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
Proposal to reform exchange controls without giving
details

Monday, 24 April 2017

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 Singapores 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 UKs 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 PMs 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, lets 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, Ceylons 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 Ceylons 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 Masters 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 NUs 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 Ceylons 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
countrys 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 Ceylons balance of payments, and
because of the uncertainties as to the future, we do not believe
this is so.....The record of Ceylons 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 Banks 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 Ceylons 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
waw1949@gmail.com)
Posted by Thavam