ECONOMYNEXT – Sri Lanka’s monetary meltdown will accelerate sharply and lead to default and sudden stop of external finance unless quick action is taken to stop money printing and restore deteriorating confidence.

Sri Lanka’s current currency crisis started in August 2019 with liquidity injections to target an ‘output gap’ and was given a turbo boost with an unsterilized profit transfer, rate cuts and outright liquidity injections in 2020.

But the steeply rising central bank credit to government and the steeply falling net foreign assets show that the monetary and fiscal trajectory is unsustainable.

Two years without action

Since money printing and the attendant foreign reserve losses started in August 2019 it is now coming up to two years with no corrective action being made.

This is the longest period of central bank policy errors tracked by this columnist, without any corrective action being made.

Usually when there is a BOP deficit from money printing in one year, corrective measures are made and the deficit falls in the second year.

In 2020, enough money was printed to trigger a 2.3 billion US dollar balance of payments deficit, after a part of the printed money was eaten by an internal drain involving an expansion of cash holdings of the public.

In 2020 Sri Lanka printed 650 billion rupees and slashed reserve ratios twice, and did a 22 billion rupee central bank profit transfer as has been reported elsewhere.

Out of these, 156.8 billion rupees were absorbed by an increase in real money demand (currency in circulation rose to 834.8 billion rupees from 678 billion rupees) which nobody can complain about.

But 2.3 billion dollars flowed out of the credit system in BOP deficit. By the end of 2020, 206.8 billion rupees were left as excess liquidity in the banking system overnight or ‘remunerated excess reserves’, where 4.5 percent interest is paid.

In the way Sri Lanka calculates reserve money, remunerated overnight excess reserves seem to be excluded, which is an unfortunate thing to do for many reasons.

By August the BOP deficit is getting closer to the full year 2020 deficit.

After exactly two years of inaction in August, monetary instability will accelerate in a meltdown rapidly unless quick action is taken to raise rates so that printing money is halted, value added tax hiked and spending cut to reduce the required corrective interest rate.

If a debt restructuring can be done with International Monetary Fund backing, to reduce the gross re-financing needs (GFN), Sri Lanka can get away with a less of an economic implosion, business failures, and bank failures than otherwise.

A brief history of time

Sri Lanka has had economic trouble from shortly after independence but there was nothing really wrong with Sri Lanka or Ceylon as it was known then.

This country’s problems started with the creation of the Latin America style central bank in 1950 and ‘development’ economics.

The development economists were trained by Western university dons who apparently thought that newly independent peoples and communities in Asia and Africa were imbeciles who were not fit to make their own decisions.

Therefore the omniscient state and the bureaucrats should make their decisions for them.

The US created the most mischief setting up Latin America style central banks in the eponymous region and in the Middle East and Asia.

They were copied by others. Russia’s central bank was a bad one from the beginning (modern exchange controls were pioneered by its Tsar Nicholas II’s pre-communist State Bank of Russia in 1905 which probably created enough inflation and hardships to fire up the Bolsheviks in the first place) so the Soviet bloc also suffered forex shortages, smuggling and black markets.

Some like Sri Lanka, Japan, Korea, the Philippines and South Vietnam were severely harmed by counter-cyclical Argentina style central banks, pushed by the Latin America unit of the Fed or the US Economic Cooperation Administration (the Keynesian Marshall Plan agency).

Post World War Germany escaped first with the Ordoliberals and the Deutsche Bundesbank replacing the Reichsbank.

Japan escaped shortly with the Dodge line stabilization and the fixing the yen at 360.

UK escaped Keynesianism with Margaret Thatcher and Alan Walters and ended 40 years of exchange controls. It is a telling fact that at one time UK tried to ‘shadow the Deutsche Mark’ the currency of the defeated foe in World War II.

Korea shut down the Sri Lanka style US-built central bank and built a new one 1960. It reformed the monetary law around a dozen times and had long periods of stability (like Bangladesh and Vietnam now) and finally fixed itself in the early 1980s monetary reform and became an OECD country in 10 years.

South Vietnam was subsumed by the north (the South Vietnamese currency was so bad that the bar girls used to keep US military currency) and fixed itself in 1989.

The Philippines is still struggling. Malaysia which never really had a chronic monetary problem during British rule and after had degenerated over the past decade with a ‘flexible exchange rate’

Sri Lanka survived wars and uprisings avoided default unlike Latin America which had a long history of foreign borrowings before the Keynesian central banks were set up.

Sri Lanka managed despite Latin America style import substitution and unemployed graduates, partly because rates were hiked at the last minute and partly because there were no bullet repayment commercial debts due in past currency crises.

On top of monetary instability Sri Lanka also has nationalism and regime uncertainty (intervention, policy uncertainty and expropriation) which is a part of state worship.

When there is monetary instability and the economy goes into a downturn, nationalism ratchets up as was seen in 2019 and was also seen with Hitler after the Weimar Republic and Great Depression.

Sri Lanka’s problems are based on its world view, propagated by the domestic education system (mostly nationalism) as well as those who qualified in some foreign universities (mostly Keynesianism and interventionism or planning).

Ripe for Downgrade

But now, with Modern Monetary Theory style money printing on top of Latin America style import substitution, commercial debt and unemployed graduates bloating the state – which is a unique Sri Lankan problem – everything is coming to a head.

The bits and pieces of central bank balance sheet that is publicly available shows that domestic assets or the paper trail of money printing had risen about 300 billion rupees over this year.

Rating agencies do no really understand soft-pegs, money printing and liquidity injections, after all their staff also went to the same universities like Harvard, Yale, Cambridge or Oxford that peddle money printing and stimulus and Western financial media lionize them.

But they do understand the opposite side of a central bank’s balance sheet – foreign reserves – which fall when liquidity is redeemed against dollars.

When foreign reserves fall, rating agencies downgrade.

By July gross official reserves had fallen to 3.8 billion US dollars, from 8.5 billion US dollars in August 2019, when output gap targeting began, ending the ability to collect forex reserves.

This is about 2 months of imports. Foreign lenders and trade creditors and other analysts get excited when reserves fall to these levels.

The International Monetary Fund’s special drawing rights (SDR) allocation would give another 800 million dollars, boosting the number in August.

However what is more of a concern is that after deducting an existing International Monetary Fund loan of 1.3 billion dollars and other liabilities such as about 600 million dollars in swaps, net dollar reserves could would fall below 500 million US dollars.

While the SDR allocation is very useful, one can see that in terms of actual net cash, the central bank is scraping the bottom.

Without the balance of the Asian Clearing Union and other liabilities it is difficult for outsiders to correctly estimate this, but these numbers should give politicians and academic policymakers pause.

Let’s hope that is not the case.

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But if this is the case, the net reserve position is not going to get better with this monetary framework where liquidity is injected to keep rates down.

Each time the economy recovers a little and private credit picks up, under the current framework excess liquidity is going to hit the BOP and more reserves will be lost.

Goldman Sachs has said in a research note that foreign reserves will be 6.4 billion by the end of 2021.

That is unlikely. In any case their calculations are flawed as it lumps private bank reserves, which are also invested domestically for the most part, as forex loans.

All this shows the plight of investment banks and why they invest in Argentina and end up in debt restructuring again and again.

However reserves in terms of months of imports, is something they also understand.

Soft-pegging is no mystery; it is note issuing banking

Soft-pegging is a big mystery to most people especially after Keynesian macroeconomics emerged as a profession.

But soft-pegging is not a big mystery. It is fairly straightforward, partial reserve backed, note issuing banking that has been in existence for several centuries and has formed the basis of debates between classical economists and Mercantilists since the 19th century.

The simplistic thinking in Sri Lanka seems to be that printing money will keep interest costs down and therefore the budget deficit.

Western floating central banks, especially the Fed, has not helped matters, with international financial media lionizing the agency and also modern monetary theory.

It seems that Sri Lanka’s policymakers do not know that when money is injected into a pegged monetary regime, foreign reserves flow out in equal measure.

Printed money will cause immediate forex reserve losses if foreign debt is repaid or when money is used to settle oil bills and import bills.

If printed money is used for domestic expenses such as salaries, their recipients will use them to buy some imported goods and local goods and keep the balance as savings.

The savings may be loaned to others who will buy imported and domestic goods. The person who sells domestic items to a state worker may use the money to travel around using fuel and eat lentils or buy other items.

Through several rounds of credit all of the new money will hit the forex market in a few weeks.

This is why reserves fall and inflation goes up when private credit recovers, even though the original problem is state worker salaries and other expense paid with central bank credit.

If the money deposited in state banks by public workers, are taken back through a Treasury overdraft and used to settle foreign debt, it will also result in a faster reserve loss.

In other words, money printing is another way of saying that the government is living off the central bank’s foreign reserves.

As reserves decline more economic controls will come. Eventually the penny will drop that reserves are going to fall some more and the attempts made to boost them are not going to be very successful.

At that time, with depleted reserves, when it is no longer possible to hold the currency peg, severe confidence shocks can accelerate a meltdown.

CAA, NMRA a big threat

When the rupee starts to fall, the price controls will come. The Consumer Affairs Authority (CAA) had already stopped Laugfs Gas.

It will impose many more price controls. Many more shortages will occur. It will be a big threat to the ordinary people. People will be branded ‘black marketers’.

The money printers are already getting ready to hike the fine on those who break price controls by 100 times.

The National Medicinal Drugs Authority (NMRA) could be an even bigger threat.

NMRA price controls will make it impossible for drug importers to operate. There may be shortages of some types of medicines.

The import substitution firms, also called ‘cronies’ will manage.

It is even possible that oil imports will have to be curtailed, if more money is printed to pay state workers and meet other expenses.

What happens to soft-pegs countries is that eventually the currency is floated when it becomes apparent to the Keynesians driving policy, that there is no way to rebuild reserves. When the rupee is floated price controls may again cause havoc.

Avoiding Worst Case Scenario – Monetary Meltdown

So what is the worst case scenario?

The worst case scenario is that the nothing will be done and the central bank will continue to print money to keep the ceiling yield on Treasury bill yields.

Whatever Keynesian or post – Keynesian economist, have been taught at university, reality always hits eventually.

Keynesian models are fine in theory, but they do not exist in the real world.

The Hicks-Hansen model (IS-LM) was dismissed by Hicks himself later.

The central bank itself is likely to be insolvent on its dollar liabilities before the end of the year unless money printing is halted.

However any kind of half-hearted Treasury bill and bond auctions, partially failed bond or bill auctions with some volumes of printed money will lead to progressively higher interest rates but the reserve losses and currency depreciation will continue.

Soft-peggers are not good at floating. Partial interventions (flexible exchange rate) will lead to even higher interest rates and more losses of confidence.

In Argentina, short term rates went up to 60 percent due to the ‘flexible exchange rate’ (which is neither floating nor pegged) that had caused so much damage to Sri Lanka since 2015 coupled with an unsterilized disorderly market conditions (DMC) rule, which also lacks credibility.

The high interest rates can kill many businesses.

The high rates from partial floating can kill finance companies and banks.

When dying banks are bailed out with printed money, it is generally even more difficult to control the exchange rate.

Inflation and cash shortages will lead to a consumption collapse which will also destroy businesses. Low reserves will lead to a default on foreign debt as happened to the Weimar Republic.

In the past floats have always worked.

The crises have come because money has been printed in the past to sterilize interventions and keep the rate down.

Whatever the central bank says to the contrary, budgets have not been the core problem in past crises, though energy subsidies have been.

It is simply a too-low policy rate and purchases of maturing Treasury bills related to past deficits by the central bank to keep rates down that has been the culprit in most crises.

There is a real hole in the budget

However this time it is different. The tax cut – the value added tax cut – in December 2019 was extraordinary.

It is one thing to cut income tax and hope for investment but this kind of fiscal destruction in a low rated country with a soft-pegged central bank is unheard of.

In 2019 Sri Lanka value added taxes were slashed to 8 percent from 15 in a fiscal stimulus on top of income tax cuts.

Anthony Barber only cut the UK VAT by 2 percent to create the Barber Boom in the UK (and subsequent currency trouble).

In most Latin American countries which default, it is purely a monetary phenomenon involving failure to hike rates when the Fed does, or lack of market pricing of fuel when the Fed is loose.

Argentina for example had relatively good budgets (deficit about 5-pct of gross domestic product) national debt about 60 percent of GDP in the last 2018 crisis.

In 2018 Sri Lanka also ran into a currency crisis despite tax hikes and the budget deficit coming down purely due to monetary stimulus.

The problem is not too much private credit at too low rates this time. This time it is clear. The government cannot meet cash expenses.

The rating agencies and investment banks are harping on interest expenses.

What they do not understand is that interest costs are not a cash flow expense, except in sovereign bonds. In domestic debt, interest can be rolled over as paper.

That is partly why the IMF focuses on the primary deficit. This is a difficult concept for people to grasp.

It was laughable to see the Yahapalana central bank talking about a low primary deficit, while turning Treasury bonds and bills issued to finance past deficits into printed money as part of output gap targeting.

Interest costs can be rolled over as paper.

However if money has to be printed for other expenses, the float will not work. That is why the deficit has to be reduced to some extent.

If not, the whole burden will fall on the interest rate. With no growth, it will be a vicious cycle.

If money continues to be printed the currency fall will not stop with a float. A float will also not stop defaults, even if it works and halts the depreciation.

If money is continued to be printed the currency, will continue to fall as it did in 2015 when the central bank ‘floated with excess liquidity’ and Indonesia’s central bank floated with bank bailout money during the East Asian crisis.

A severe currency fall will lead to an inflationary blow off like in Argentina which will lower government cash expenses and salaries of state workers and the unemployed graduates that were hired.

Unfortunately private salaries and pensions of old people will also go up in smoke in the same way. All this shows that stimulus, MMT and soft-pegged central banks are not a joke.

Debt Restructuring – Gross Financing Needs

If default comes, there will be a ‘sudden stop’ of external financing.

That means no import credit, no DA/DP. Everything will have to be paid up front. So imports are going to be even more difficult.

Most analysts are talking about government foreign debt. But there are other private loans. There are supplier credits. There is supplier’s credit to the CPC for example.

There are SOE loans. No country can actually continue to repay debt on a net basis for a long period.

Usually countries and companies pay back loans but take new loans as they grow. Each year outstanding loans grow.

However it is possible to repay some amount.

To do that the Gross Financing Need (GFN) has to be minimized. There are several ways to do this.

These are hair-cuts, maturity extensions, grace periods and interest rate cuts.

It is likely that Paris club donor will agree to maturity extensions.

But it becomes even more difficult to repay debt with a falling currency as all the domestic financial resources that are generated diminish in value.

So it is important to get GFN to a manageable level.

“Gross financing needs of the government in any year are defined as the sum of the primary fiscal deficit, the debt service (i.e. sum of principal and interest payments) falling due in that year, and any outlays to meet contingent liability materializations and/or building government financial assets,” according to the IMF.

The IMF may not know much about pegging or has lost the knowledge as shown by the double discretionary ‘flexible’ exchange rate, ‘flexible’ inflation targeting, that cause exceptional monetary instability.

And it may not know much about the best way to fix budgets in this anti-austerity era as seen by the failed ‘revenue based fiscal consolidation’ debacle which saw spending rise from 17 to 20 percent of GDP.

The IMF’s lack of knowledge on effective pegging and the lack of rule based monetary policy is the reason that soft-pegged central banks go to the IMF again and again.

However IMF can give advice, and has experience to restructure debt and the clout to gain confidence.

That is why when there is an IMF program state creditors certainly fall in line and so do most private creditors.

There will be a greater chance to reduce holdouts and messy court actions in New York with an IMF program.

There are several ways the debt can be re-structured to reduce the annual cash outflows.

The International Monetary Fund generally defines sustainable public debt as follows:

“Public debt can be regarded as sustainable when the primary balance needed to at least stabilize debt under both the baseline and realistic shock scenarios is economically and politically feasible, such that the level of debt is consistent with an acceptably low rollover risk and with preserving potential growth at a satisfactory level.”

This columnist is of the view that it is quite possible to run a country without going back to sovereign bonds.

A country with monetary stability (strong currency) can not only survive without going to capital market but also build reserves and export capital.

Vietnam has 100 billion US dollars in reserves which are basically financing deficits in the US and Euro regions.

Bangladesh 36 billion dollar. So that is not a serious problem if the central bank is reformed and the exchange rate is fixed with a wide policy corridor (or none if it is a true hard peg).

Most East Asian nations with central banks that did not print money and have strong pegs and are net creditors.

The problem is mostly lack of knowledge and a Keynesian/Mercantilist view that there is prosperity at the end of the depreciation tunnel.

Though depreciation has failed for 70 years from 4.70 to 200 rupees to the US dollar, true believers continue to worship at its altar.

Political Options

What is politically feasible? What is economically better for the poor?

They are not the same.

What is politically feasible depends on how much the public can be duped or plays to their existing beliefs, particularly the anti-austerity brigade and state sector unions.

The vocal anti-austerity brigade and opposition will raise the roof if anything is done to contract the state. It is called the Rajya sevaya kap-pardu kireemer (trimming the state service)

That is why ‘revenue based consolidation’ was so attractive to statists and leftists.

When the current administration suggested that state workers make a relatively mild sacrifice to help with expenditure, the opposition leader protested vehemently.

These are some of the options. Instead of doing things piecemeal, it is better to go for an overall program.

a) A 10 percent hike in VAT – this will raise prices by 10 percent and reduce salaries by 10 percent of all wage earner and pensions, however it will keep the value of pension funds and bank deposits including of retirees intact if the peg can be maintained.

b) The alternative is a steep fall in the rupee and an inflationary blow off: It will raise prices, it will cut real salaries, it will destroy bank deposits and pensions, but will only give a partial solution in terms of higher revenues. Monetary meltdowns have led to 90 percent or more falls in real income in some cases.

c) A cut in state worker salaries and a hiring freeze – state austerity. It will leave the poor unharmed, but will affect state workers. However state worker bank deposits and pension funds will not be harmed. Even for state workers it will be better than a monetary meltdown.

d) A quick privatization program. This will bring revenues, perhaps foreign investments and unleash long term growth.

The government is trying to sell land and trying to list Selendiva but is facing opposition from its own quarters. But these land sales are half-hearted.

e) Debt restructuring to reduce GFN to a manageable level. Debt re-structuring will help keep the interest rate correction to a manageable level.

If GFN is manageable, the IMF will give a sign off on its debt sustainable analysis and the World Bank, and Asian Development Bank and other lenders will give budgetary finance.

But without meaningful fiscal reform they will not be able to do it.

If China is willing to help, well and good.

Doing nothing will lead to a Latin America-style monetary meltdown. Meltdowns have serious consequences as outlined earlier.

Fiscal austerity leads to slow or mild negative growth. Meltdowns and ‘sudden stops’ lead to economic implosions.

There can be severe poverty, very high interest rates, business failures, bank failures and nutrition problems to put things mildly.

With the price controls of the Consumer Affairs Authority, National Medical Regulatory Authority severe hardships will be forced upon the people.

Monetary meltdowns in other countries have led to mass migrations and boat people.

This is why it is better to take quick comprehensive action, forget ideology and not do half-measures.