The Prime Minister’s recent announcement that the capital account will be fully liberalized this year has raised many eyebrows. The intent of liberalizing the capital account is to fill the domestic savings gap via foreign investments. However, the pros and cons and timing of the move require careful analysis.

The critical question is whether the country could take a risk of large capital outflows at a time when the external reserves are low, the trade deficit is high, debt repayment obligations are large and country’s risk ratings are poor.

Trade and current account liberalisation
The current account was liberalized in November 1977 as a major component of trade liberalization. However, Sri Lanka’s capital account liberalization has been limited as the external reserve situation has not been healthy in most years. It is deemed dangerous to liberalise the capital mobility, especially with exchange rate volatility. Therefore, there have been only very short periods of capital account liberalisation. Capital mobility from Sri Lanka to outside countries has been under tight control.

There are several reasons to advocate the liberalisation of the capital account. Liberalizing the capital account would further integrate Sri Lankan economy with the world economy via increased capital inflows and outflows. Openness to international trade would wideneconomic opportunities. Foreign capital could be used to finance local investmentsthat are lacking at present. Local investors would get a diversified portfolio to invest in, and the return on their savings would be high.

Higher economic growth and more employment opportunities are expecteddue to more Foreign Direct Investments (FDIs) in the country.Other benefits coming in tandem with FDIs are state-of-the-art technology, managerial expertise and know-how that would be transferred in due course to Sri Lanka.Foreign capital could be a growth potential for Sri Lanka, if the present current account deficit is matched with opening up of the capital account, and achieving a capital account surplus.

Theoretically, capital account liberalization should enable transfer of capital from capital-rich countries to capital-poor countries, but the reality could be different due to a number of reasons. The inflow of foreign capital could reverse at any moment depending on the political climate of the country, investor confidence and behaviour of the exchange rate. Unless a sound policy environment exists in the country, there is always the high risk of capital flight. At a time where Sri Lanka’s foreign debt is massive and on the rise, fully liberalizing the capital account would lead to more foreign borrowing, which increases debt servicing costs and in turn, more capital outflows. The country would be too much dependent on foreign funds while foreign investors have the chance to own domestic assets.

Liberalisation this year?
Proponents view capital account liberalization as one that would bring Sri Lanka long-term foreign capital with the benefits mentioned above. However, opponents point out that Sri Lanka’s growth rate has been declining over the past few years, expenditure on imports is continuously increasing and much higher than export earnings, and the current global economic conditions would further reduce the demand for our exports.

The IMF loan facility and other lending options could improve the exchange rate, but would have the reverse trend due to high imports. Our reserves are low and can cover only about three months of imports. Remittances are not expected to rise, even though tourist earnings are expected to. On the whole, opponents view the current external position as not appropriate for further liberalizing of the capital account.

What is needed?
What is required at present is to create the macroeconomic environment necessary to acquire the benefits of capital account liberalization. There should be a policy environment that encourages capital inflows. Lack of a properly developed financial market and risk management strategies would make benefits of the move too limiting or even dangerous. At a time when Sri Lankans are also figured in Panama papers, the risk of capital flight is evident.

Transparency and market discipline with right institutions and right monitoring of transactions are imperative. Policymakers should ensure adequate supervision and regulation of banks and financial institutions. Interest and exchange rates are the two key monetary policy instruments to be managed effectively to result in a healthy balance of payments position. Fiscal discipline, investor confidence, political stability and good governance should not merely be words!

Although releasing of controls plays an important role in the globalized business environment and controls do hinder growth, Sri Lankan capital market liberalization should be evaluated from a macroeconomic perspective. Unless and until we are certain of strong macroeconomic fundamentals, we should not proceed. Liberalizing the capital account is a good move towards realising the benefits of an open economy, but Sri Lanka must wait till the right macroeconomic environment is developed.