him were irksome restrictions. When controls were expanded to cover Sterling Areas in 1947, he had started to work with a skeleton staff of just nine members under him. He had admitted that with the expansion of work, controls got multiplied by manifold overstretching the capacity of the limited staff. 

Biographers have noted that “with the introduction of extended controls, every transaction involving foreign trade or foreign remittances had to pass through the Exchange Control Department requiring close coordination with other Government departments such as Customs, the Post Office, Import and Export Control and Food Control” (p 126 of N U Jayawardena: The First Five Decades). 

As expected, along with the expansion of the work, the staff too got multiplied from nine to 191 within a mere one and a half years making it a congested working arrangement. 

Such a development is natural with any control system where staff requirements grow faster than the growth of the workload generating inefficiency, ineffectiveness and deviation from the original purpose. The most ominous outcome is the fall of the regulators into the hands of those to be regulated – a development known in economics as ‘Regulatory Capture’. 

It is difficult to believe that NU, the market-oriented man, was not aware of these shortcomings inherent with the system he was to operate. Thus, he had put his caution to pen when he wrote the Administration Report for 1949, as quoted by the two biographers, questioning openly whether the ends of exchange controls could not be better served by methods based on the alternative principle of regulating the demand for foreign currencies at a stable exchange rate through the price mechanism. There, Hayek had spoken through NU’s lips but it had fallen on the deaf ears of policymakers at that time.

The unfounded fear of reserves getting drained out

The fear of the economic policymakers in the first few years after independence was that the massive amount of foreign reserves left to local rulers by British colonial masters when they left the country would soon be drained out. A warning in this regard had been given by Dasgupta who later became the Director of Economic Research of the newly established Central Bank when he published a brief survey of Ceylon’s economic conditions in 1949. 

As mentioned above, the foreign reserves inherited by independent Ceylon were a handsome amount sufficient for financing the future import requirements of 17 months. The fear of it getting drained out appears to be unfounded as noted by a World Bank team that visited Ceylon in 1951 to assess the country’s economic situation and propose way forward strategies. 

Their report, titled ‘Economic Development of Ceylon’, had given the following piece of advice to Ceylonese policymakers: “It may seem that earmarking half the available external assets for a contingent reserve bespeaks an overcautious attitude. But because of the character of Ceylon’s balance of payments, and because of the uncertainties as to the future, we do not believe this is so.....The record of Ceylon’s balance of payments is thus one of fair stability and only occasional difficulty (p 59).” 

The World Bank has thus made a favourable estimate of the balance of payments for Ceylon during 1953-58 and suggested that the surplus coming from the balance of payments should be used for part financing the investment requirements during that period. But, except providing a brief account of how exchange controls were being operated in Ceylon, it had not made any recommendation about whether it should be abolished or continued with. 

Introducing the most draconian piece of legislation

Ceylon had used the Defence (Finance) Regulations promulgated in 1939 even after its independence. It was first implemented by a separate government department called the Exchange Control Department under the leadership of its controller N.U. Jayawardena. 

However, when the Central Bank was set up and NU became its first Deputy Governor, exchange control was transferred to the Central Bank. The Central Bank’s Annual Reports from 1950-1955 had spoken of a very favourable and improved external situation in Ceylon with no any hint of foreign reserves draining out of the country as feared by Dasgupta. 

Yet in 1953, when NU was the Governor of the Central Bank, Exchange Control was made a permanent law by enacting the present Exchange Control Act. Naturally, Ceylon would have followed the British Exchange Control Act enacted in 1947. But Ceylon did better than that by introducing the most draconian piece of legislation to the permanent law book of the country.

The next part of the series will analyse how Ceylon’s Exchange Control Act became a draconian law and how it differed from its British counterpart.

(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected])