Introduction
Foreign Exchange Reserves are one of the leading indicators of a country’s economic stability. Forex reserves are maintained by the central bank of a country primarily in the form of foreign currencies, bonds, treasury bills, and gold. Some of their key uses are to maintain liquidity during economic crisis, financing foreign debts, development of critical infrastructure, and assure investors that a country has the means to maintain internal financial stability. It is crucial for developing and emerging countries to develop a diversified portfolio of strong foreign currencies that are uncorrelated to its domestic currency. The most prominent forex currencies are the U.S. dollar, Euro, Pound, Yen, Swiss Franc, and Australian dollar.
The year 2022 has been the worst in Sri Lanka’s 75-year economic history. Inadequate monetary and fiscal policies combined with the effects of the Covid-19 pandemic forced the island nation to default on its foreign debt payments. Instead of focusing on economic policies that would maintain long-term stability, the Sri Lankan government favored populist measures. Where the appropriate measures would be increase tax revenue, reduce trade deficit, increase interest rates, cut down government subsidies, reduce government expenditure, and reduce reliance on predatory loans, the government did the exact opposite. All these errors culminated into the collapse of what should have been the nation’s top priority, Sri Lankan foreign exchange reserves.
A nearly complete depletion of FOREX reserves has disabled Sri Lanka from financing for the most basic imports crucial for the daily needs of its citizens. For several months in 2022, its citizens had to cope without fuel, medicine, and power. People of once a food exporting country had to face scarcity of food. The scarcity has led to inflation of over 70 percent with food inflation standing over 85 percent. The Sri Lankan FOREX reserve disruption can be linked to some key areas of their economy: tourism revenue, exchange rate, tax revenue, capital account, and government expenditure.
Literature Review
Foreign Exchange Reserves and Tax Revenue
In an effort the fulfill election promises, in 2019, the Sri Lankan government launched a series of unprecedented tax cuts. They reduced Value Added Tax (VAT) from 15 % to 8 % and Telecommunication Tariff by 25 %. Meanwhile, they eliminated National Building Tax (NBT), Economic Service Charge, Debit Tax on financial institutions, Capital Gains Tax, VAT on property, Pay As You Earn (PAYE) Tax, and Credit Service Tax. Tax evasion was an existing problem within the country. Due to the reduction and abolition of listed taxes, the country lost over a million taxpayers. The drastic reduction in its sources of revenue, the government became unable to sustain its expenses. The massive budget deficit had to be financed with the aid of the Central Bank of Sri Lanka. With the advent of the global Covid-19 pandemic, the pressure on central bank reserves were mounted. In under a year, government intention of increasing disposable income through slashing taxation had failed. Realizing its failing policy, in 2022, has reintroduced higher than before VAT and Corporate Income Taxes. The new VAT and Corporate Income Taxes of 12 % and 30 % are expected to bring in a combined $325 million. These measures should stabilize government deficit and alleviate pressure from the central bank.
( Bhowmick)
FOREX and Tourism
Tourism is a significant contributor to Sri Lankan GDP. The tourism industry, nearly 13 percent of the GDP, is a large part of the government revenue and a source of employment for hundreds of thousands. Prior to the Covid-19 pandemic, it brought in as much as $5 billion via two million tourists annually. Apart from government revenue, it brought vital foreign currency into market circulation. This massive industry was hard-earned by the island nation. After three decades wasted in a civil war that lasted from the 1980s until 2009, tourism began to tick up. However, due to a series of unfortunate events, it has been brought to a halt. In 2019, terrorist bombings took place in the capital city of Colombo. In 2020, the ongoing global pandemic. In 2021, the economy began declining drastically. In 2022, the Russian invasion of Ukraine disrupted trade and tourism from Eastern Europe. According to recent data, the number of tourists has fallen to under half a million. While tourism revenue has fallen to under a billion USD. (Devapriya)
Figure 1 Data from World Bank.
FOREX and Capital Account
Sri Lanka has a long history of Balance of Payment imbalances. Balance of Payment is the sum of a country’s current, capital, and financial accounts. Ideally, the balance of payment should be zero, but that is rarely the case when working with national economies. The central bank of Sri Lanka consistently reported a negative BOP over the last decade. The most recent report from 2020 indicates a negative balance of $3.3 billion. Economists from the University of Kelaniya suggest high foreign reserve assets and exports to improve the balance of payment. They found that the increase in money supply and exchange rate can negatively impact BOP. As a capital account comprises the balance of trade ( exports – imports), net income ( remittances), and net transfers( foreign grants) it serves as a massive source of foreign reserve assets. (Udayanga)
FOREX and Currency Devaluation
Economists at the University of Buenos Aires found a significant positive relationship between currency devaluation and labor-intensive industry output. The study based in Argentina found that labor-intensive economies can greatly benefit from undervalued currency due to its impact on exports. A similar case can be applied to Sri Lanka which is a technologically weak and labor-intensive state. Sri Lanka had been experiencing a steady currency decline against the dollar for the past several decades. It experienced a massive and unprecedented decline in 2022 when the Rupee fell from 200 LKR/USD to 376 LKR/USD. Though declines in currency can be helpful to certain export industries such as fabrics, tea, and tourism, they can greatly deter the nation’s ability to afford goods and services from foreign markets (Palazzo).
Figure 2 Data from ADA Derana.
FOREX and Government Expenditure
Researchers at the University of Lagos found that targeted government spending can have positive impacts on economic growth. In the case study for Nigeria, they found that certain industries such as telecommunication, education, and health can significantly improve growth and general prosperity. But not all government spending is equal, spending on agriculture and natural resources infrastructure was found to be negatively impacting the Nigerian economy. Sri Lankan economic crisis can partially be attributed to reckless government spending on foreign debt-financed projects that cannot even bring enough long-term revenue to pay off their cost. The government also focused on reshaping Sri Lankan agricultural industry to meet international “green” standards which ended up devastating their agricultural output. It is suggested that the government take a more targeted spending approach on highly profitable and foreign reserve-intensive sectors of the economy such as tourism and exports which Sri Lanka has an advantage in. (Babatunde).
Contribution
There is a lack of research aimed at finding direct relation between FOREX reserves and the variables listed in this paper. FOREX crisis is a recurring phenomenon in developing countries often because they are highly susceptible to external shocks. For crisis management, when these countries secure financing through domestic and multilateral institutions, they often come with conditions that tend to make the crisis worse. My research will contribute to the existing literature by testing the existing economic research and general recommendations/conditions given to nations when under the FOREX crisis.
Economic Theory and Hypothesis
| Tourism revenue | H1 |
| Exchange rate | H2 |
| Net income (CA) | H3 |
| Tax revenue | H4 |
| Government expenditure | H5 |
| Exports (CA) | H6 |
| Exports x Exchange rate | H7 |
| Government expenditure x Tax revenue | H8 |
| Tourism revenue x Exchange rate | H9 |
| Foreign Exchange Reserves |
Hypotheses
The main hypotheses are summarized as follows:
H1: Foreign Exchange Reserves accumulation is dependent on tourism revenue
H2: Foreign Exchange Reserves accumulation is dependent on exchange rate.
H3: Foreign Exchange Reserves accumulation is dependent on net income.
H4: Foreign Exchange Reserves accumulation is dependent on tax revenue
H5: Foreign Exchange Reserves accumulation is dependent on government expenditures.
H6: Foreign Exchange Reserves accumulation is dependent on exports.
H7: Foreign Exchange Reserves accumulation is dependent on the interaction between exports and exchange rates.
H8: Foreign Exchange Reserves accumulation is dependent on the interaction between government expense and tax revenue.
H9: Foreign Exchange Reserves accumulation is dependent on the interaction between tourism revenue and exchange rate.
Economic Theory
Using the analysis found in the literature review, I am hypothesizing that the independent variables: tourism revenue, tax revenue, exchange rates, net income, and government expenditure affect the dependent variable, foreign exchange reserve. Tourism revenue should have a positive effect due to its ability to directly bring foreign reserves into market circulation. Exchange rates have the powerful ability to influence the exports of developing countries. Net income is income from countries’ foreign assets and remittances. It is a large component of the current account. Net income should also have a positive impact on FOREX reserves. Government expenditures can have a positive or negative relationship. It depends on whether the government is spending on the correct projects that suit the national economy. Its negativity could suggest that the government needs to reanalyze where it is spending.
Empirical Methods
Data
The model is based on data collected for the last fifty years (1972-2021). However, some of the variable data was unavailable for some years. Correction for unavailability was made using R for consistency. Annual data for foreign reserves held by the Central Bank of Sri Lanka was collected from the World Bank. Annual tourism revenue (USD), tax revenue (USD), net income (USD) and government expenses (USD) collected from World Bank. Exchange rate (LKR/USD) collected from World Bank.
Empirical Model
(Without interaction terms)
Foreign Exchange Reserves = + Tourism revenue + Exchange rate + Net Income + Tax revenue + Government expenditure + Exports + u.
(With interaction terms)
Foreign Exchange Reserves = + Tourism revenue + Exchange rate + Net Income + Tax revenue + Government expenditure + Exports + exchange rate*exports + tax revenue*expense + tourism revenue*expense + u.
Empirical Model Description
The model includes the hypotheses listed in the conceptual framework. Foreign Exchange Reserve is the dependent variable. Tourism revenue, exchange rate, net income, tax revenue, government expenditure, and exports are the independent variables. Export*exchange rate, government expense*tax revenue, and tourism revenue*exchange rate are the interaction terms. The intuition behind the independent variables H1-H6 has been explained in the economic theory section. Interaction term H7 assumes cheaper LKR can influence exports. Interaction term H8 assumes tax revenue might influence how much the government spends. Interaction term H9 assumes cheaper LKR can induce more travelers to choose Sri Lanka as their holiday destination.
Results
Tourism revenue, net income, tax revenue, and government expenditure positively impact foreign exchange reserves. While exports and exchange rates negatively impact foreign exchange reserves. The results show that a unit increase in tourism revenue can increase foreign exchange by 6.982 units. A unit increase in exchange rate decreases forex reserves by 1.421 units. A unit increase in net income increase forex reserves by 2.96 units. A unit increase in tax revenue increase forex reserves by 4.25 units. A unit increase in government expenditures increases forex reserves by 5.7 units. A unit increase in exports decreases forex reserves by 2.2 units.
Tourism revenue is significant at the five percent level. The exchange rate is significant at five percent, one percent, and 0.1 percent levels. Net income is significant at five percent and one percent levels. Tax revenue is significant at the 5 percent level. Exports are significant at the five percent level. The value of R^2 is equal to 95.8 percent. This high R^2 value means that 95.8 percent of the variation in the dependent variable is explained by the model.
The results for tourism revenue, tax revenue, net income, government expenditure, and exchange rate are as expected. The results for export revenue being negative is unexpected. However, this could be because, in Sri Lanka’s case, peaks in exports are due to large dumps in exchange rates. This could mean that at times when there are spikes in exports, the imports become just as expensive and burdensome on forex reserve assets. In Sri Lanka’s case, export spikes, often, have occurred due to internal crises such as civil wars, governments being overthrown, or health crises.
Conclusion
Foreign reserve assets are a key part of a globally integrated developing economy like Sri Lanka. It was the general mismanagement of the economy on multiple fronts that led to a near-complete depletion of their Forex reserves in 2022. In its attempts at crisis management, the Sri Lankan government and economic policymakers must not forget what led them here. The literature review and econometric analysis suggest that lax taxation, overeager green policies, unsafe tourism environment, unbalanced trade, and non-targeted development projects spell trouble. To prevent a forex crisis in the future, the Sri Lankan government must consistently practice restraint and discipline over their economic handling. Instead of foreign debt and central bank bailouts, they must create and retain avenues to sustain reliability in their coffers.
Policy implications
- Maintain a safe and secure environment for return/increase in foreign tourists and tourism revenue. Increase spending in programs catered to promotion of safety inside the country.
- Establish a monetary policy that gradually devalues the Sri Lankan currency aimed to increase foreign spending inside Sri Lanka and promote export goods/services of comparative advantage. Prevent stark declines in currency which counter any positive effects of currency devaluation.
- Improve/modernize tax collection process such that it eliminates tax evasion. Increase tax collection to pre-2019 levels as they allowed government to sustain its operations.
- Direct government expenditures to projects that provide the highest profitability in the short and long term. Focus of expenditures on key industries and projects that attract foreign investment and improve business experience in Sri Lanka.
References
Bhowmick, S., 2022. Understanding the Economic Issues in Sri Lanka’s Current Debacle, OBSERVER RESEARCH FOUNDATION. Retrieved from https://policycommons.net/artifacts/2477522/understanding-the-economic-issues-in-sri-lankas-current-debacle/3499598/ on 21 Nov 2022. CID: 20.500.12592/74hfzp.
Devapriya, Feature the crisis in Sri Lanka – media.defense.gov. (n.d.). Retrieved November 21, 2022, from https://media.defense.gov/2022/Aug/12/2003055791/-1/-1/1/JIPA%20-%20DEVAPRIYA%20-%20AUG%202022.PDF
Ekonomia I finanse – WNUS.EDU.PL. (n.d.). Retrieved November 22, 2022, from https://wnus.edu.pl/sip/file/article/view/16097.pdf
Palazzo, G. (2022). Currency undervaluation and export surge episodes: What sectors take off during the real exchange rate undervaluation stimulus?.
Sri Lankan rupee depreciated by 44% against dollar so far this year – adaderana biz English: Sri Lanka Business News. Adaderana Biz English | Sri Lanka Business News. (2022, May 13). Retrieved November 27, 2022, from http://bizenglish.adaderana.lk/sri-lankan-rupee-depreciated-by-44-against-dollar-so-far-this-year/
Babatunde, Government spending on infrastructure and economic growth in Nigeria. (n.d.). Retrieved November 28, 2022, from https://www.tandfonline.com/doi/pdf/10.1080/1331677X.2018.1436453
OLS Estimates
Significant at 5%: *
Significant at 1%:**
Regression
| Variables | Estimates | Standard Error | T test | Pr(>|t|) | Significance |
| Tourism revenue | -9.610 | (5.669) | -1.696 | 0.106 | |
| Exchange rate | -3.679 | (1.787) | -2.059 | .053 | |
| Net income | 1.497 | (1.130) | 1.325 | .200 | |
| Tax revenue | 2.910 | (1.619) | 0.180 | .859 | |
| Government expense | 6.279 | (7.202) | 0.872 | .394 | |
| Exports | 8.779 | (2.235) | 3.928 | .001 | * |
Regression2
| Variables | Estimates | Standard Error | T test | Pr(>|t|) | Significance |
| Tourism revenue | -7.701 | 6.369 | -1.209 | 0.242 | |
| Exchange rate | -2.800 | 2.209 | -1.268 | 0.221 | |
| Net income | 1.410 | 1.152 | 1.223 | 0.237 | |
| Tax revenue | 4.507 | 1.657 | 0.272 | 0.788 | |
| Government expense | 7.353 | 7.463 | 0.985 | 0.337 | |
| Exports | 9.388 | 2.429 | 3.865 | 0.001 | * |
| Exchange rate*exports | -1.478 | 2.2124 | -0.696 | 0.495 |
Regression3
| Variables | Estimates | Standard error | T test | Pr(>|t|) | Significance |
| Tourism revenue | 4.854 | 6.748 | 0.719 | 0.481 | |
| Exchange rate | -1.088 | 3.257 | -3.340 | 0.003 | ** |
| Net income | 2.094 | 9.852 | 2.126 | 0.048 | * |
| Tax revenue | 1.938 | 1.465 | 1.323 | 0.203 | |
| Government expense | 3.117 | 1.007 | 3.095 | 0.006 | ** |
| Exports | -7.197 | 5.880 | -1.224 | 0.237 | |
| Exchange rate * exports | 9.231 | 3.980 | 2.320 | 0.033 | * |
| Tax revenue * expense | -8.079 | 2.690 | -3.003 | 0.008 | ** |
Regression4
| Variables | Estimates | Standard Error | T test | Pr(>|t|) | Significance |
| Tourism revenue | 6.982 | (2.583) | 2.703 | 0.015678 | * |
| Exchange rate | -1.421 | (3.102) | -4.581 | 0.000307 | ** |
| Net income | 2.960 | (9.166) | 3.229 | 0.005250 | ** |
| Tax revenue | 4.250 | (1.553) | 2.737 | 0.014607 | * |
| Government expense | 5.702 | (1.317) | 0.433 | 0.670753 | |
| Exports | -2.201 | (7.670) | -2.896 | 0.011133 | * |
| Exchange rate * Exports | 2.248 | (6.180) | 3.637 | 0.002219 | ** |
| Tax revenue * Expense | -5.251 | (2.574) | -2.040 | 0.058226 | . |
| Tourism revenue * Exchange rate | -5.644 | (2.186) | -2.582 | 0.020062 | * |
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