The communities in the Batticaloa district range from Arab, East Asian and Indian traders who came by sailboat, to the Portuguese and Dutch who came to the island as invaders.

The majority community is Tamil speaking, split between Hindus, Christians and Muslims and the Sinhala speakers, who are a minority. Portuguese is still spoken here and there are half a dozen Tamil dialects you can hear as well. The ethnic Tamils, are, by far the larger community and consider this region as part of their homeland.

Batticaloa also was the epicentre of the conflict between the state and the Liberation Tigers of Tamil Eelam in the East of Sri Lanka from the early 1980s for nearly three decades. The fighting, particularly during the 1980s was intense and was often in urban areas of the district which was held mostly by government troops.

Although the fighting was between the Tamil separatists and the government forces, as in any war ordinary civilians from all communities were the victims.

In the early days of the conflict, there were some Muslims who supported the struggle for the separate state of Tamil Eelam, says former Vice-Chancellor of the Eastern University Prof. T Jeyasingham. “Nineteen-ninety was the year when the Muslims turned over, meaning they began welcoming the Army and became government supporters,” he told EconomyNext in an interview.

That was also the time when LTTE cadres attacked a mosque in Kattankudy, a Batticaloa suburb which is exclusively Muslim, killing 147 worshippers. There were also instances when the Tigers looted shops in the area. By then the Tamils and the Muslims had become enemies.

Social Worker N Manoharan said, that the Muslims, by forming their own political parties won the support of the Sinhala-dominated government and then used that advantage to better their lot.

Because of the security situation, Tamil traders found it difficult to ply their trade to Colombo and other Sinhala majority areas.

“This helped the Muslims to take over the trade entirely. I think we made a few billionaires during that time,” Jeyasingham said.

The Easter Sunday attacks by an extremist group that had its roots in Kattankudy changed all that, the Professor says. “After the Easter (attacks) I think there were lots of changes in the dynamics. All the advantages they, the Muslims had, came to a standstill, so this may be the best time to negotiate with them where they can speak without all the flanks and this and that.”

One of the three churches hit by the suicide bombers on April 21, 2019 is the Zion Church in Batticaloa.

Fr. Rajan Rohaan of the American Mission in Batticaloa says soon after the attack Muslim Civil Society leaders contacted him as he is the current Chair of the Batticaloa Inter-religious Forum.

“They wanted to come to condole with the families and offer aid,” he said.

However, after discussing the offer with his fellow Pastors, Rohaan turned down the overture for the moment.

Rohaan says that the Tamils in Batticaloa saw the attack on the Zion Church as an “attack on the entire Tamil community, not just the Tamil Christians.”

As a result, the simmering anti-Muslim sentiments in the city and its surrounding area came to the surface. Groups of young Tamil men began distributing leaflets in the city urging their community to boycott Muslim shops and also forced Tamils working in Muslim establishments to stop.

This hugely disrupted the economy of the district. Many eateries are Muslim-owned in Batticaloa and Tamils are their customers. Trade is dominated by the Muslims as they have done over the centuries. The boycotts “robbed many vulnerable people of their livelihoods,” Selvarajah Ariyamalai, a Field Coordinator of the Suriya Womens’ Centre Batticaloa told EconomyNext in an interview.

Rohaan who is the Pastor of St John’s Church, observes that there is the rise of Nationalism in Batticaloa. “There is the rise of Tamil Nationalism and Sinhala Buddhist Nationalism. Then there is the Arabianisation of the Muslim community. So the people of Batticaloa are living with this extremism; that is the real challenge.”  

An hour’s bus ride from Batticaloa city lies the rural community of Oddamavadi and there resides Katugastota Mahindalankara Thero, the only Buddhist Monk involved in the inter-religious peace-building efforts.

His temple is in an area which once was a Sinhala-majority area, but now has more Tamils and mixed-race families. At the time of our visit, there were some local volunteers cleaning the temple grounds, and they were all Tamil speakers.

Mahindalankara Thero says the volunteers, mostly women, are children of Sinhala and Tamil parents. “Here we are trying to build a program that will bring peace among the communities,” he told EconomyNext in an interview.

For the Muslims, they have seized the opportunity to reach out to the other communities Abdul Latif Sabeel, Secretary of the Kattankudy Mosques Federation told EconomyNext.

“After this incident (4/21) the bonds between the Tamil and Muslim communities have strengthened,” he claimed. “We are working with Hindu temple Gurus and the Christian churches,” he said.

He went on to say that the Muslims cannot live in Sri Lanka as a separate group. “We have to build this feeling among all communities,” he added.

“At the same time we have to respect the other religious groups,” he said.

But, says Rohaan, it is not as easy as it sounds to build bridges to bring these communities together. The underlying tensions still remain, he believes.

He says, however, that there has to be a realization that all the communities have a single purpose.

He points out that as a “Civil Society actor I would like to work for democratic rights. As a Tamil, I cannot work for only the rights of Tamils. I have to work for the rights of the Muslims, Sinhalese and others.” (Colombo February 08, 2020)

Total vehicle registrations fell to 26,201 units in June from 32,635 in May, data compiled by J B Securities, a Colombo-based equities brokerage shows.

The June 2019 car registrations were the lowest since June 2012, when registration were at 1,458 in the wake of a 2011/2012 soft-peg collapse. In the 2011/2012 balance of payments crisis the rupee collapsed from 110 to 130 to the US dollar.

In 2018, the rupee soft-peg which authorities call a ‘flexible exchange rate’ collapsed from 153 to 182 to the US dollaras money was printed by terminating repo contracts and by term reverse repo auctions, overnight cash auctions.

More money was also printed to repay bonds in a so-called ‘buffer strategy’ by re-financing a bank overdraft, while still more was printed to accommodate maturing derivatives. The central bank had largely stopped directly buying bills from weekly auctions with printed money.

In July excess liquidity was further built by unsterilized dollar purchases and a Soros-style swap, analysts have said.

Nixon Shock

Authorities then slapped credit controls on selective imports such as vehicles, in a Nixon-shock stype bid to delay policy corrections and effectively directing rupee bank reserves to other areas such as purchasing bonds from fleeing foreign investors, critics say.

Nixon shock import controls were slapped by US authorities when the Bretton Woods system of soft-pegged exchange rates collapsed amid money printing by then -Fed chief Arthur Burns.

Since Sri Lanka does not have a floating exchange rate, all injections of cash against domestic assets tend to weaken the peg, unless the peg is defended with forex reserve losses.

The International Monetary Fund suspended Sri Lanka program in 2018 as the central bank lost reserves and Nixon-style controls were slapped.

The central bank has promised not to impose new external controls for ‘balance of payments’ reasons.

Imports of two wheelers also fell to 21,416 unit in June, down from 26,175 units in 2018.

Three wheelers fell to just 821 units, from 2,050 units in 2018. Both two – wheelers and three-wheelers are imported by less affluent people.

Total vehicle registrations fell to 26,201 units in June from 32,635 in May.

After Effects

Monetary instability has since ended but credit is contracting, leading to a fall in imports and tax revenues.

The 2018 soft-peg collapse came very close on the 2015/2016 soft -peg collapse from which the economy had barely recovered, which analysts have called a bust-bust.

There have been calls to abolish the central bank in favour of a currency board, bring criminal penalties to stop the central bank from following money policies (domestic operations) inconsistent with a peg, or go for inflation targeting.

The central bank has proposed changes to its monetary law to move towards a modified inflation targeting framework, which it calls ‘flexible inflation targeting’.

Fears have been expressed that the central bank will still operate a peg (intervene in forex markets to build reserves or otherwise target the exchange rate altering reserve money in either direction), without a floating exchange rate, leading to the same consequences.

You may also read:

Sri Lanka goes from boom-bust to bust-bust with soft-peg: Bellwether

Sri Lanka controls imports in ‘Nixon-shock’ move to protect soft-pegged rupee

The new law will outlaw some forms of money printing. In a surprise President Maithripala Sirisena had opposed the halting on money printing. (Colombo/July23/2019)

“We are talking to a few leading companies – foreign partners – who will add a lot of value into our businesses when they invest,” he told economynext.com in an interview.

Wegapitiya declined to identify the potential investors yet, saying Laugfs group has signed non-disclosure agreements with them while talks were going on.

The group’s restructuring spun off the hotels, power and emission testing businesses.

The revamp, which consolidated its core liquid petroleum gas (LPG), shipping and storage units into a pure play energy firm, was aimed at attracting foreign partners with specific knowledge of key sectors.

Some of the strategic partners who were keen on joining up in businesses like leisure had not been willing to come when they saw non-related units in the group.

Laugfs is aiming to be a regional LPG supplier, not only supplying its existing Bangladesh market but to use its position to be an Indian Ocean player, eying opportunities in south Asia and as far as east Africa, Wegapitiya said.

Existing operations include a procurement arm in Dubai, a fleet of three ships and storage and distribution of LPG in Sri Lanka and Bangladesh.

The group’s trading unit in Dubai is handling increasing volumes, the shipping arm is expanding its LPG product vessel fleet and the southern Hambantota port storage terminal commissioned in May will be a blending and supply hub.

Talks on getting strategic partners were temporarily delayed by April’s suicide bombings of churches and hotels by Islamist extremists which killed over 250 people and sharply reduced tourist arrivals and led to travel warnings against visiting the island.

The potential strategic partners of Laugfs Gas had not withdrawn in the aftermath of the attacks, which presented Sri Lanka with renewed security concerns after the end of its 30-year ethnic war 10 years ago.

Representatives of foreign parties were supposed to visit the island for talks in April but the Easter Sunday bombings ruined that plan.

“It was only a few weeks ago that some of those countries where our potential partners are headquartered relaxed travel advisories,” Wegapitiya said. “Talks are going on and we are hopeful.

“Our operation now is mainly focusing on the local market but there is potential in the wider Indian Ocean market, in Asian and African countries.”

Laugfs projects its Hambantota 30,000 metric tonne LPG transhipment terminal will have annual exports of 500 million US dollars, receiving bulk shipments in big vessels and exporting on smaller ships as many regional ports cannot handle big ships.

Wegapitiya said the company expects a strategic partner into the business.

“The first phase of the storage terminal has enough capacity to operate for a couple of years. The strategic partner is coming in as an equity partner, as a minority strategic partner.”

Laugfs group has been making losses in recent quarters which it attributes mainly to rupee depreciation and LPG price controls. At end-2018 it had total assets of 34.4 billion rupees and 14.8 billion rupees debt.

In the March 2019 quarter, the net loss of Laugfs Gas shot up 379 percent to 473.4 million rupees from a year earlier, owing to finance costs and soaring foreign exchange losses.

The group has spoken of expanding in a big way its existing three-ship fleet of LPG ships under Laugfs Maritime.

 “Now we are looking at more ships. When the storage terminal is fully operational, we’ll need more ships, which we will either buy or charter,” Wegapitiya said.

Right now Laugfs has a ship trading LPG between Vietnam and China.

LPG trading volumes by Dubai-based SLOGAL Energy DMCC are “growing slowly and gradually,” Wefapitiya said.

“Our Dubai operation is going to be one of the leading trading and supply chain companies in the Indian Ocean region. Our target for the 2019-20 financial year is to handle one million tonnes for our own and foreign markets.”

Apart from Bangladesh, Laugfs also sees big LPG market potential in Myanmar and Kenya.
(COLOMBO, 15 July, 2019)
 

"Clearly it is something we have to be cautious about and monitor very carefully," Governor Coomaraswamy said.

"It is not at crisis levels, we have had higher levels in the past. What we have to do is get growth growing again. We are trying to push lending rates down and push liquidity in to the system."

Bad loans spiked after the central bank triggered a currency collapse by printing money just as growth picked up in 2019 which left the rupee at 182 to the US dollar by end 2018 from 153 at the beginning of the year.

Monetary instability kills consumption, which hits revenues of companies, whose loans then go bad.

At the beginning of 2018, bad loans were at 3.0 percent, as tighter accounting rules forced banks to disclose bad loans early.

After the 2008 soft-peg crisis and capital flight bad loans peaked at 8.8 percent. After spiking during the 2015/2016 soft-peg crisis, bad loans fell to a low of 2.5 percent by the end of 2017.

The 2018 soft-peg crisis came quickly on top of a 2015/2015 crisis, but the currency fall is deeper, and liquidity shortages were prolonged.

Amber Light

Gross non-performing loans had grown to 323 billion rupees by the end of the first quarter of 2019, from 200 billion rupees a year earlier, according to central bank data, under tighter accounting rules.

"I do not think we are at the point where red lights are flashing." Governor Coomaraswamy said.

"It is probably in the amber light stage."

Sri Lanka is also considering giving a moratorium for about 100 billion rupees of tourism loans. Banks will not have to provide for loans suspended after the moratorium was announced. However the sector is expected to recover next year.

At the moment banks are well capitalized, with ratios generally above required levels, Deputy Governor Nandalal Weerasinghe said.

"If NPLs are rising banks will have to provide. That will have an impact on capital. At the moment capital is above even after making provisions NPLs."

But loans at finance companies were at 7.8 percent by March 2019. In March 2018 bad loans were at 5.82 percent of gross loans.

However in the finance company sector, there are several legacy companies dating back to the 2008 soft-peg crisis which ended a bubble which grew for several years.

At the time the central bank was battling fiscal dominance, with the Treasury apparently vetoeing attempts to raise policy rates. (Colombo/July15/2019)

Vice Chairman of Sri Lanka Airport and Aviation Services Ltd Priyantha Kariyapperuma  said the embarkation tax will lower ticket prices and make Sri Lanka more affordable.

The budget for 2019 hiked the embarkation tax to 60 US dollars from April 01, about 10,500 rupees per passenger at the current exchange rate.

Malaysia charges 40 ringgit (about 9.67 US dollar)or 1,750 rupees per passenger. For ASEAN region it is half.

In an ex-Colombo ticket to Malaysia, about half the ticket cost is taxes.

There has also been a proposal to cut handling fees. Handing fees go to SriLankan Airlines, which is suffering losses. Handling fees are a key source of profits for the airline. (Colombo/July05/2019)
 

An electric track is being designed as a second line running from Maradana to Padukka along the Kelani Valley line.

A triple line from Maradana to Ragama will be expanded up to 4 lines.

A double line from Ragama to Veyangoda will be expanded to 3 lines.

A double line from Colombo Fort to Panadura along the seaside will be made into a triple like.

A double line will be developed between Ragama to Negombo along the Puttalam line and connected to the Katunyake airport.

The Asian Development Bank has given a million US dollar grant for a feasibility study and 10 million dollars for planning and procurement.

Stage one is expected to cost 300 million US dollars and State two another 300 million US dollars.  Preliminary feasibility has been completed and detailed design is underway, the report said.

The tracks will be built on railway land and private land acquisition will be minimized, the report said. (Colombo/July05/2019)
 

"We are seeing a large increase in demand of about 75 percent," says General Manager of LOKX Security Services, Major (retired) Surangoda De Silva.

"We don’t even have security surveillance equipment, we are already run out of stock," he said.

The Easter Sunday bombings sent government departments, private companies and schools scrambling to get security officers to carryout searches or simply check the identity and keep records of the visitors.

"We are even getting inquiries from the montessories," said De Silva said.

Before Sri Lanka’s civil war ended in 2009 hardly anyone could enter into a building without showing their ID cards and giving reason and the person they wanted to see and bags were checked.

But on Easter Sunday, the bombers walked in to hotels with heavily laden bags, mostly unchallenged, except for the Zion Church in Baticaloa, where a parishioner gave his life grappling with a suicide bomber.

Read More:

Sri Lankan man who confronted bomber at church door remembered 

Despite the immediate growth in demand for security services, economic conditions are likely to dampen demand in the long run.

Sri Lanka is currently going through an economic downturn after two currency crises came in quick succession amidst policy errors involving a soft-pegged exchange rate regime generating prolonged liquidity shortages on top of a political crisis.

In the December 2018 quarter the economy grew 1.8 percent.

In the first quarter of 2019 bank balance sheets were seen shrinking and credit contracted after period of liquidity shortages.

Industry veterans fear that the growth may not be sustainable.

"Industry is crashing, it is in decline,” says Major Tissa Aluvihare, ex-President of Sri Lanka Security Service Providers  Associaton.

“It will be even more (after the attack) because there’s a huge problem in the cash flow.

“Business are not functioning, the economy has burnt because of the circulation of money and companies don’t have the liquidity anymore.

"It’s a catch 22, the entrepreneur wants but he’s unable to pay.”

The industry is also finding it difficult to get people.

Many young people are moving to other service sector jobs, industry officials say.

Aluviahre says about 70,000 people are employed by the companies in the association.

Another industry official said at one most of the workforce for security forces came from North Western province. But with the province becoming more economically active, the supply is drying up.

The charge per security point ranges from 1200-1500 rupees for a 12 hour shift.

A highly trained armed security guard may have a premium of about 2500 rupees.

To deploy a security guard only on daytime per month, costs on average 42,000 rupees.

To attract more people, firms may have to pay higher salaries. But industry officials say in the current environment it is not possible to hike charges.

“How can we ask clients to pay more in this situation?” the head of a security firm based outside Colombo said.

Officials say even existing companies are finding it hard to pay the bills and are delaying payments. (Colombo/May20/2019)

“From nothing about three to five years ago, last year they bought 10 million plus kilos of tea,” Wijewardena told economynext.com in an interview.

In the first quarter of this year, almost 2.8 million kilos of ‘Ceylon tea’ were exported to China, up 210,300 kilograms or 8.2 percent from a year ago.

China’s market share of total Sri Lankan tea exports in the first quarter was 3.77 percent, up slightly from a year ago..

“These numbers are huge,” Wijewardena said. “And this is a great opportunity for our industry as we are now open to a market with the highest population in the world.”

Wijewardena attributed the surge in tea exports to China mainly to Chinese youth developing a liking for consuming black tea with milk.

 “And that is going to be a big market for us,” he said, noting that they expect exports to China to increase further.

China was the seventh highest export market for ‘Ceylon tea’ in March this year, ahead of other key markets like Syria, Germany and Japan.

Iraq was the top buyer of Sri Lankan tea in 2018, importing almost 10 million kilograms of tea, up by 4.02 percent from a year ago.

Prices for Sri Lankan tea are higher when compared with other competing countries like Kenya.

Wijewardena said Sri Lankan tea carries a premium quality image, which attracts higher demand and global recognition.

That’s why consumers in a big market like China resort to buying Sri Lankan tea instead of many others like CTC type tea which is what Kenya mainly produces.

“Fortunately the ethnic problem has not affected us.” Wijewardena said referring to recent turmoil within the country. “Transportation takes place and auctions are going on as usual.

“We didn’t have a single auction which was canceled. We got security for such possible cases and so far no disruptions were seen.”
(COLOMBO 21 May 2019)
 

A 3 kilometre linear park along Beira Lake shore was built with 640 million rupees of funding from the World Bank. Another 2.5 kilometre stretch of linear park was now being built.

Megapolis Minister Patali Ranawaka said 200 acres of land along the lake belonging to state agencies like Sri Lanka Ports Authority, Sathosa and Transport Ministry will be developed into a commercial hub.

He said the lake was highly polluted and a program will be launched soon to clean it up.

About 350 families living in underserved shanties had been moved without using force to a high rise development in Dematagoda area, he said. (Colombo/June13/2018)
 

"The decision taken by President (Ranasinghe) Premadasa in 1992 to privatize (or peoplise) estates, was a bold decision," Dissanayake told forum of top executives of privatized plantations.

"It was taken amid reservations. But today we can see that it was the correct decision.

"It was enormous burden to the government, the tax payers of this country to keep subsidizing the plantations companies."

The ‘state’ plantations were originally expropriated from domestic and foreign investors by the post-independent ruling class of Sri Lanka, and was part of several moves that made the country a backward nation in Asia, analysts say.

Many of the foreign investors went to Kenya and set up new plantations.

By the 1990s Sri Lanka’s state plantation could not even pay salaries of works and peoples tax money taken from other activities were being channelled to keep afloat a business that was once a revenue earner.

At first only management was given, but later a stronger claim was given through the sale of long lease, on which rentals are now paid to the Treasury.

After privatization many of the firms became profitable under the same estate managers (planters) who ran them under state control.

However Minister Dissanayake said not all privatized plantations were being managed well.

"You know your industry," Dissanayake told the estate managers. "I am not a planter, I am a lawyer. You know more than me. I do not have to tell you what to do. But then after 20-year when we look back we find lapses in some practices in basic plantation management.

"You know this, I know this. We do not want to interfere or intervene in your management model. If you are running profitably, we have to stay back as much as possible. That is my thinking.

"That is thinking of my party the United National Party which introduced free market reform to this country."

He said the country was maintaining at least the current level of growth due to free markets. The leftist parties on the other hand wanted more regulation.

"We have seen this happen," Dissanayake said.  "Over 20 years since 1994 there has been more regulation of the economy."

He said the private firms were also not innovative enough. The privatized firms had complained that the government had not given permission for them to carry out many proposals.

The government as ‘Golden Shareholder’ can deny permission for innovation.

"Fair enough, I accept that," Dissanayake said.

But he said after he took over the portfolio several assessments were done.

"Most of the RPCs (Regional Plantations Companies) had done well. But there are a certain RPCs that are dragging the sector down.

"There is a lack of investments, there is a lack of innovation, lack of dynamism, and sad to say lack of ethical practices.

Minister Dissayanake said he believed the state should get ‘some teeth’ in monitoring the RPC, because he thought the assets of the companies ‘belonged to the people of the country."

"I would like to assure you that I would not try to interfere in your affairs," he said.

"That is not my intention at all. Therefore let us come to a reasonable compromise where we have greater access, greater voice in a monitoring mechanism."

Analysts say if the market is allowed to work, the ownership of badly managed plantations will eventually change.

A case in point is Agalawatte Plantations which is on track for a rights issue to raise new shares after a change in ownership.

While the current minister is a believer in free market policies, the setting up a new regulatory body at a cost to the tax payer may be mis-used by future administrations, they say.

Meanwhile analysts also point out that some plantations that remained in state hands had shown much worse performance. (Colombo/June06/2018)
 

The 39 kilomtre stretch from Mirigama to Kurunegala is being built by 16 contractors starting from multiple locations allowing it to completed fast, Sri Lanka’s Road Development Authority Chairman Nihal Sooriyarachchi said.

Local contractors were allowed to build the expressway to give them experience to bid for international projects, he said.

The first phase of the central bank expressway from Kadawatha to Mirigama was held up with the Chinese government delaying the approval of a 1.1 billion US dollar loan.

But the Chinese contracting firm had done about 5 percent of the work with its own funds, he said.

The RDA is now trying to adopt the strategy as in phase 02, to build the expressway from multiple locations.

"We are now talking to the contractor to begin building the phase from six locations," Sooriyarachchi said.

"They can also use local contractors if necessary."

There was also a delay in awarding the contract for the third phase of the central expressway to a Japanese contractor.

Sooriyarachchi said work on the third phase will begin in a ‘month or two."

In the meantime access roads were being built to phase 02, so that motorists can start using the 39 kilometre stretch even if the rest of the sections are not yet complete, he said. (Colombo/June06/2018)

The central bank is now under an International Monetary Fund bailout program where it is re-building foreign reserves lost in the 2015/2016 balance of payments crisis.

The central bank has to re-build foreign reserves – a tell-tale characteristic of a pegged exchange rate – which are ultimately also needed to repay the bailout loan.
 
IMF Logic

The IMF meanwhile is also calling for a ‘flexible exchange rate’.

"There is a lack of logic in IMF position," Central Bank Governor Indrajit Coomaraswamy says.

"Because the central bank has not for the last 18 months sold dollars to the market. That is as flexible as it possibly can be.

"At the same time we are being told that we should purchase dollars they have given as a target to build up reserves."

Up to March 2018, Sri Lanka’s central bank was operating a strong peg backed with complementary monetary policy where it bought dollars and mopped up (sterilized) the new money  by selling down its Treasury bill stock acquired to generate the 2015/2016 BOP crisis.

Such a policy (sterilized forex purchases) is ‘tighter’ than a currency board (fixed exchange rate) found in countries like Hong Kong where interventions are unsterilized and Sri Lanka had before the central bank was created in 1950.

Mopping up the new rupees by selling down Treasury bills prevent commercial banks from loaning the newly created cash to customers who would then import goods or services with the money, demanding dollars.

Sterilized dollar purchases therefore creates an excess of inflows over outflows preventing pressure on the currency.

During such times, if the central bank wants, it can appreciate the currency at will. In years like 2009 and 2010 it did. In 2017, under a policy of targeting the Real Effective Exchange Rate, the central bank depreciated the currency on top of currency collapses in 2015 and 2016.

The central bank however claims that it no longer operates a peg or crawling peg from 2001 when it ‘floated’ the currency.

Deputy Governor Nandalal Weerasinghe says the monetary authority stopped quoting two way daily, in 2001 and ended its ‘crawling peg’.

Soft-peg

Classical monetary economists go beyond the political definitions (pegs, crawling pegs, managed floats, bands) to easily identify the type of monetary regime a central bank is operating.

A central bank whose reserve money grows in step with its domestic assets is unquestionably operating a floating exchange rate regime and all its money is ‘printed’ against T-bills, no reserves are collected, any reserves remaining are simply legacy reserves). There is no sterilization.

Such a central bank targets an interest rate and has to allow the exchange rate to fall when rates are cut such as in April, depending on domestic credit conditions. When rates are raised the exchange rate may appreciate against other floating currencies, depending on domestic credit conditions and the policies of other central banks.

Any monetary authority that consistently grows base money by only acquiring foreign assets (building forex reserves) targeting an exchange rate but not an interest rate, is operating a credible peg or fixed exchange rate, also called a currency board. Again there is no sterilization.

Such a regime will not sterilize purchases and will also not sterilize sales of dollars when credit and import demand picks up (exchange rate fixed, the interest rate floats).

Such a regime cannot create money by purchasing domestic assets (Treasury bills) by law and is not really a ‘central bank’ which prints money to resist interest rate increases or expand reserve money. Hong Kong, Macau, Brunei operate such systems as well as some other countries.

Stable countries like Dubai, Kuwait, Oman and Saudi Arabia also operate quite similar regimes (currency board-like-systems) involving a peg which has a lot of credibility. They piggy-back on US policy rates and they are satisfied with US policy.

Pegged regimes are said to be operating an ‘external anchor’ with no independent domestic monetary policy. As long as the currency does not depreciate, inflation will generally be around the anchor currency (which is usually the US dollar), or a little higher,

Singapore Monetary Authority operates a somewhat similar system (no policy rate) but involving long term appreciation against the US dollar, because its architects found the Fed to be running less than prudent policy over time, (a modified currency board).

All other ‘intermediate regimes’ (managed floats, pegs, crawling or otherwise) with their own policy rates are soft or non-credible pegs. They also sterilize interventions.

Because these soft-pegged central banks can generate reserve money by acquiring domestic assets (T-bill purchases by rejecting bill auctions or using term reverse repo auctions) as well as dollar purchases, the peg can get de-stabilized at any time.

In 2015 when Sri Lanka’s BOP troubles were gaining strength, and even the IMF said the island was not yet in a crisis, Steve Hanke, a top economist from Johns Hopkins University in Baltimore, Maryland, and director of the Troubled Currencies Project at Cato Insitute, a think tank, suggested that Sri Lanka should set up a currency board to get out of the problem with the soft-peg. 

Only a few months later, Sri Lanka got (yet another) IMF bailout.

A soft-pegged central bank which sterilizes dollar purchases with no problem for long periods will suddenly trigger a BOP crisis if it then tries to sterilize dollar sales (East Asian crisis) or acquires domestic assets to target a policy rate or finance deficits (Sri Lanka) or repay domestic debt.

This is why Central Banks in Sri Lanka, Argentina, Mexico, Venezuela, Iran, Philippines, Indonesia, India and a number of ex-Soviet states, which have soft-pegs, end up permanently depreciating their currencies and generating high inflation and BOP crises.

April Debacle

Sri Lanka abandoned its consistent monetary policy which was backing the peg towards the end of March 2018 and started pumping liquidity into the banking system by purchasing domestic assets.

In April there is a real demand for cash (an expansion of base money) during New Year season which is generally satisfied by dollar  and domestic asset purchases by the central bank.

In countries with credible pegs in East Asia, the requirement is satisfied (during Chinese New Year for instance) by allowing banks to go short reserves.

There was also a repayment to rupee bond holders at around in the first week of April by the Treasury.

If a central bank defends a peg, purchasing dollars, (preventing the exchange rate from appreciating) it also has to defend the exchange rate and prevent it falling when excess liquidity goes up, in order maintain the credibility of the peg.

Even in a hard peg or currency board, when excess liquidity builds up from foreign asset acquisitions, (unsterilized forex purchases) and imports or capital outflows return, the peg has to be defended with unsterilized sales (mopping up domestic money with sales of the anchor currency) allowing rates to go up.

Sri Lanka’s central bank was operating a peg for the past 18 months, sterilizing forex purchases (foreign assets rising and domestic assets falling) indicating a policy mix tighter than a hard peg or currency board, where dollar purchases would have been unsterilized.

As the exchange rate came under pressure after the Hindu Sinhala New Year, the central bank made a violent shift from a peg which was blocking appreciation until March to a floating exchange rate, with its monetary base expanded by domestic assets.

The central bank said initially that it will not intervene in forex markets. This policy is consistent with maintaining an overnight interest rate target and an exchange rate which floats and weakens.

It also mopped up some of the printed money by expiring term repo deals and selling down a part of the 73 billion rupees of Treasury bills acquired to keep rates below the policy floor. Open market operations to maintain a target interest rate is also consistent with a floating rate.

Unsterilized Defence

The central bank then started to intervene in forex markets switching back to a peg as the rupee continued to collapse amid excess liquidity in May.

Analysts had warned the central bank in 2015, not to float the currency with excess liquidity in money markets, but to force banks which are lending without deposits, to borrow at the highest overnight rate and then float.

As of May 09, forex interventions were unsterilized, indicating that liquidity that gets mopped up by central bank dollar sales are not replaced to create more excess liquidity as the central bank did in 2015.

While foreign assets are falling due to peg defence, excess liquidity is also falling, leading to a shrinking of the overall base money, which is consistent with maintaining a peg and there is no contradiction in policy.

The central bank is also using moral suasion on forex dealers, which analysts say is inconsistent. Moral suasion should instead be used on banks that are borrowing from the standing liquidity facility.

The unsterilized peg defence is also consistent with what usually happens after the end of the New Year season in Sri Lanka, though the same effect can be achieved by selling down Treasury bills.

As long as base money is shrinking, the central bank is not triggering a balance of payments crisis by its interventions. Eventually when excess liquidity runs out with dollar sales, rates will start to move up, in conflict with its objective of keeping rates low (and a domestic anchor).

On May 08 the maximum overnight repo rate went up to 8.20 percent from 8.15 percent. The weighted average rate has moved up from 7.88 percent on April 27 to 7.99 percent on May 08.

The central bank can trigger a BOP crisis when (and if) it continues to defend the currency, and starts to sterilize the interventions to prevent reserve money from shrinking and rates rising. This can be via T-bill acquisitions or reverse repo auctions.

Sterilizing forex sales is neither consistent with a floating rate nor a pegged exchange rate and usually leads to balance of payments crises.

Because Sri Lanka is in fact operating a peg, regardless of claims to have a float or flexible exchange rate, any inconsistent policy will lead to a loss of credibility in the peg among market participants. The first stage of loss of credibility is exporters, holding back and waiting for the currency to fall.

The second stage of the loss of credibility of the peg is when bond holders sell and there is capital flight. Capital flight can trigger a BOP crisis even when credit growth is mild. However it is not clear whether there is a pick-up in credit at the moment.

Helping Government Debt Service

In Sri Lanka, the central bank is also forced to build up reserves and maintain a peg due to its requirement to help service government debt.

Central Bank Governor Coomaraswamy says while there is a strong logic in those who argue that that intervening is a problem, Sri Lanka’s mountain of foreign debt requires a buffer.

"We have to tailor our policies to the circumstances that confront us," he explained. "Our circumstances are that we need to build up reserves

"For instance our short term liabilities to reserves cover ratio was 53 percent in 2015 went up to 63 percent last year and it is well over 70 percent now.

"But the median for comparator countries is 140 percent.

"So we need to build up reserves. There is a is a strong logic to build up non-debt creating reserves and purchasing form the market is one means of doing so."

The government also needs reserves because it does not by itself generate US dollars, Deputy Governor Weerasinghe said.

Governor Coomaraswamy says while the central bank can print money to repay domestic debt, it cannot do so for foreign debt.

Some countries have specific laws restricting reserve appropriations.

Analysts say past experience in Sri Lanka has shown that providing forex reserves to the government to settle foreign debt has no effect on domestic reserve money or the exchange rate as the net effect is a book entry where dollars are effectively ‘sold’ against T-bills (no reserve pass through).
 
However the government finally has to generate domestic resources to repay foreign debt through taxation or domestic debt sales. When the T-bills acquired by the central bank to ‘sell’ dollars are sold down later domestic (private) credit is eventually curtailed.

On the other hand if the central bank prints money to repay domestic bond holders, reserve money will expand and the exchange rate will come under pressure and there will be no dollars to service foreign debt.

Classical economists have pointed out that if a government raises resources through taxes (curtailing domestic consumption) or issuing bonds in domestic markets (curtailing domestic private credit), an equal amount of forex will be ‘saved’ for repayments.

But analysts say in economic history it was shown to be a difficult concept (the Transfer Problem) for people in pegged countries or those that follow Keynesian policies to understand.

Domestic Anchor

The Central Bank is planning to implement what it calls a ‘flexible inflation targeting’ regime. For orthodox inflation targeting to work the peg has to be abandoned.

That the regime is called ‘flexible’ inflation targeting has raised concerns among central bank watchers who have observed the conduct of the monetary policy in Sri Lanka for decades and who fear that it will give more discretion for policy miss-steps as in the past.

Deputy Governor Weerasinghe says eventually the central bank hopes to stop collecting forex reserves, when a sufficient buffer has been build up.
 
However he is not sure whether a fully floating rate can be operated in Sri Lanka.

"All the emerging markets that have a flexible exchange rate they intervene whenever they think necessary," he said.

Only countries like Australia and New Zealand have "100 percent flexibility" in the currency in this region, he said.

Weerasinghe says there is no one-to-one price rise with deprecation in Sri Lanka based on past experience and under an inflation target, the idea is to use domestic monetary policy to counter inflation.

Even when the Sri Lanka rupee quoted daily to operate a peg the pass through to inflation from currency depreciation was only about 0.2 percent for every 1 percent fall in the currency, he says.

He did not elaborate on the time period.

However unlike in Sri Lanka, low inflation, independently floating central banks, do not permanently depreciate their currencies.

While a currency collapse immediately inflates the prices of exports and imported commodities (traded goods) it may take time to translate into non-traded items, as there are delays in salaries and rents, transport costs in catching up.

Salaries sometimes may never catch up if the currency continues to depreciate and if US policy is also loose, leading to lower living standards, poverty, political unrest and strikes.

A further complication is that the US dollar also floats. It is not possible to always accurately measure the movement of the US dollar. A so-called ‘dollar index’ has been created which can be useful to some extent.

Tracking the Singapore dollar, which is driven by an explicit exchange rate based monetary policy, may also be a proxy.

When a domestic anchor is targeted, the central bank ignores foreign exchange movements.

"Whatever impact the currency depreciation has on inflation will be adjusted through monetary policy," explains Governor Coomaraswamy.

"If your monetary policy is targeting a particular (inflation) rate then you know whatever impact that currency depreciation has on inflation can be neutralized through your monetary policy."
 
Multiple Anchors

At the moment however all indications, domestic and foreign asset changes in the balance sheet, the movement of the dollar rupee exchange rate which has diverged from better central banks, and the loss of credibility by market participants in April show that the central bank is in fact operating a non-credible peg.

The targeting of a Real Effective Exchange Rate Index, analysts have warned, doest not just involve outsourcing monetary policy to a better central bank like the Fed, as Dubai and Hong Kong have done, but also results being hostage countries like India and China, which have suboptimal monetary policy.

Under the current IMF program, while a reserve target has been given, no ceilings have been imposed for domestic assets of the central bank, which would have been consistent with collecting forex reserves and operating a peg (external anchor).

Instead, the central bank was given an inflation target band as a performance criterion, which is a domestic anchor, while the reserve target forces it to operate a peg involving sterilization. 

Whatever the claims of a flexible exchange rate or domestic anchor, the results of targeting multiple anchors is ultimately experienced by market participants and the electorate.

In 2015 the central bank poured liquidity and printed money because the ‘core inflation index’ was low, (domestic anchor) despite operating a peg at 131 to the US dollar for about 18 months (external anchor) clearly showing the danger of dual anchors.

The BOP crisis that resulted triggered capital flights and led to a collapse of the currency, the full inflationary effects of which are yet to be seen.

Sri Lanka then ended up in an IMF program under which in 2017, Sri Lanka generated the highest inflation in Asia after Mongolia, which had also just emerged from a BOP crisis and currency collapse.

Analysts also say the problem of operating a peg and contradictory domestic policy can be explained in a much simpler way.

When a peg is operated, the balance of payments essentially drives the monetary base and interest rates. Any attempts to resist a contraction in base money (sterilizing forex sales) generates a credit bubble and a BOP crisis.

In the same way, any attempts to resist an expansion of the monetary base and a rate fall (sterilizing forex purchases) will also slow the credit system and lead to a fall in economic output. (Colombo/May09/2018)

Usually, following a balance of payments crisis, inflation rise as the currency collapses, and then it tends to fall, partly helped by a re-appreciating exchange rate, though growth will also fall.

This time however, while paying lip service to a flexible exchange rate, the central bank has bought 1.7 billion US dollars, resisted upward pressure coming on the exchange rate which comes when credit weakens and liquidity is withdrawn from money markets.

Amusingly all this has been blamed on coconuts. The currency has been depreciated to target a real effective exchange rate index.

Non-oil Crisis

The 2015/2016 Yahapalanaya BOP crisis has provided important lessons.

Sri Lanka’s recent balance of payments crises were mostly tied to rising oil prices which were then subsidized with printed money. Electricity is also subsidized either via the petroleum utility or directly by the electric utility.

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This was the case in the 1999/2000 crises (Brent crude rose from around 10 dollars in Jan 1999 to 26 dollars a barrel by December 1999).

The rupee collapsed, the government changed. Then under UNP led administration with the central bank under Governor A S Jayewardene inflation fell to almost zero despite rising oil prices helped by an appreciating exchange rate and a fuel price formula.

Then in 2004 as money was printed to subsidize oil with Wimal Weerawansa asking for the World Bank plug to be removed (price formula) inflation rocketed and the rupee fell. Then from December 2003 there was a credit collapse after the tsunami and the rupee stabilized and a BOP crisis was avoided.

In 2008 Sri Lanka ran into another crisis as oil was subsidized and Brent crude shot up to 137 dollars a barrel in the last gasp of the ‘mother of all liquidity bubbles’ fired by the US Fed. Brent crude which was about 58 US dollars in February 2007 rose to 138 by June 2008.

The 2011/2012 crisis was also connected to rising oil prices and also a drought which pushed up thermal generation. Brent crude rose from about 78 US dollars a barrel in September 2010 to 126 dollars by May, while a drought pushed up oil imports further.

The central bank in 2011, cut rates despite rocketing credit growth, driven by borrowings from petroleum and power utilities.

The 2015/2016 Yahapalanaya crisis was unique in that oil prices were collapsing in that period. It was purely driven by money printed to accommodate a runaway budget and unchecked liquidity releases.

This helped conclusively show that a 70 year old widely accepted Mercantilist myth that oil imports caused BOP crises in Sri Lanka false completely false.

In fact it is amusing to note that even the International Monetary Fund was saying in early 2015 that low oil prices would help the balance of payments. So did Fitch Ratings, showing that Mercantilist thinking is widespread.

In fact oil prices has no effect on the balance of payments. If oil prices fall, non-oil imports will go up, as people divert spending to other goods (or save more which is then loaned to others as credit by banks).

If oil prices go up and retail prices are also raised – absent subsidies and money printing- non-oil imports will fall. If oil retail prices are kept down, and money is printed non-oil imports will continue unchecked or grow, while oil imports will also grow with printed money generating a BOP crisis.

Like in 2011, there was rate cut in April 2011 as private credit raged and the budget went off the rails. The central bank released 630 billion rupees of liquidity and lost 4 billion US dollars of forex reserves in the crisis.

In Sri Lanka with foreigners now owning bonds, capital flight also starts as soon as the credibility of the soft dollar peg is undermined by the central bank, making for faster draw down on foreign reserves. When rates are cut foreign investors will also get profits if they cut and run.

The 4 billion dollar question is, why did the central bank cut rates?

Bondscam Report

The recently released Bondscam Report presents a clue.

To digress, the bondscam report shows senior officials are remarkably if not hilariously clueless about what goes on in different areas of the country and also the activities of other departments. Some officials are also astonishingly clueless about their own departments.

How people can be so clueless is a mystery. But it also shows why market participants are able to run rings around some of these officials.

To get back to monetary policy, the testimony of key officials to the Bondscam Commission is revealing in terms of the thinking and how the BOP crisis was created in the first place.

It shows that fiscal dominance (pressure from the Treasury to print money) is not the reason for BOP crisis and high inflation.

Nandalal Weerasinghe, Deputy Central Bank Governor and a senior hand in charge of monetary policy was of the view that there was no need for rates to rise in February 2015.

“The witness stated that there was no reason to guide the Interest Rates up. He stated that if there is a need to guide the Interest Rates upwards or downwards, it should be done gradually, within the Policy Corridor,” the commission report said.

“In answer to a Question from the Commission, witness stated that the Board Paper submitted to the Monetary Board on 23rd February 2015, there was no recommendation to guide the Interest Rates upwards and even in the event of being decided that the Interest Rates should be guided upwards, it should have advocated the policy of gradualism. Sudden shock to Interest Rates will create implications to the economy.

The board paper suggested in February that that a 5.0 percent lower floor policy rate be removed but that a 6.5 percent rate be cut to 6.0 percent.

It was not done by the Monetary Board on that day, but a couple of days later Governor Mahendran lifted the rate without going to the monetary board, eventually leading to the Bondscam scandal.

That Sri Lanka was heading into BOP crisis was evident from late 2014 to outside analysts, provided the central bank did not raise rates. And the central bank’s miss-steps were forecasted and chronicled both by this columnist and also reporters.

A glance at some of the headlines shows this.

Oct 2014

Sri Lanka in danger of travelling the PIGS path with low nominal interest rates: Bellwether

Dec 2014

Sri Lanka may lose forex reserve beauty contest amid ultra-low interest rates: Bellwether

Feb 2015

Sri Lanka keeps rates unchanged amid rocketing credit, currency pressure

April 2015

Sri Lanka cuts interest rates dsestpite, state borrowings, revenue concerns

May 2015

Sri Lanka policy rates unchanged amid exchange rate pressure

May 2015

Sri Lanka holds rates amid monetary expansion, rising imports

June 2015

Sri Lanka knocks hard at BOP crisis door: Bellwether

July 2015

Sri Lanka not very concerned about monetary policy due to low inflation: Deputy CB Governor

July 2015

Sri Lanka prints over 100 billion rupees

Aug 2015

Sri Lanka central bank says rising credit a concern; policy rates kept low

Sept 2015

Sri Lanka is not in an immediate BOP crisis: IMF

Oct 2015

Sri Lanka policy rates unchanged, credit growing

Jan 2016 (based on Sept data)

Sri Lanka private credit soars to Rs158bn amid money printing

Feb 2016

Sri Lanka raises policy rates 50bp citing credit and money growth

The April 2015 disastrous rate cut was followed by more liquidity releases like some strategic bomber carpet bombing the banking system, putting Ben Bernanke’s helicopter drops to shame.

After mumbling about many things for more than a year the central bank finally raised rates by a measly 50 basis points in February 2016, after the horse has bolted so to speak.

In fact the rupee was also floated in mid-2015 without a rate hike, in a remarkable turn of events.

Core Inflation

The targeting of a core inflation index by the central bank may also have contributed to the latest crisis.

In early 2015 Sri Lanka’s ‘core inflation’ a misleading inflation measure where many items such as oil and food are taken off was low. Core-inflation is particularly dangerous over short periods.

Even Former Deputy Governor W A Wijewardene, a definite inflation hawk, told the Commission he did not see a need to raise rates in February 2015 as core inflation was low.

Core inflation was indeed low.

In fact a 2006 base index showed that ‘core inflation’ was 2.1 percent in January 2015 and it fell to 0.8 percent in February.

At the time headline inflation was shown as 3.2 percent in January and 0.6 percent in February with the 2015 budget having cut fuel and other commodity prices.

In ordinary times a core index tends to show lower levels of inflation when the Fed fires commodity bubbles sending oil, food commodities (and base and precious metals) prices up.

In Sri Lanka after the CCPI index was revised later, the February 2015 core inflation (as well as headline inflation) showed a higher number which was constantly rising.

The question to ask is would the central bank have raised rates earlier if the 2013 base core-inflation index was used? The answer is probably not.

All this shows that Sri Lanka cannot even construct a useful inflation index and using the existing indices are likely to drive the country into a BOP crisis. And then high inflation after the currency collapses.

Core inflation indices are misleading to use in any monetary regime.

The US Fed for example targeted core inflation while commodity prices soared, generating the Great Recession. In a country with a managed exchange rate (soft-peg) targeting a core-inflation index is suicidal.

Supply Shock Deception

In fact Ben Bernanke is a great proponent of another whopper. That so-called ‘supply shocks’ cannot be countered by monetary policy.

Governor Indrajit Coomaraswamy, without doubt a highly capable and outstandingly honest person, has also fallen for this. He has blamed coconuts for 2017 inflation.

No economist or Mercantilist of any repute has claimed that half the inflation is caused by cost-push and half or some other percentage by demand. Mercantilists, James Stuart, John Law onwards, claimed that all inflation was caused by cost factors.

They argued that money supply had little do with it. Of course claims ‘money supply has little to do with inflation’ are again creeping into the discourse as linear statistical relationships between chosen money supply variables and inflation become harder to find.

Money supply, classical Mercantilists argued, adjusted to price increases not the other way around.

Bernanke’s duplicity on supply shocks is easily revealed.

While claiming that supply shocks cannot be contained by monetary policy, he and Greenspan conveniently printed more money amidst productivity gains from technological developments, and muted commodity prices from 2000 onwards, helping create the mother of all liquidity bubbles and the Great Recession.

In other words, these central bankers are quite willing to print money with loose policy to create more inflation in the face of a ‘positive supply shock’. But they are remarkably unwilling to counter a ‘negative supply’ shock with tight policy.

It is through such deceptions that central banking is kept on.

In any case the price increase of one or two goods cannot cause the general price level to increase over any significant length of time, unless there is monetary accommodation. In general, large increases in the price of one or two goods will leave people with less money to spend on other goods.

If one accepts that a central bank can only contain core-inflation and not the inflation that everyone feels (headline inflation), then inflation targeting should be abandoned altogether.

That is why the inventors of inflation targeting deliberately set a real inflation target in the form of so-called headline inflation, instead of an imaginary one like core-inflation.

The Depreciation Deception

Another deception long practised by central bankers is to try to minimize the effects of depreciation.

When a currency falls from say 100 to the dollar for example the price of exported and imported goods will double.

If tea was priced in the export market at 2 dollars a kilo (200 rupees), before depreciation the and sugar at 50 rupees kilo, after depreciation tea will go up to 400 rupees in a short time. A kilo of sugar will double to 100 rupees a kilo immediately.

Eventually the price increases of traded goods will be passed on to non-traded goods and services, subject to any productivity improvements. Any currency appreciation can reverse the effects as well.

Though the price of the dollar has inflated 100 percent in rupees, just like the price of sugar inflated 100 percent, the depreciation is calculated in such a way as to say it was only 50 percent (i.e the value of the rupee has halved compared to the dollar).

If the rupee falls to 10,000 to the US dollar, the depreciation is calculated as 99 percent only. At 20,000 to the dollars it is around the same.

For example from December 2014 to December 2017 the rupee fell from 131 to the US dollar to 152.8 to the US dollar which is a rupee/dollar inflation of 16.6 percent.

The December 2014 date is a pretty good starting point since the rupee has been stable for a long time prior to that and it can be assumed that most or all of the effects of the 2012 currency collapse had been dissipated by that time.

The CCPI (revised again) went up from 105 to 122.9 or 17.05 percent. In a hilarious development the core inflation index went up from 106.1 to 124.9 points or 17.72 percent, which is higher than the increase in the headline inflation.

So what does that mean? The central bank is responsible for all the headline inflation and then some?

In a pegged exchange rate the total inflation that is created is the domestic inflation (from currency depreciation and demand pressure) plus the inflation created by the anchor central bank, in Sri Lanka’s case the Fed.

It is true that the domestic demand pressure is now down. With dollar purchases being sterilized, the central bank cannot create any demand pressure per se. In fact listed companies are seeing a narrowing of margins and gross profits, which shows that demand pressure is not there.

However inflation is still being created by currency depreciation by the central bank and also by the Fed. This currency depreciation, in a bid to target a REER index can create full blown stagflation and delay a recovery in credit as domestic purchasing power is destroyed.

Inescapable Reality

Whatever pegged central bankers say they cannot escape a self-evident reality. Whether the currency is defended to prevent it from weakening or to prevent it from going up, (like now), it is a peg.

As a result – whether they like it or not – the domestic money supply is going to be determined by the balance of payments. When credit growth goes up, if the central bank resists interest rates hikes by printing money, a BOP crisis will develop due to the misalignment of the money supply with the balance of payments.

This is why stable financial centres raise their policy rates when the US raises rates.

In other words if liquidity is released (money is printed) when credit demand goes up to resist rate rises in a peg, a BOP crisis is the result.

This column has previously pointed out that in March 2016 policy suddenly improved as excess liquidity was allowed to run and 100 plus sterilization stopped.

Until then the central bank’s domestic operations department was injecting cash through reverse repo auctions and outright purchases, at volumes exceeding the outflows, rapidly making the BOP crisis worse.

The Bondscam Report shows that it was actually Arjuna Mahendran who gave the order to stop it.

“On or about 03rd March 2016, Mr. Mahendran had telephoned Mr. Rodrigo (head of domestic operations) and instructed him, that the conduct of Reverse REPO Auctions should be immediately stopped, so as to stop the injection of liquidity into the market through Open Market Operations.

“In this connection, Mr. Rodrigo said that the “Governor telephoned me in the morning, and said to immediately stop conducting of reverse REPO Auctions.”.

“When the Commission of Inquiry asked the witness why Mr. Mahendran had issued such instructions, he said, that Mr. Mahendran had mentioned that the CBSL had earlier increased the Statutory Reserve Requirement in an effort to reduce Liquidity and that the intention of the CBSL was to “drain liquidity.”

“Mr. Mahendran had said that, in this background, Liquidity should not be injected into the market by CBSL and that the CBSL wanted Interest Rates to move up.”

Whatever Mahendran’s faults, and whatever the motivation, he was spot on regarding ending cash injections. Until then the central bank seemed to have been unaware of what it was doing.

Overnight Price Signal

The whether or not the dollar peg is under pressure can be seen by the way the overnight interbank market interest rates behave.

Overnight gilt backed repo rate was a little above the 5.0 percent ‘lower policy rate floor’ until February 27, when ex-Governor Mahendran ordered its removal outside the monetary policy meeting. Rates then moved towards 7.0 percent, but in April rates were cut back to 6.0 percent.

Until March the domestic operations department continued to pour liquidity sterilizing over 100 percent of outflows from currency defensive keeping overnight rates near the 6.0 percent floor of the policy corridor instead of the ceiling rate.

From March rates hit the ceiling of the policy corridor at last, after the Governor telephoned the head of domestic operations and told him to “immediately stop conducting of reverse REPO Auctions.”

Such is the fate of the people of Sri Lanka.

Even then cash injections continued through bill purchases, sterilizing 100 percent, but money was no longer in excess and some banks were borrowing through the window at the highestr rate.

A perusal of both the domestic asset stock (T-bills of the central bank) and the overnight rates show that the 205/2016 BOP crisis ended somewhere around May/June 2016.

Now with rates hitting the floor of the corridor, the central bank is resisting a further fall based on market rates. It can cut rates without causing any damage to inflation. If rates are cut the credit cycle will turn faster.

However the central bank should also allow the exchange rate to appreciate a little to head off the inflation from the Fed. In fact it could have done so many months ago.

External conditions are hotting up now. Stock markets around the world are hitting new records. Oil is rising. Oil at 100 dollars a barrel, gold at 1,700 may return, unless the Fed tightens and withdraws its mountain of excess liquidity pretty fast.

In the US companies that are not much leveraged may be able to stand higher interest rates.

Countries with better pegs from China to Malaysia are already allowing the exchange rate to appreciate against the dollar. Floating rates are floating up.

Whether this phenomenon will moderate the REER index (through a fall in the nominal effective index) and reduce the need to depreciate and generate more inflation remains to be seen.

One mercy of defending the peg, and having BOP crises in quick succession – even if the currency is not allowed to re-appreciate – is that banking crises are avoided.

If an inflationary crawling peg like 2001-2008 on or the 1980s, is operated (helped by REER targeting), bubbles will also become bigger and finance companies and banks will get into trouble when rates are eventually hiked.

Sri Lanka’s planned modified inflation targeting regime is full of holes. It is not just the over-dependence on targeting core-inflation that is troubling. But there is also a plan to manage the exchange rate with forex auctions, indicating a glorified peg will be operated.

A 4-6 percent inflation target will then give enough room for the central bank to delay rate hikes in 2019, sterilize the forex auctions, and run headlong into another BOP crisis. And then an ‘overvalued currency’ will be blamed.

This column is based on ‘The Price Signal by Bellwether‘ published in the February 2018 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.

Unlike the erotic art of lap dance, the 21st century Sri Lankan version was performed by  students  dressed in black leggings, yellow skirts and black short-sleeved jackets to symbolize the computers given by the education department.

They were to rhythmically punch the air with notebook computer replicas made of wood and painted black and yellow to match their highly modest costumes.

The troupe was seen rehearsing on Saturday  without the “laptops” and their teacher said they had orders to drop the props, but keep only the dance routine.(COLOMBO, February 3, 2018)

The taxation changes of bonds including government debt, under a new income tax law also raised the question of indirect expropriation, according to some analysts, though uncertainty prevails.

"The 5 percent withholding tax rate is applicable at the time of payment of interest," Thanuja Perera, consultant to Sri Lanka’s Finance Ministry told a forum organized by the Ceylon Chamber of Commerce refereeing to corporate debt.

"So payments made after this date – after April 01, 2018 – will be subject to the 5 percent withholding tax."

Under a new income tax law interest on private corporate debt will be taxable, with a final 5 percent tax being deducted from individuals and standard taxation for companies with the withholding tax being an advance payment.

Sri Lanka made interest on bonds issued from January 2013 tax free in a blatantly interventionist move to ‘promote corporate bonds’ which was used by large investors as a tax shelter.

Selective Implementation?

A boost to the investment climate was made by the state going through tax holidays already granted under the Board of Investment concession as befits a free country.

Tax holidays themselves, where different persons engaged in the same activity is treated differently, may amount to an undermining of just rule of law, liberty advocates say.

However in reversing the tax free status of bonds already issued, Sri Lanka is going against the policy of allowing tax holidays already granted by the Board of Investment to run its course, raising questions over selective implementation of the law.

The income tax law, to which many changes were made to the original draft, in the so-called ‘committee stage’ is not available in final form yet.

There is a lot of uncertainty in corporate and gilt markets, where participants are seeking clarity.

For example in a more damaging fallout, there is the risk that some corporate bonds, issued before 2013, where withholding tax has been already paid, being taxed twice.

Sri Lanka’s Hatton National Bank issued 10 year bonds in September 2011, expiring in 2021.

At the time the prospectus informed shareholders that withholding taxes have been paid.

"In terms of Section 135 of the Inland Revenue Act No 10 of 2006 as amended by Inland Revenue (Amendment) Act No 22 of 2011 the Issuer of any corporate debt security is required to remit withholding tax at the rate that may prevail at the relevant time on the entirety of the interest which may accrue on such corporate debt to the Inland Revenue Department at the time of the issue of such corporate debt security," the prospectus said.

"Pursuant to such a deduction and remittance being made there would be no further withholding of any tax by the Issuer on any interest being paid on such corporate debt security."

Prospective investors were informed that there is interest rate risk (the bonds were fixed rate), re-investment risk (of coupons), default risk and liquidity risk.

The possibility of the government deducting a withholding tax at a later date was not listed as a risk.

Own Goals?

There are not many tax paid bonds in existence now as most have expired. There are more tax free bonds, but they are also expiring progressively.

Some liberty advocates and those who want to reduce investment risks of the country, and create a safer and more predictable business environment, are puzzled why bureaucrats and politicians are pushing up risks of investing in Sri Lanka by retrospective taxes, or practices which could amount to indirect expropriation in ‘own goal’ types of actions.

In 2015 Sri Lanka imposed retrospective corporate taxes to get 60 billion rupees, undermining the investment environment of the country, at a time when the country was already struggling for foreign direct investment. There were also so-called ‘revenge taxes’.

In 2011 there was an expropriation law.

It is not clear how much cash the state will get by reversing the tax status of existing corporate bonds. Whether the tax gains justify the damage done to the investment framework is not known.

Prepaid taxes

In government bonds, the income tax law has said there will be no withholding tax from April 2018. However withholding tax at 10 percent has already been paid on all bonds issued and held in portfolios of domestic and foreign investors.

Government bonds rates are now quoted net of tax. The practice of paying withholding tax ‘upfront’ was done for ease of secondary market trading, which is peculiar practice.

Officials say even in existing bonds, where taxes have already been paid there will ‘no withholding tax’ in the future. Since taxes have already been paid at 10 percent in existing bonds, the question may be academic.

Meanwhile no mention has been made on returning taxes already paid by bond holders, for the balance tenors of the bonds to make good the claim that there will be ‘no witholding tax’ in the future for bonds already issued.

Investors in government bonds ‘grossed up’ their income by 10 percent to claim the taxes already paid, when filing returns. With no credit for withholding taxes already paid, and no prospect of a return of such taxes, there is a risk that they may lose the income they had after paying a 28 percent income tax.

"We are still trying to make sense of the effect of the laws. One effect would be that in future, a higher interest rate would be demanded," a gilt dealer said.

"However markets overall viewed the Inland Revenue Act positively. Rates came down after the law was passed."

Theres is a risk that the biggest hit would fall on pension funds of old people, such as the Employees Provident Fund, which own most of the bonds.

Uncertainty

Taxation of pension funds has already been raised from 10 percent to 14 percent. In the past due to the 10 percent tax credit, pension funds hardly paid any taxes.

If there is no credit for taxes already paid, there is a risk that the tax would be effectively 24 percent, on the existing portfolio.

The denial of the tax credit for bonds in issue – where future taxes on the remaining duration of the bond is charged to the past – or the non-return of taxes, may amount to an extraordinary case of retrospective taxes or a novel method of expropriation unknown to other jurisdictions, liberty advocates say.

Under a new law, foreign investors in bonds may also have to pay capital gains tax and income tax. They also will not be able to claim credit for taxes already paid. It is not yet clear whether they will have to open tax files here.

The new income taxes come into effect in April 2018, giving ample time for foreign investors to decide whether to stay in the country or not. With budgets improving Sri Lanka’s interest rate are also easing, which means bond prices are rising able to absorb some shocks.

In the past Sri Lanka imposed many taxes on midnight or January 01 after a budget, without parliamentary sanction.

Imposing taxes after passing them in parliament with a future effective date is a major improvement in business climate and treatment of unarmed citizens by an armed state with coercive power, analysts say.

While governments are entitled to change taxes, people can make long term decisions only when the rules of the game do not change suddenly.

State Minister of Finance Eran Wickramaratne had said that the new income tax law will bring predictability to the tax framework in the future as few changes are envisaged.

Though many transitional provisions had been provided, in the case of corporate and government, there is still uncertainty. (Colombo/Sept12/2017 – Update II)

Sri Lanka has already said para-tariffs such as cesses which were imposed to allow politically connected rent seeking domestic producers, which critics generally call ‘crony capitalists’ to exploit the poorest consumers with higher than global prices will be gradually removed.

"A part of the philosophy of liberalizing is that we want the markets to function freely. We want it to function responsibly," Wickramaratne said.

"When taxes are reduced prices should reflect it. The consumers should benefit. Generally we are weak on the regulation side and people take advantage of it. That is why on about 17 items we still have maximum retail prices – on the retail side.

"But gradually you will see an easing of that. We will remove it."

Price controls remove the most important signalling mechanism for markets, both for producers and consumers.

When prices rise more people will import, paying freight and other charges. When chicken meat prices rise, farmers will be incentivised to raise more chicken.

When the new production comes to the market prices will fall. In the interim however prices will remain high. Some consumers will meanwhile temporarily shift to other alternatives such as fish.

Price controls also discourage the raising of quality over time, as producers who make a better product cannot charge extra.

A controlled price means production will not increase and only the larger more efficient producers will be able to survive.

When price controls of chicken was in place, prices hardly moved but eggs which were not under control, moved up and down.

Prices generally move up above global levels when the government imposes import duties or when the central bank prints money, debases the currency and creates demand pressure and inflation. When the currency depreciates, the price increases are made permanent.

Sri Lanka cut taxes on rice and several other foods as a drought hit domestic production.

Butafter the currency collapse in 2015 and 2016, Sri Lanka’s price structure is now permanently up and rice and other goods have to be higher than before even if they are imported at a lower duty.

But usually retailers are blamed for rising prices, not central bankers or politicians who imposed import cesses or taxes.

Prices controls dating back to the Roman ‘edict on maximum prices’ in 301 were triggered by the inflation of the currency, when Emperor Diocletian debased the silver denarius using copper.

The same process now happens when the central bank buys Treasury bills with printed money and expands reserve money, when budget deficits or credit demand rises.

In Sri Lanka price controls were widely seen in the 1970s. When prices are controlled, the government creates black markets and hoarding incentivising other law-abiding citizens to disregard the law.

High import duties also generate smugglers. In communist states in Europe, especially the Soviet Union, black marketeers and smugglers were the biggest ‘entrepreneurs’. (Colombo/Aug10/2017)

Government loyalists side stepped the findings of the Committee on Public Enterprises (COPE) during a debate initiated by the JVP and went onto the focus on the alleged corruption during Mahinda Rajapaksa’s decade in power.

Government’s anti-corruption activist and deputy minister Ranjan Ramanayake diverted attention to bond scams under the Rajapaksa administration and large scale corruption between 2005 and 2015.

Speaker after speaker from the government tried to say that corruption under the former government was worse than at present.

Donald Trump’s campaign manager Kellyanne Conway recently offered "alternative facts" when video and photographic evidence proved that their claims of record crowds at the presidential inauguration were false.

Amidst the mudslinging and outright lies, Opposition leader R. Sampanthan moved to lift the quality of the debate by focusing on the real issue – a debilitating plague of corruption.

"What is happening now. I am not saying Mr. Ranil Wickremesinghe is corrupt. I am not saying Mr. Maithripala Sirisena is corrupt, but there is corruption. you know it," Sampanthan said.

He said much was talked about the corruption that prevailed during the previous regime, but not a single person had been convicted or even indicted.

"Has anyone being convicted? No. Are you framing false charges that you cannot substantiate. The country needs to know.

"When there is so much of corruption levelled against the former government, why is it that no one has been convicted, or no one has even been charged in a court of law. Is it because you are protecting them?," he asked the government.

"Or is it because your charges are thoroughly unfounded and you cant substantiate them?"

Sampanthan said the country was "stinking" of corruption, but the worst thing was the loss of Central Bank’s credibility.

"The Central Bank has lost its credibility in this country. The Central Bank’s  misconduct, their misbehaviour, their acting beyond the legitimate functions of the Central Bank did not start yesterday or the day before.

"It started a long time ago, during the last regime. The Central Bank was accused of engaging in political propaganda on behalf of the government in the US."

He said the country had suffered immensely and wrong doers must be punished irrespective of their station in life. (COLOMBO, January 24, 2017)