ECONOMYNEXT – Sri Lanka’s authorities are targeting and blaming Middle Eastern workers for not sending money through the formal banking system expanding the blame game from the usual scapegoats for forex shortages coming from contradictory money and exchange policies.

Undiyal transfers take place because the central bank is creating forex shortages and dollars are not available to people who are armed with excessive rupee created by a soft-pegged central bank.

Expat workers added to the list of usual suspects in current crisis

Soft-peggers in Sri Lanka in a heavy descent deep into Mercantilism usually blame imports, the trade deficit, petroleum, the current account deficit for currency troubles instead of themselves and the domestic operations department which is creating liquidity and generating outflows.

Exporters are also blamed for ‘holding back dollars’, importers are blamed for ‘non-essential imports’ but the issue department of the note-issue bank which creates a ‘super abundance of paper money’ as classical economists used to say, gets away scot free.

In this crisis where money and exchange policy conflicts intensified to a degree not seen in the past due to a surrender requirement and the currency collapsed from 180 to 360 to the US dollar, open account imports and foreign workers are blamed.

Food importers are still able to do open account imports due to long relationships when oil importers for example are unwilling to ship goods without pre-payment due to credit taken to perpetuate soft-pegging in the past.

Open account imports also do not create any problem. It is simply a priority allocation method.

There is a real transfer of goods to the country through the open account imports if they are financed through Undiyal/Hawala as claimed.

Whether the settlement is net through Undiya/Hawala or gross through the SWIFT system does not matter.

Even if the dollars came through the banks and were given to food or other importers the result is the same.

However the banking system has no method of prioritizing money for food, with new money being printed to pay state workers and or for other reasons (sterilizing interventions made with ACU money) creating a forex shortage.

Most of the ancient trading system – and not so ancient trading system during the British period – operated through the series of trade credit and bills of exchange.

Indian Undiyal

The 1,000 billion US dollar credit from the State Bank of India also works in an Undiyal fashion.

The following is the operational detail of the Indian credit line.

The Sri Lankan importers pay the Treasury in rupees based on the trade documentation involving the invoice and shipping documents, like someone trying send a child’s education fees via Undiyal.

Sri Lanka will then owe a US dollar amount to India.

At the other end the Indian importer will be settled Indian rupees by the state bank of India.

A foreign inward remittance certificate (FIRC) will be issued to the Indian exporter to enable him to claim the Indian rupees as export revenues.

This is exactly what happens in an Undiyal/Hawala settlement system.

In any case family members of foreign workers who get money in US dollars also convert them to rupees (unless it was a Vostro transfer).

That money is used to import food or other items. Whether the Middle East worker sends the money in US dollars or Dirhams and it is given to food importers by banks is not relevant if food comes to the country through open account imports.

What is different in the Indian credit line is the timing of the settlement of the other leg of the transaction.

Unlike Undiyal, where family members send money to the country, closing the other end of the transaction, under the credit line, Sri Lanka will owe the money to India in a loan denominated in the currency of a third country, the US Fed and it will not be settled immediately.

The Sri Lanka rupees paid to the Treasury by importers will be used by the Treasury to fund its deficit. The Treasury will settle the money later and the national debt would go up in the meantime.

In the Undiyal the national debt would not go up as both ends of the transaction is finally cleared.

There is a real transfer of wealth and real transfer of goods in either case. If open account importers are not using Hawala the same pressure would fall on the official banking channel.

But if food really comes through open account imports as claimed by officials then a priority need of the population is being met.

Sterilized vs Unsterilized Interventions

For a pegged exchange rate to work at say fixed 360 to the US dollar the central bank must be prepared to supply dollars in an unlimited amount. If dollars are rationed – as now – there are forex shortages at the fixed exchange rate.

In a fixed exchange rate unlike a float, dollars cannot be allocated to different users through price.

In a fixed exchange rate, the rationing of dollars happens through the rationing of credit and rationing of rupees. For a fixed exchange rate to work interventions have to alter reserve money.

That is why when interventions in the form of dollar sales are sterilized soft-pegs collapse. The opposite – the sterilization of inflows – however works, since domestic money is under-supplied. Most East Asian nations with excessive foreign reserves do this.

Currency boards where interventions are unsterilized neither oversupply nor under supply money or credit.

That is why the Sterling Area survived for a century without an International Monetary Fund, but the Bretton Woods collapsed in 1971 in about a quarter century despite the IMF.

Sri Lanka, former ‘First World’ countries in Latin America and permanently developing countries in Africa are suffering due to rejecting classical economics and embracing the Latin America/Cambridge/Saltwater which claimed soft-pegging was possible.

Soft-pegging is inherently flawed and unsound

Soft-pegging failed in both the US and UK. UK tried a second time with the ERM and again failed.

IMF programs will restore soft-pegs and get a working monetary regime by sterilizing inflows (under a Net International Reserve Target) after smashing the economy to kill private credit.

When money is printed to suppress rates and the peg collapses sky-rocketing interest rates is the result. To stabilize and bring down the rates the credibility of the peg has to be restored.

IMF will usually not disburse money until money-exchange policy conflicts are eliminated.

However in any case an IMF program does not reform the central bank to tame its domestic operations or eliminate its ability to create money and exchange policy conflicts in the future by operatng a single anchor regime like a currency board or a floating rate.

In fact the opposite is done with flexible inflation targeting.

To have true inflation targeting a clean floating regime is needed, without an NIR target.

That is why Washington has not been able to solve Latin America defaults despite promoting depreciation, the Banker Plan, Brady bonds or other permutations of policy, which are unfortunately foisted on other nations as well.

That is why central banks who are clients of IMF, go repeatedly to the agency after printing money to sterilize outflows in a clear rejection of the classical greats and the embrace of post-depression – mainly English speaking – Mercantilists who mainstreamed what were fringe ideas in classical liberalism.

Sri Lanka has seen monetary instability and political upheavals going beyond the usual strikes seen in Western nations when central bank create excessive inflation due to soft-pegging.

Rejecting classical economics, rejecting sound money and embracing soft-pegging and unsound money with dual anchor conflicts has consequences.