ECONOMYNEXT – In 2018, instability generated by an inconsistent monetary policy framework not only killed a nascent economic recovery that began in the first quarter, but also brought the country into the brink of sovereign default.

The liquidity shocks generated in the attempt to pursue independent monetary policy while operating a soft-pegged exchange rate with multiple convertibility undertakings has led to a collapse of the exchange rate, undermining the free trade strategy of the government and triggered capital flight.

The Central Bank placed milder versions of Sirimavo Bandaranaike-type trade controls and is now placing restrictions on exporters and foreign investments in bonds, to be able to pursue flawed policy for longer periods and keep operating a soft-peg.

In addition to trade controls and taxes on gold – gold being like the metador’s flag to money printers throughout history – foreign investment in rupee bonds are going to be halved.

But foreign investors in bonds and exporters, by their actions, block the Central Bank from operating inflationary policies early, helping avoid bubbles and high inflation.

Crises Coming Faster

Sri Lanka’s balance of payments and currency troubles are now coming often, with greater depreciation. What used to happen every 5 years is now happening every 2 to 3 years.

The 1999/2000 crisis was followed by the 2004 one, which was fairly mild. The 2008/2009 crisis followed. The gap in that decade was 4/5 years.

Because then Central Bank Governor Nivard Cabraal allowed the rupee to bounce back after the 2008 crisis, the depreciation in those years was lower and the state was not able to destroy the real wages of the people as much would otherwise have been. The small savers who get relatively low rates of interest were also protected.

But crises have come in quick succession after that.

The next one came in 2011/2012. The rupee fell to 130 to the dollar from 110. The rupee was not allowed to appreciate. The next one came in 2015/2016. The rupee fell to 150 to the US dollar. In 2017, the rupee was deliberately and wantonly depreciated, despite a massive balance of payments surplus, which was made possible by slowing credit and inflow sterilisation. This was to meet a real effective exchange rate target.

The current currency collapse came in 2018, had seen the rupee collapse from 153 to 182 to the dollar.

One reason for frequent crises is a stronger reinforcement of Keynesian-led ideology that money can be printed to boost an output gap, which also led to the collapse of the Bretton Woods system.

Sterilization Securities

The proximate reason for increasingly narrower gaps between currency crises is the lack of effective tool to mop up inflows. The termination of the use of Central Bank securities left the agency without an effective tool to mop up inflows and keep rebuilding reserves. Instead, term repos were used.

In December 2017, this column warned that the Central Bank could face balance of payments pressure soon because a new credit cycle was beginning. (Sri Lanka’s Central Bank should sell own securities in new credit cycle: Bellwether)

"It is now that the first policy errors that will help create the next balance of payments crisis cum currency collapse will be made," the column said.

"Simply put, when domestic credit demand goes up (due to budget deficits, due to subsidizing imported energy or simply stronger private credit), the Central Bank, instead of allowing rates to go up, prints money to keep rates down, driving credit and imports to unsustainable levels."

"The resulting pressure on the exchange rate, when seen by dealers, eventually drives foreign investors to sell bonds, generating capital flight, while exporters hold back dollars and take further rupee credit.

"As the Central Bank intervenes in forex markets, selling dollars, and then prints more money by purchasing Treasuries to keep rates going up (sterilising the forex sales), a vicious cycle is generated."

All this eventually happened in 2018. It could also have been prevented.

Data showed that the Central Bank had stopped mopping up inflows from around February. It then terminated term repo deals, which had been used to mop up inflows.

This is quite similar to Argentina’s Central Bank creating a secondary market for its own sterilisation securities to keep overnight rates down.The IMF team that went to fix Argentina stopped the practice.

Reckless Domestic Operations

Data shows that even more reckless domestic operations were performed in April. Rates were cut as feared and tens of billions of rupees were injected into the banking system.This was partly out of a belief that rates can be cut if inflation falls. But such an ‘inflation targeting’ approach can be followed only if there is a floating exchange rate, where no foreign reserves are collected.

This column had shown that a strategy involving repaying maturing bonds with state bank overdrafts which was then re-financed with window or OMO money would lead to capital flight and balance of payments crises.

"Sri Lanka is on a recovery path, and this is the time when commercial bank credit picks up, the Central Bank cuts rates and pushes the country into balance of payments trouble," this column warned in ‘Sri Lanka is recovering, Central Bank threat looms’.

In August and September, more reckless domestic operations were performed. However, there was a small improvement in policy during the current crisis, in that the central bank did not permanently sterilise interventions through outright purchases of Treasury bills. However, it then cut the statutory reserve ratio, releasing more liquidity on a permanent basis.

Weimar Republic

This column also warned that taking the foot off the mopping-up operations and injecting money will push credit to levels exceeding the deposits raised by banks, and the Central Bank will run out of reserves to repay debt in an emergency.

This column had anyway warned that that numbers would not be met because the economy and domestic credit was recovering. (Sri Lanka is recovering, central bank threat looms)

Sri Lanka ended the year with 6,935 million US dollars of reserves rather than the highly optimistic 9.7 or 10 billion dollars forecasted by the Central Bank.

That also came to pass.

Furthermore, this column had warned that there was a real possibility that the Central Bank may not be able to repay foreign debt, if it continued on this path of imagining that it could cut rates and print money, while operating a peg.

The same phenomenon was seen in Germany’s Weimar Republic and is seen in many Latin American nations.

"The phenomenon was famously underlined by the debates between Swedish economist Bertil Ohlin and Keynes in the 1920s, over what was referred to as the ‘transfer problem’," this column explained. (Sri Lanka’s Weimar Republic factor is inviting dollar sovereign default).

"Keynes believed war reparations led to balance of payments problems in the Weimar Republic which eventually descended into monetary chaos. The Allies were misled into thinking that a ‘favourable’ balance of trade was needed to repay foreign loans."

Economist Ludwig von Mises explained the problem as follows.

"The truth is that the maintenance of monetary stability and of a sound currency system has nothing whatever to do with the balance of payments or of trade.

There is only one thing that endangers monetary stability—inflation. If a country neither issues additional quantities of paper money nor expands credit, it will not have any monetary troubles."

"An excess of exports is not a prerequisite for the payment of reparations. The causation, rather, is the other way round. The fact that a nation makes such payments has the tendency to create such an excess of exports. There is no such thing as a "transfer" problem.”

By replacing Sri Lanka with Germany, the problem with the Central Bank’s money printing was illustrated with the words of economist Ludwig von Mises.

"If the German [Sri Lankan] Government collects the amount needed for the payments in Reichmarks – [in Rupees]) by taxing its citizens, every German [Sri Lankan] taxpayer must correspondingly reduce his consumption either of German [Sri Lankan] or of imported products.

"In the second case the amount of foreign exchange which otherwise would have been used for the purchase of these imported goods becomes available. Thus collecting at home the amount of Reichmarks [Rupees] required for the payment automatically provides the quantity of foreign exchange needed for the transfer."

"They all clung to the error that it was not the increase of bank credits but the unfavorable balance of payments that was devaluing the currency."

"But most of those men who between 1914 and 1923 were in a position to influence Germany’s monetary and banking policies and all journalists, writers, and politicians who dealt with these problems labored under the delusion that an increase in the quantity of bank notes does not affect commodity prices and foreign exchange rates."

Almost a century later, nothing much has changed in Sri Lanka. Unfavourable balance of payments is still blamed for currency troubles, by central bankers, politicians and journalists, with a few exceptions.

The taxes on gold, restrictions on car imports were early signs that similar mercantilism was at play, and the consequences were inevitable.

Sri Lanka is in an ideological straitjacket that is difficult to get out of.

Instead of engaging in questionable ‘debt management’ practices involving building rupee ‘buffers’ and printing money to repay bonds, the Central Bank should stop injecting rupee reserves into the banking system, and operate a consistent peg, if it wants to collect reserves either to use it as a buffer to repay loans or build confidence to roll-over debt.

Printing Privilege

Sri Lanka and its people – mostly the poor – have paid a high price to give senior central bankers the priviledge of cutting rates when the economy recovered, and target the exchange rate at the same time, – which according to even standard theory – is not possible to do.

Why people who are perfectly sane otherwise, continue to do this is a mystery.

The IMF also gave a foreign reserve target, which de facto requires the Central Bank to operate a peg that is tighter than a conventional currency board or hard peg. But there were no corresponding monetary policy targets to make sure that a reserve collecting peg was in fact operated.

In a hard peg, the reserve money supply is determined by the balance of payments, with interest rates floating. The floating rate will allow just the bare amount of reserves to be collected to maintain reserve money – real demand for money.

But when there is a forex reserve target, the money supply has to be below what is determined by the balance of payments. Reserves will have to be collected and exported to countries like the US by contracting the current account.

In order to collect forex reserves at a volume bigger than reserve money, the interest rates then has to be slightly higher than what is determined by the balance of payments. In other words the system has to be tighter-than-a-currency board.

But the Central Bank did the opposite. The results are now there for all to see.

Instead of building reserves, the Central Bank engaged in reckless injections and a deadly ‘buffer strategy’ to generate monetary instability. Not satisfied with that, to create the August liquidity shock, even more reckless Soros-style swaps were used.

No way can fiscal dominance be blamed for the current crisis. Mangala Samaraweera raised taxes and also market priced fuel. State Minister Eran Wickremeratne publicly refused to interfere in the Central Bank.

If there is to be stability and growth, the Central Bank has to operate not a second class peg with a ‘flexible exchange rate’ as it is doing now but a first class one.

Debt Repayment and Inflation Targeting

If the Central Bank wants to collect reserves and sell to the government to repay debt, it has to re-think inflation targeting as well.

It is not possible to operate an inflation targeting framework with a consumer price index as a domestic anchor and try to collect forex reserves and make the balance of payments determine the money supply.

Sri Lanka will then move from a second class peg (flexible exchange rate) to second class inflation targeting (flexible inflation targeting).

To operate inflation targeting successfully, the peg and any plans to collect reserves have to be abandoned.

Once credibility of the peg is restored with the IMF deal and exporters start to sell dollars, the rupee has to be allowed to appreciate.

The IMF anyway will not give one cent without credibility of the peg being restored. The Central Bank should mop part of the inflows every week.

After that the current liquidity shortage can be filled with dollar purchases. Because injections have been made by term repo auctions, any dollar purchases made after the credibility of the peg is restored will automatically be mopped up or sterilised.

After liquidity shortages are filled, at least part of the inflows must be moped up through outright sales of Central Bank held Treasury bills every week.

At no time should the foot be taken off the brake pedal. At no time should weeks and months be allowed to lapse (like in February and March and also the August restoration of credibility) without any mopping up.

Transforming Dollar Debt into Rupee Debt

Mopping up is required to squeeze the external current account and keep the peg on the strong side of the convertibility undertaking.

Open market operations to inject money (Treasury bill purchases or reverse repo injections) sets off a cascading expansion of credit in the banking system, making borrowers usually big corporations and the government live beyond their means either in their investment or consumption activities.

In the same way, mopping up will set off a cascading contraction in credit. This will slow growth, but foreign reserve accumulation (involving ‘below the line’ export of capital) will have to slow growth below what it would have been, had the exchange rate been a floating one.

The forex reserves can then be used to repay debt. Forex reserves can be sold to the government for Treasury bills. Reserves can later be replenished by the sell down of those bills in the market later. This way the current account will be squeezed.

‘Foreign debt’ will then be transformed in to ‘domestic debt’. The central bank has been doing this for decades with World Bank and Japanese loans.

It is not necessary always to borrow dollars to repay foreign loans.

This should be the central strategy of managing debt, not raising extra debt through the liability management law.

Central Bank profit transfers to the government in the form of rupee liquidity have to be halted. Provisional advances have to be converted into Treasury bills and sold down.

REER targeting should be halted immediately. If any policy error is committed which leads to loss of credibility of the peg and capital flight, any remaining excess liquidity should be mopped up to generate a liquidity shortage before the currency is floated.

It must be noted that any float will necessarily undermine the credibility of the peg in the future.

Ideally, the lid should be blown off the ceiling policy rate. But if the currency is to be floated, this is the only safe way. However, if the currency is allowed to re-appreciate, capital flight will be less in future episodes.

Unlike in April and in 2015, the currency should not be floated with excess liquidity in money markets.

Legislators could, if necessary, bring a separate law to criminalise such actions and punish central bankers who authorize or engage in such activity.

Bond Markets

A key danger to economic stability is overdrawing state banks and filling liquidity shortages with printed money.

Overdrawing the Bank of Ceylon to meet government cashflow should be halted. Treasury bills were invented in developed markets specifically to avoid bank financing of cashflow deficits, which are then filled by Central Bank open market or window money or shorting the reserve ratio.

Recent controls on Treasury bond auctions, which may make bank primary dealers to go the window for printed money (and non-bank ones to go bankrupt) should be discontinued forthwith. If possible single price auctions should be started instead.

All remaining forward forex guarantees should be settled in paper, if the peg goes to the weak side. The bills should then be progressively sold down to contract credit and the current account.

The policy corridor should be widened as much as possible to help restore credibility of the peg as quickly as possible and stop making it go to the weak side in the first place. About 400 basis points should be a good start.

Narrowing the policy corridor will be another disaster in the line of the ‘buffer strategy’ and ‘floating with excess liquidity’. One reason that the April debacle did not produce a full blown BOP crisis is the wide policy corridor.

As outlined in the column (how to improve the credibility of the peg) limits should be placed on banks on the volume of window money that can be obtained at the ceiling rate. Injections through auctions below the ceiling rate should be halted.

The Central Bank should also reconsider any attempts to bring in second class inflation targeting, which is called flexible inflation targeting. Argentina’s Central Bank also had second class inflation targeting. The IMF team suspended second class inflation targeting as soon as it went in.

Sri Lanka may not be as bad as Argentina since the capital account is less free, but with large volumes of dollar sovereign debt, Sri Lanka may get there.

If Sri Lanka wants to be a financial centre, second class pegs and second class inflation targeting will not help the country get there. Sri Lanka is now in global service chains producing software, legal and accounting services not counting tourism. Financial services are also on the same path.

The ideology that money can be printed to close an output gap while operating a peg is dangerous.

It was the same kind of ideology that led to Federal Reserve’s peg with gold collapsing in 1971-3, which led to the collapse of the Bretton Woods system and introduction of Sirimavo Bandaranaike trade control policies in Sri Lanka.

While capital flight may force policy corrections and liquidity shortages, which will delay inflation and prevent bubbles, currency deprecation will lead to delayed price rises, labour unrest and a destruction of real capital that will hinder long term productivity gains.

The idea that money can be printed even with a floating rate is dangerous, unless the inflation target is narrow.

It may be pertinent to recall the words of the Friedrich von Hayek’s words after winning the Nobel prize in 1974, when the world suddenly realised that his opposition to Keynesianism was correct when the Bretton Woods system collapsed.

"…[E]conomists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue," Hayek said.

"We have indeed at the moment little cause for pride: as a profession we have made a mess of things."

 This column is based on ‘The Price Signal by Bellwether‘ published in the February 2019 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. To reach the columnist write to: bellwetherECN@gmail.com.