Mechanics of International Trade

March 10, 2014

Mechanics of International Trade – A Guide with Special Reference to Sri Lanka
By Ananda Liyanage

Foremost Publishers

Table of Contents

01  A brief description of the economic development of Sri Lanka from ancient times
02  The efforts of the banking industry from the very beginning to cope with the demands of the economy
03  The rationale for a country to engage in international trade instead of thriving for self sufficiency
04  The economic indicators which a country has to monitor when engaged in international trade
05  The role played by the Monetary Authority of a country in managing its economy
06  The regulatory framework in Sri Lanka for banks engaged in international trade operations
07  The theory for determining the value of a currency against other currencies.
08  The key factors to be considered before entering into a contract of sale in international trade
09  The risks and uncertainties of international trade as opposed to domestic trade
10  The various documents that  are required in international trade and their significance 11  The different methods for international trade settlements and the role of banks in such processes
12  The technicalities and rules that are applicable in documentary collection and credit operations
13  The possibilities for finance available under documentary trading
14  The ability of banks to enhance the potential for finance in international trade operations
15  The special types of documentary credits that have been developed to meet special requirements
16  The understanding and control of domestic risk in international trade
17  The fixing of credit lines and credit ceilings in international trade
18  The technique for fixing current prices of foreign currency required by importers and exporters
19  The technique for fixing future prices of foreign currency required by importers and exporters
20  Basic knowledge required to understand and apply foreign exchange quotes and forward changes
21  Tools available in the market for traders to counter foreign exchange fluctuations
22  The technique for transferring funds in settlement of international trade transactions
23  The purpose of indemnities and guarantees in international trade operations
24  Other supplementary services provided by banks to facilitate international trade
25  The need for correspondent banking relations in international trade
26  The role played by the carrier to facilitate international trade
27  The role played by the underwriter to facilitate international trade
28  The incentives offered by the State to encourage international trade
29  The support services provided by other organisations to promote international trade
30  The categories of services that a bank can extend to a customer to facilitate international trade
31  Decisions of the Judiciary in matters related to Documentary Collections & Documentary Credits
32  The spectre of fraud affecting international trade operations
33  The legal framework applicable to international trade operations in Sri Lanka
34  A summary of misuses and abuses of certain fundamentals of  international trade
35  Some prospects for the development of international trade in Sri Lanka


  1.  The judgment of the Supreme Court in the appeal of Vanathawilluwa Vineyard v Commercial Bank
  2. The Hague Rules as amended by the Brussels Protocol 1968
  3. A checklist to ensure compliance of documents with the provisions of UCP 600
  4. A c  hecklist to avoid loss by supporting illegal activities inclusive of money laundering
  5. The terms and conditions of insurance policies covering shipment by sea
  6. The terms and conditions of insurance policies covering shipment by air
  7. A summary of the rise and fall of banks in Sri Lanka from the earliest times
  8. Uniform Rules for Collections (1995 Revision) URC 522
  9. Uniform Customs and Practice for Documentary Credits (2007 Revision) UCP 600
  10. Uniform Rules for Bank to Bank Reimbursements Under Documentary Credits (2008 Revision) URR 725
  11. Uniform Rules for Demand Guarantees (2008 Revision) URDG 758
  12. Incoterms 2010


A brief description of the economic development of Sri Lanka from ancient times

The economic development of Sri Lanka from the ancient times to the present can be broadly divided into three periods. The first is the ancient and medieval period when there existed a strong agricultural economy. However towards the end of this period the political ambitions of the rulers had undermined the strength of this economy. The second is the period of domination by European powers. The European rulers geared the economy during this period for exploitation by them. The third is the period since independence, which continues up to the present date. This was marked with an initial lack of foresight and with subsequent efforts to rectify the defects in the economy.

Ancient and Medieval Periods

In ancient times Sri Lanka was known to be a self-contained agrarian economy with a substantial agricultural surplus. The irrigation technology, which was mastered and refined by the irrigation engineers of the period, made it possible for the rulers to engage in massive irrigation development projects.

During the Anuradhapura period, the reigns of Vasabha (67-111 AD) and Mahasena (274-301 AD) are particularly  noteworthy as periods of great irrigation works. These great works made it possible for the cultivation of paddy in the dry zone which, apart from the regular supply of water, afforded excellent conditions for cultivation. The reign of Dhathusena (455-473 AD) saw another period of development in the irrigation systems. Towards the end of his reign of there existed two major irrigation networks, one based on the waters of the Mahaweli River and its tributary the Ambanganga and the other based on the waters of the Malwathu Oya and Kala Oya.

During the next five centuries these major irrigation networks were supplemented by lesser works spread over a substantial part of the dry zone.

These irrigation networks, comprising huge artificial lakes, storage tanks and canals transformed what has once been jungle and arid dry zone in to rich, fertile land resulting in the cultivation of paddy on a massive scale. The agricultural surplus thus created permitted in turn, the maintenance of these irrigation systems as well as the creation of other magnificent edifices such as the great dagobas some of which stand even today, as proud monuments to their makers and the economy which sustained them.

There existed during this period, side by side with the agrarian economy, a very prosperous trading economy in Sri Lanka. From very early times merchants were attracted to the island by the prospect of trade. The principal goods on offer were pearls, gems and ivory. However, at no time during this period was the economy dependent on trade.

The shift of the seat of power to Polonnaruwa did not in any way change the agrarian economy of the island. During the Polonnaruwa period restoration and expansion work of the irrigation systems were undertaken. The contributions of Vijayabahu I (1055-1100 AD), Parakramabahu I (1153-1186 AD) and Nissankamalla (1187-1196 AD) are noteworthy. This period was sadly, the last period of the development of an irrigation system and the agricultural economy thereafter fell gradually to fall from its former glory to less than a subsistence level during the next eight centuries. It is some consolation that the recent Mahaweli development project aims at restoring some of the grandeur of this agricultural economy after the lapse of almost eight centuries.

The island’s external trade during the Polonnaruwa period gained in importance with the decline of the agrarian economy. By this time the exports of the island were pearls, gems, cinnamon and elephants and Sri Lanka had become a vital link in the trade routes between the East and the West. This strategic geographical location made the island an important point of transit. The First Interim Report of the Presidential Commission on Finance and Banking dated 31st March 1991 gives a very brief but lucid account of this feature that merits quotation.

“Sri Lanka’s character and location as a large and fertile offshore island in the very centre of the Indian Ocean and at the southern extremity of 7the South Asian subcontinent had a profound impact on its social and economic evolution. Sri Lanka in historical times was a model centre of communication across the Indian Ocean just as it is today. A significant part of the wealth of its ancient civilization came from its role as a major trade and transhipment centre in the ocean network, which was or amongst the world’s largest trading systems before the dominance of Transatlantic trade in modern times and recent developments in the Pacific Basin.

Numismatic and epigraphically evidence as well as both domestic and foreign historical records, indicate the existence through much of Sri Lanka’s history of a developed shipbuilding industry and another technical and support service adjacent to good natural harbours; port, customs and transhipment facilities; a prosperous import and exports trade; a monetary exchange system; and the presence of foreign trading communities resident in its ports and urban centres. Of particular interest is the evidence of an elaborate system of custom dues and taxes levied on imports and exports and, specially, entrepot trade. For instance, a system of inner and outer custom boundaries existed at certain ports and was clearly associated with transhipment. Thus, in ancient times Sri Lanka was not only a country with a substantial agricultural base, a highly developed irrigational technology and a rich rural hinterland but also a society with advance commercial and monetary systems, comparable with those prevailing in the most developed nations and regions of the time. Recognition of these historical antecedents would not only provide inspiration to contemporary planning but also serve as a pointer to the realization of hitherto untapped potential for the development of the country in regional and global contexts”

In the period that followed the external trade of the island increased. Cinnamon became the principal item in the export trade together with areca nut, gems and elephants. The principal imports were cloth and dry fish. The export trade of the island particularly cinnamon was destined to receive the attention of the European maritime powers in the period to follow with drastic results for Sri Lanka.

Period of Foreign Domination

The period of foreign domination can be considered under three periods when the three European maritime powers ruled Sri Lanka, first the Portuguese, then the Dutch and finally the British each for approximately a century and half.

The Portuguese Period

The first major European power to enter the arena was the Portuguese in the year 1505. The Portuguese were a trading nation and were not interested in territorial conquest. The Portuguese used their naval power to take control of the commerce in the island. They initially occupied the Western and Southern coastal regions of the island. They extended their position by conquering the Kotte and Seetawake kingdoms. They also took over the kingdom of Jaffna. They did not, to the very end of their rule, control the eastern part of the island or the kingdom of Kandy. Despite sporadic failed incursions.

The main objective of the Portuguese in Ceylon was the cinnamon trade, both from an economic and political point of view. They first declared that cinnamon could be exported only through the port of Colombo. They finally made the cinnamon trade a monopoly of the State. They were also interested in the trade of areca nut with India, which paid for the import of rice and cloth from that country.

The Dutch Period

The Portuguese ceded the Maritime Provinces of the island to the Dutch in 1656 and the Jaffna kingdom in 1658.  The Dutch controlled only about half the area occupied by the Portuguese. More importantly they controlled the major ports on the eastern coast. The Vereenidge Oost-Indische Campagine (VOC) of 1602 the greatest commercial company in the world at that time received state support and monopolistic privileges from the Dutch. The VOC in Sri Lanka under Dutch rule was mainly interested in the protection of the cinnamon monopoly.

The Dutch showed an interest, and at times encouraged other crops like coffee, pepper and cardamoms. This interest was however due to the inadequate supply of these commodities for the European market from the other eastern possessions of the VOC. The sudden increase in the demand for these commodities resulted in a policy of encouraging production in the island and similarly a fall in the demand resulted in a policy of discouraging production in the island. The Dutch did not pursue a consistent policy towards these crops other than cinnamon although they did encourage subsistence agriculture and paddy cultivation. They were instrumental in commissioning irrigation works for the first time since the Polonnaruwa era, The Urubokka dam being an impressive engineering feat of the Dutch. They were however, not too successful in promoting paddy cultivation as the import of rice from India had to be continued to meet the country’s requirement monthly. There was in fact an acute shortage of rice in the areas controlled by the Dutch, up to the very end of their rule. The Dutch were also instrumental in building a network of canals to transport people and goods in the island’s western coastal region that have survived up to the present day.

The British Period

The Dutch were ousted by the British in 1795. The English East India Company took over the trade which up to then was controlled by the VOC. In 1815 the British conquered the kingdom of Kandy and for the first time in its history the entire island came under foreign rule. From 1802 the East India Company had the monopoly in the cinnamon trade in Sri Lanka. However their contract with the British Government was not renewed in 1822 and control of the cinnamon trade was taken over by the State.  It was later handed over to other merchants.

In the mid 1830’s coffee was introduced as a plantation crop. The cultivation of coffee in Sri Lanka was to meet the demand for coffee in the European and British markets. By 1840 a large area of land was under coffee plantation. A fall in coffee prices in 1845 as a result in the drop in consumption and over production very nearly caused the collapse of the coffee industry. However by 1850 the industry was recovering. The British attempted to introduce sugar and cotton plantations to the island but the lack of capital which was tied up in the coffee plantations hindered these efforts. Coconut as a plantation crop was introduced in the year 1860. The decline of the cinnamon trade continued during this period mainly due to the substitute Cassica that entered the market.

The production of coffee declined mainly due to a leaf disease that spread rapidly in the 1880’s, resulting in the ultimate closure of the coffee plantation. The coffee plantations were ultimately closed down.  The fall of the coffee industry did not result in the  collapse of the economy. Tea, which had been planted as an experimental crop in 1860’s, gained ground and by 1910 was the leading plantation crop of the Island. The fall in tea prices at the turn of the century resulted in the reduction in the acreage under tea. An alternative crop was needed.  Coconut was already established as a plantation crop. In this situation, rubber, which was introduced as an experimental crop during the 1870’s, was selected and by 1910 rubber become the largest export product of the island after tea.

The first two decades of the 20th century were troubled times for the island. The First World War during the second decade and the depression that was to follow resulted in the stagnation of the island’s economy. Sri Lanka took steps to curtail the production of tea and coconut during the war period but rubber production was needed to prosecute the war recorded a boom. However during the depression the production of rubber was also curtailed severely effecting the economy and the living standards of the population.

At the outbreak of the Second World War the rubber industry once again experienced a boom. The Japanese conquest of Malaya and the Dutch East Indies made Sri Lanka the principal if not the only supplier of rubber so desperately required for the war effort. The wartime prosperity raised inflationary pressure in the island.

The British made a valiant effort during the latter part of their rule to increase agricultural output by undertaking restoration work on the ancient irrigation systems. They however, expected immediate results and when this was not forthcoming switched  their efforts to other areas. The British was instrumental to a large part creating the major road network in the island that exists up to date and almost the entire rail network. Their efforts in developing the road and rail networks are great engineering feats of the period.

Period since Independence

It was in this economic context that Sri Lanka gained independence in 1948.  The economy that was inherited from the British was dependent on three export crops, primarily tea and toa lesser extent rubber and coconut. The once flourishing agricultural economy was now unable to cope with the domestic demand.  It was necessary to import rice and other foodstuffs that accounted for almost half of the import bill of the country.

The first Government of independent Sri Lanka elected in 1947 which was the United National Party (UNP) under the leadership of D.S. Senanayake realized the folly of being dependent on the three export crops whose prices tendered to fluctuate with the world economic conditions. They took inspiration from the ancient rulers to develop agricultural production, that is rice and other foods, in order to be both curtail  imports and to improve the Balance of Payments position. Towards this policy they implemented the Gal Oya scheme the most ambitious irrigation scheme undertaken for almost eight centuries.

The first period of independence experienced a growth in exports during 1950 – 1955. The cultivation of rice made steady progress during that same period. The increase in revenue due to the growth in exports increased consumption levels in the economy. It would have been wiser for the new Government to contain consumption and direct the earnings from this economic activity to the industrialization of the country and the diversification of exports.

In 1952 the UNP was returned to power despite S.W.R.D. Bandaranayake leaving the party in 1951 to form the Sri Lanka Freedom Party (SLFP). Power however shifted at the 1956 election in favour of the camp led by the SLFP. The policy of the SLFP of nationalizing resulted in the control by the State of certain areas of the economy. The economic situation continued to worsen with deficits in the balance of payments during the period 1957- 1960.

The assassination of S.W.R.D. Bandaranayake in 1959 created the necessary atmosphere for the return of the SLFP under the leadership of the assassinated leader’s widow Sirimawo Bandaranayake.

The full force of the economic crisis that had been gathering after the reversal of the boom conditions in the export trade in 1955 was felt in the 1960s. The prices for tea exports continued to fall despite the increase in the quantity exported. Apart from the year 1965 there was adverse balance of payments throughout the 1960s. It therefore, became necessary for the government to impose severe exchange control restrictions. Import of luxury items and later even essential items were restricted. This prompted the government to extend State control over the key areas of the economy. There was, however, no increase in production and therefore despite or due to the controls the situation did not improve.

At the 1965 election the UNP was returned to power with Dudley Senanayake the son of the first Prime Minister of Independent Sri Lanka as its leader. The fall in prices of tea and coconut resulted in a fall in production and the total receipt from exports declined in 1966. The UNP continued to believe in traditional agriculture and encouraged and organized the sector. There was a notable improvement in paddy cultivation during the period 1967 – 1970. By the end of it the country was 75 per cent self sufficient in rice.

These economic reforms were not continued as the UNP lost the elections in 1970 and did not benefit from the gradual revival of the economy that they had initiated. In 1970 the SLFP was returned to power once again as the United Front (UF) with a coalition with two left-wing parties. The weak economic situation and the arrest of which had been the main theme of the previous government continued unchecked. The prices of the country’s principal imports, which included food, rose to unprecedented levels without a corresponding increase in export earnings.

By 1971 the government was compelled to introduce cuts in the import of food and encourage food production. Their short-sightedness in not continuing the program for the production of food initiated by the previous government which would have made Sri Lanka self sufficient in food by 1976, resulted in planning a food program all over again. The acute shortage of rice and food substitutes imposed by the cut on the import bill forced the government to encourage locally produced food substitutes. The final nail in the coffin was the unprecedented rise in oil prices with its effect felt in all sectors of the economy.

The UF government began to break up in the year 1975 when one of its coalition partners left the group. The other partner followed suite in 1977. Only the SLFP remained in the UF government at the end of its period in office.  In the elections of 1977 the UNP was once again returned to power under the leadership of J.R. Jayawardena. The economy inherited by the UNP dominated by the state sector. The new government took an absolutely controversial view for the rejuvenation of the economy. They announced their policy of a ‘free economy’.

They were favoured by an increase in the prices of tea and rubber from 1977 onwards. The government stood firm in its commitment to give new life to the private sector and was rewarded when employment opportunities increased and  economic activities were stimulated. They continued to withdraw state intervention from many areas of the economy including areas that had been traditionally controlled by the state through the privatization of public corporations.

The commencement of the accelerated Mahaweli development project with a view to restoring the former glory of ancient Sri Lanka in agriculture was a firm policy of the government, which the UNP has cherished since their term as the first government of independent Sri Lanka. The hydroelectric power that was to be generated by the Mahaweli development project was seen as a requirement of the country for industrialization. The government was fully committed to agriculture and the uplifting of the living standards of the rural population.

In employment the entry of private enterprise and the State sponsored Export Processing Zones created an abundance of opportunities. The control on imports was relaxed with the result of removing shortages in any commodity. The increase in oil prices, the devaluation of the Rupee and the inflationary trend created by the development programs and irrigation programs had to a great extent been countered by the benefits of the policy of a free economy.

The policies of the UNP, the economic upliftment of the country and the disarray of the opposition parties kept the UNP in power for an unprecedented 17 years. What ultimately caused the downfall of the UNP was the political and economic excesses of their rule. The wastage of resources, capital and state revenue and the autocratic power they wielded in the political life of the people resulted in the defeat of the UNP in 1994. The UNP, which continued in power for 17 years, built around it a sense of isolation that resulted in disregarding many basic rights and requirements of the population by only concentrating on their economic needs.

The Peoples’ Alliance (PA) government, which came to power in 1994 under the leadership of Chandrika Bandaranayke Kumaranatunga and Sirimawo Bandaranayake the daughter, and widow respectively of S.W.R.D. Bandaranayake, was once again a coalition of many parties who were not stained with the political and economic excesses of the UNP.  The economic policies of the UNP however, have continued up to date which is appreciated since any change would have caused a multitude of problems that the economy faced during the first three decades of independence.

The PA and its successor the United Peoples Freedom Alliance (UPFA) was in power for 19 years with alliances with different partners other than for a brief year in 2001 when the UNP was returned to power. However the efforts of the UPFA at economic upliftment were subject to the settlement of the question of the separatist war which continued to rage over much of their period of rule in the northern and eastern parts of the island.

In this context the year 2009 stood as a year of great significance to Sri Lanka. In the month of May the factions fighting for a separate homeland within the borders of Sri Lanka was decisively defeated heralding in a unified Sri Lanka after three decades of war. However, the anticipations of those who expected a swift change to their economic woes were not realised as reconstruction and reconciliation cannot be realised in the short term.

However it is noteworthy to observe that certain foreign powers who had hitherto paid little attention to the woes of Sri Lanka began to take a negative interest in her domestic matters to such an extent that one is left to imagining whether the ending of the war and the anticipated economic upheaval would act contrary to the economic needs and aspirations of such foreign powers.

The embracing of an open economic policy has to be rethought again on a broader field. Although in the short term it provided employment and much needed investments the long term consequences are yet to be seen. Questions are raised today as to whether a controlled liberalization policy wouldn’t have better suited a developing country such as Sri Lanka.

However it must be realized by the people and rulers of Sri Lanka that it is now not possible to turn back the clock. There should be a united effort irrespective of cast, creed, race, religion or political affiliation to make the best out of the present situation and seek economic independence after 65 years of political independence.

© Ananda Liyanage

ISBN 10: 9551509048 | ISBN 13: 9789551509040

Publisher: Foremost Productions

Purchase Mechanics of International Trade online at Sarasavi.lk or at major bookshops in Sri Lanka.


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