ECONOMYNEXT – Sri Lanka’s intensified forced dollar conversion rules of exporters and dollar salaries of residents is serious cascading policy error that will worsen the foreign currency crisis and the dollar liquidity crisis in bank funding books.

This will worsen the dollar funding crisis of banks that began to build up with credit downgrades in late 2020 as overseas banks cut limits to Sri Lanka and declined to roll-over maturing credit lines.

De-dollarization of deposits therefore is a soft-pegging cascading policy error.

Cascading Policy Errors

State banks in particular are exposed to Ceylon Petroleum Corporation loans, which have been taken during times of money printing by the central bank in another unusual cascading policy error, where it is barred from buying dollars in the market and is forced to borrow dollars.

This policy error has persisted for some time at least from the 1990s.

The practice of taking oil credits from Iran and now India when money printing creates forex shortages is an extension of the policy error.

The sudden rush to borrow abroad, instead of squeezing the current account, allows domestic economic agents to live off borrowings instead of their current earnings.

The financial account inflows widen the current account deficit. Central bank Mercantilists and other then complain of a widening current account deficit for BOP troubles.

Sri Lanka and third world central banks have an unfortunate tendency to make policy errors that worsens external troubles.

These policy errors can cascade into a mutually self re-inforcing vicious cycle that accelerates rapidly the last stages, as market participants get panicky.

When only one type of bank notes are in circulation, policy errors of the note-producer affects the entire credit system and therefore individuals and firms – which is generally called ‘the economy’.

Sri Lanka has to take quick action to restore the lost confidence in the rupee triggered by liquidity injections and cascading policy errors to avoid an acceleration of a monetary meltdown with serious consequences for all citizens and less affluent in particular.

Already inflation has risen to 9.9 percent far above the policy rate of 6.0 percent and difficulties in paying for imports are intensifying.

While getting ready for a possible float and a rate hike, the central bank should not engage in de-dollarization attempts but instead allow parallel dollarization.

Deposit Dollarization

With banks having loaned dollars to the government and the CPC, it is a mistake to stop dollar inflows going to dollar accounts of residents or any other person.

Banks had already reduced their negative net foreign asset position from 4.4 billion US dollars in October 2020 to around 2.8 billion by October 2021.

Banks had cut their dollar borrowings from around 5.3 billion dollars at the end of the third quarter of 2020 to about 3.8 billion dollars by the third quarter of 2021.

It was in part financed by foreign currency deposits which went up to 10.9 billion dollars by the end of September 2021 from 9.3 billion US dollars a year earlier.

Since banks have dollar loans to the government it is a mistake to stop dollar deposits.

The steep negative swap rates are an overt sign of this problem.

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Due to the forced conversion rule a part of these moneys will now be parked outside, reducing inflows, expecting a devaluation.

Bill stock musical chairs

Sri Lanka’s crippled bond markets are now limping back and the central bank has sold down some of its Treasuries stock held outright to market participants.

To permanently get rid of bills there has to be an interest rate that curbs domestic credit, which will reduce and generates and excess of dollars through a working spot or forward market for dollars.

However neither the spot nor forward markets are working.

In sharp contrast, due to the interest rate mis-match with dollar yields higher than rupee rates, implied forward rates in swaps are steeply negative.

As a result, any Treasury bills sold from the outright stock are taken back to the balance sheet of the central bank, through standard liquidity facility (SLF) window.

In October the central bank’s Treasury bill stock as published went down from 1,433.9 billion rupees to 1,466 billion rupees.

However in the same month, overnight injections made against Treasury bills went up from 261 billion rupees from 368 billion rupees.

After discounting the 31.5 billion rupees mopped up through repo auctions, the estimated Treasury bill stock had gone up from 1,755 billion rupees to about 1830 billion rupees ignoring any haircuts.

Sterilized Interventions

The reason this liquidity is injected is to maintain the policy rate of 6.0 percent.

Any dollar interventions made in the forex market to give dollars for oil or other imports will also be similarly offset with new liquidity injections.

This is the typical currency crisis that happens in a Latin America style central bank, even without a budget deficit.

Mexico for example defaulted in 1994 as the Fed hiked rates, with a budget surplus due to this sterilization of the balance of payments.

Sterilization of the balance of payments is the siren song of Latin America style central banks which try to maintain a policy rate despite strong domestic credit and external outflows.

Turkey is now in a similar situation.

As long as injections continue, the demand for dollar to go out, will be higher than inflows creating forex shortages. Parallel exchange rates emerged when the central bank does not redeem all rupees hitting forex markets.

In short, once the credibility of the peg where everyone will be willing to part with their dollars at the fixed rate in the spot market is lost, it cannot restored easily, unless rates are very high and credit is sharply showed. A float can get the spot market working again.

Therefore authorities should be prepared for a float to end sterilized interventions, but in the meantime should allow parallel dollarization, not discourage it.

More on the difference between floating and fixed exchange rates, and why some currencies depreciate permanently can can found here: Why Sri Lanka’s rupee is depreciating creating currency crises: Bellwether

Jumping through the non-credible peg gap

Due to the legal tender monopoly in a soft-peg, Sri Lanka’s government finds it very difficult to get hold of dollars that come in to the country, to repay its dollar debt.

In a soft-pegged country (or hard pegged country), taxes are paid in domestic currency and domestic transactions happens in local currency due to legal tender laws.

The government first has to get hold of some rupees from taxes or borrowings and again exchange the money to US dollars, either by purchasing dollars in the forex market with the rupees (the raising of which either through taxes or borrowings should have reduced consumption, investment and therefore imports) or through a roundabout process via the central bank where reserves are appropriated against T-bills issued to the central bank.

In Sri Lanka while state agencies like Ceylon Petroleum or private importers can get dollars directly from exporters jumping through one hoop of the pegged system (buying dollars), the government has to jump through the hoop twice as the Treasury does not directly deal in the forex market unlike in other countries.

For the government get hold of dollars, the recipients have to sell the dollars to the central bank, which creates more rupees. Liquidity is created when dollars are sold to the central bank. Unless the liquidity is sterilized through a sell down of a Treasury bill held by the central bank, the recipients of the rupee (or who borrows the new rupees) will demand the dollars back.

If the government pays rupees directly to the central bank to get dollars, a liquidity short is created in the banking system, like in any intervention.

If the money is not printed, there will be as liquidity shortage, private borrowers will be crowded out and rates will rise.

However if money is printed again to maintain the policy rate, there is no crowding out, and import demand will not be reduced.

In times when there is already a forex shortage (lost credibility of the peg) due to earlier liquidity injection, the problem is worsened when this liquidity is re-filled and currency problems persist.

Once the credibility of the peg has been lost due to liquidity injections, it is difficult for anyone to exchange rupees for dollars.

People with dollars do not want to sell. Due to liquidity injections the demand for dollars is higher than the supply pushing the exchange rate down.

When the central bank reduces its interventions (giving dollars in exchange) parallel markets develop.

In any case the government cannot get dollars to repay debt, since already there is a shortage of dollars for current imports.

It is possible to get dollars from reserves against T-bills without disturbing reserve money by making the entire transaction go through one bank (such as when the billion dollar bond was repaid) but even so, reserves are needed and the T-bill have to be sold down later to re-build reserves.

These practices, where the central bank acts as the dollar banker to the government, make it impossible for Sri Lanka to have a successful clean floating exchange rate therefore also makes successful inflation targeting almost impossible.

It also force the government to jump through two hoops to get dollars, via the central bank.

Parallel Dollarization

Leaving aside the question of a float, which will end sterilized intervention, parallel dollarization of payments will reduce also the corrective interest rate and the economic contraction required to re-establish the credibility of the peg.

As explained before the problem in government not getting dollars is due to the legal tender law of forcing domestic economic to transact in rupee and pay taxes in rupees.

As soon as this rule is removed a part of the problem is solved.

The central bank should not impose a surrender rule requiring dollars to be paid to the central bank (creating liquidity at zero interest rate in the process which harms the peg) but dollars should be paid directly to the government for existing rupees.

One part of the surrender rule, allowing exporters to buy SLDBs is correct. That will directly transfer dollars to the government without having to go through the rupee credit system.

However since some SLDBs were earlier repaid in rupees, their attractiveness is now less than before.

In the same way the exporters should be allowed to pay taxes in dollars.

The government can give the same two rupee extra (a discount) for paying taxes in dollars now given to expat workers.

Expat workers are paid this subsidy even if the dollars do not go directly the government at present.

But these are all part of soft-pegging cascading policy errors employed by central bankers who studied in Anglo American universities in the 60 and 70s, that makes a perfectly well functioning economy go into crisis.

Exporters and hotels can also pay electricity bills in dollars. This will keep the power flowing to their factories and hotels. They can also pay dollars for fuel. This will keep fuel flowing to their factories and trucks.

Exporters and hotels should also be allowed to pay their suppliers in dollars. That way the problem that is there with some inputs to the export industry will disappear.

This includes tea exporters. Plantations have to buy some chemicals and other inputs for which suppliers can no longer get dollars. Some export manufacturing firms also get inputs from local importers including specialist chemicals where the agencies are held by locals.

In fact SLDB bond auctions should be held weekly like Treasury bill auctions.

Governor Nivard Cabraal’s suggestion of allowing car imports for dollars and taxes to be paid in dollars is absolutely correct.

Latin America, style sovereign default is a problem partly due to legal tender laws, and partly due to the soft-peg, but it is rarely a fiscal matter.

In Sri Lanka there is a revenue problem after the 2019 tax cuts but in Latin American countries including Mexico has defaulted purely due to the legal tender law and soft-peg (interest rate controls) with budget surpluses.

Argentina defaults with 5 percent deficit and 50 to 60 percent debt to GDP ratios.

Parallel dollarization will also push some rupee out of circulation and allow the central bank to mop it up.

Defaulting Soft-pegs

Most defaults happen with soft-pegs due the problem of converting domestic money to dollars in the face of sterilized interventions.

It is not very common free floating countries to default. For a floating country to default it has to be mostly a fiscal issue that makes people lose confidence in the domestic currency bonds.

This is not common. We can see this clearly in Sri Lanka now. The loss of confidence in bonds was achieved in Sri Lanka by the central bank though price controls on auction yields, and low rates.

A 10 percent of GDP budget deficit is something this country has had before but certainly interest rates had not been this low.

Dollarized countries also default rarely but even when they do its effects are for the most part not very devastating as in a soft-peg country when the currency also collapses.

And dollarized countries recover quickly as soon as budget numbers are fixed and confidence in domestic bonds is restored.

Ecuador defaulted last year but its bonds are now actively trading after a distressed bond exchange (DDE).

DDEs make debt numbers look better, but many countries where monetary knowledge was high, including Germany after World War II, UK under Thatcher and several East Asian countries including Malaysia have in fact repaid debt ahead of time.

Ecuador’s Fitch rating went from B- to CCC to CC to C to (RD) restricted default and now has been upgraded to B- after the DDE.

That is because the currency does not fall and it is the US dollar, issued by some other central bank.

This is far cry from the situation when the Ecuador’s currency melted as a soft-peg devastating its people, which led to dollarization.

In 2000 the Ecuador Sucre crashed to 25,000 when the US hiked rates to 6.50 percent. Sri Lanka’s rupee also collapsed at the same time.

The Sucre is rock solid now because the central bank cannot do open market operations and engage in ‘monetary policy’ to manipulate interest rates.

The Cambodia riel is also rock solid at 4,000. Unlike Ecuador, the Cambodian Riel is used in parallel in fair amounts.

The Riel collapsed two Fed cycles earlier in 1989/1990 when Sri Lanka also had problems including with the JVP uprising.

IMF program

Sri Lanka can allow cars to be imported for dollars and taxes to be paid, and workers to be paid in dollars and their savings to be kept in dollar deposits and invested in SLDBs with or without a float.

IMF does not directly advice dollarization, due to mistaken opposition from the US Treasury, but it does the US no harm. IMF advice tends to encourage manipulation of domestic interest rates to create instability as seen now in Cambodia.

But IMF programs are useful in building confidence and therefore keeping the corrective interest rate low.

IMF also can do the numbers and convince foreign and other investors.

Whether these numbers are correct or not does not matter (they are sometimes wrong and their entire premise is also wrong as this columnist can attest) but that is not relevant.

What is relevant is that it will restore confidence.

Once IMF says that the debt is sustainable people will believe. It is eminently possible to fix the country with a 20 percent VAT hike, a hiring freeze and a wage freeze is already apparently on.

A VAT hike to 20 percent in much more preferable to a fall of the currency to 250 lower to the US dollar and massive inflation. Even without a VAT hike prices are now rocketing.

VAT is a superior tax to the cascading social security tax and will not harm companies with narrow margins and will promote economic efficiency, fast growth and export competitiveness.

Mercantilists and crocodile tears anti-austerity brigade will oppose a VAT hike but will allow a currency collapse because the classical economic concept of sound money is no longer understood in the Keynesian/John Law religion which has replaced reason.

It is the tragedy of our times which has led to the failure of the Washington consensus and IMF programs and social unrest.

Unlike VAT which only hits earnings that are spent, the depreciation will also hit savings and lifetime savings which are not spent.

IMF programs however will bring benefits.

a) As soon as IMF determines that the debt is sustainable based on the policy framework investors will believe.

b) When the currency is floated, sterilized interventions will end and the currency wills stabilize. It is important not to give any dollars for oil or sell dollar for disorderly market conditions (DMC). Stay put and allow the currency to fall and it will stabilize.

c) IMF will give a fully financed program along with ADB and World Bank loans.

d) It is a waste to sell land assets without an IMF program. They can be built into a private sector development budget support program.

e) List Sri Lanka Insurance, state bank listing and removing the golden share of plantations could be tied to a private sector development budget support loan.

f) It may be possible to do SriLankan Airlines as well.

g) Debt restructuring can sometimes be cosmetic, sometimes useful. The world is such that bond investors are now conditioned to a debt restructuring. They may even prefer a bond exchange to a default and marked to market losses. Ecuador got 98 percent agreement for its DDE. While they may appreciate Sri Lanka’s insistence on repaying debt, most may accept a bond exchange which will reduce mark-to-market losses.

Parallel dollarization will reduce the likelihood of a missed coupon payment or future default.

Parallel dollarization will help banks repay dollar deposits with fresh inflows rather than depend on government repayments of SLDBS.

In some countries failure to repay dollar and rupee deposits had led to storming of central banks. In Sri Lanka however, dollar deposits are repaid in rupees, unless the customer wants to go abroad.

Unlike in the 1970s in Sri Lanka in 2021 everyone knows what the central bank did since ball-by-ball coverage of its policy errors were available from the first profit transfer made in February 2020.

At all costs a central bank profit transfer should be avoided in 2022.

An IMF program will help Sri Lanka get over the current problem. It will not stop future crises, currency depreciation and social unrest and more trips to the IMF.

As long as the central bank monetary law allows the Monetary Board to print money at will, giving it discretionary independence, balance of payments problems, trade restrictions, exchange controls and social unrest will persist.

That can only be done with a radical overhaul of the central banks constitution to eliminate the discretionary independence and commit it to a rule of law for stability.

Or full dollarization, as planned in the Colombo Port City, can also solve the problem forever.

Full dollarization is just one step away from dollarizing taxes to the Treasury and utility payment to the CPC, CEB and Water board. When workers of export firms and hotels are paid in dollars, dollarization will accelerate.

The workers will happily receive dollars at a higher rate from exporters and hotels. If hotels and exporters pay their workers in dollars they can save all their money in dollars and buy Sri Lanka government bonds in dollars.

But given the Anglo-American university ideology as well as IMF’s Treasury backed ideology, dollarization around the world is usually involuntary, after a severe collapse of the currency that completely erodes confidence in the currency.

That is why ‘economists’ will reject the idea to import cars and pay taxes in dollars which will also avoid the problem of jumping into the domestic reserve money and back into dollars.

As a result a float that allows the central bank money to survive and create more problems as the soft-peg is re-established as a deadly ‘flexible exchange rate’ in the future is the usual outcome in a permanently ‘developing’ country with out-migration and no future.

The column is based on a column published in the Echelon magazine in November 2021.
(Colombo/Dec22/2022)