ECONOMYNEXT – Sri Lanka’S rupee has fallen with amid two liquidity spikes in 2018 just as the economy started to recover, underlining the need to bring restrains to the central bank ability to generate monetary instability as the country moves into global and domestic uncertainty.

Monetary instability has tended to come faster after the central bank stopped issuing its own securities to mop up inflows a few years ago and started using short term repos instead. Since 2015 monetary instability is coming quick and fast.

Note: This column appeared in the November 2018 issue of Echelon Magazine and was written before a political crisis added to risks.

After the 2015/2016 balance of payments crisis, the rupee was pushed down in 2017 to maintain a real effective exchange rate peg, importing the monetary policy of the worst central banks in the region such as India.

The rupee has collapsed from 131 to 172 in the last three years. Up to September the rupee had collapsed from 152 to 173 by the third week of October, as the central bank switched from a peg to a float with excess liquidity in place as it tried to manipulate rates down. It then undermined a float purchasing dollars was also selling dollars to defend the currency recreating a peg.

The rupee has so far inflated around 29.1 percent against the dollar since the current administration came to power. Domestic inflation, which has non-tradables have not yet caught up. The Colombo CCPI has grown 17.1 percent since December 2014 and the CCPI core index has grown 19.9 percent.

The costs are heavy.

An entire free trade strategy of the administration is in a shambles. Anti-free traders are baying at the heels of the Finance Minister.Tax revenues are being lost because vehicle and other imports have been hit.

The currency fall is making it difficult for Finance Minister Mangala Samaraweera to market price fuel as the rupee falls as the currency peg adds to the costs like in India, making him lose tax revenues.

A fragile recovery has been undermined with both currency depreciation and interest rates giving a double hit on consumer spending.

The National Medicinal Regulatory Authority through its price controls have also hurt pharmaceuticals sector. It is a threat to businesses and it is a threat to the banking sector and its depositors.The falling rupee has worsened pharma troubles. Drug prices may not be in the inflation index, but the cost rises are real.

Fiscal Policy

All this is happening despite Finance Minister Samaraweera running a budget as tight as possible. There is primary surplus in the budget also.

Governor Indrajit Coomaraswamy, honest to a fault, has publicly said this.

In Malaysia in the early 1980s when Daim Zainudeen tightened budgets, Bank Negara Malaysia gave him strong exchange rate at around 2.6 to the US dollar to carry out his reforms.But Samaraweera had been denied this foundation.

A central bank will peg to the US dollar (external anchor) because monetary policy of the Fed is better and importing the policy of a stronger central bank will provide domestic stability.By targeting a REER peg, which may include bad central banks, a country will import the policy of the worst central banks in the basket. That is all there is to it.

There is political will to raise taxes and also market price oil, but the central bank has failed to deliver on the exchange rate either through floating or a sustainable peg. Make no mistake, the rupee is not even close to a floating exchange rate. In that case the rupee should have appreciated sharply like the Malaysian Ringgit in 2017.

It is said of Daim that he cut spending, raised taxes and forced state enterprises to tighten, which helped Malaysia ride out a bubble and a downturn. Daim is credited with repaying loans ahead of time before he retired.

Samaraweera had done quite similar things in the face of severe opposition, including from within the coalition, but the falling currency may leave him with a different epitaph.He has been denied a floating exchange rate as well, which may move down but will go back up again over time.

It is an outright lie to say that East Asian nations had undervalued their currencies. East Asian nations – including China from 1993 to 2005 – had used the exchange rate as a tool of domestic stability which helped keep nominal interest rates and inflation down.

A country with a falling currency will have high nominal interest rates compared to one that is running consistent policy involving a floating exchange rate or a fixed peg backed by floating interest rates.

Paper Principle

Sri Lanka’s monetary instability, and blaming current account deficits rather than monetary policy for currency troubles could have a far more dangerous outcome.

This column has warned several times that if the central bank injects liquidity into money markets in a big way it will result in dollar sovereign default. The biggest danger to repaying foreign debt is central bank liquidity.

It is not clear exactly what the central bank would do under the new Liability Management Act.

If it will simply raises, and keep dollars as dollars for repayments no harm will be done. If the money is used to inject liquidity via Soros-style swaps instability will be the result.

If under the law any ‘buffers’ of a domestic nature are going to be built involving paying down state bank overdrafts, and running them up suddenly with lender of last resort printed money, there is also danger for the country.

Paying bonds prematurely by converting paper to liquidity with dollar conversions will also have deadly consequences.

There is danger for the country any time the central bank does not roll-over paper for paper and instead disturbs reserve money and therefore the exchange rate.The legacy central banks swaps are also a danger. All central bank swaps must be rolled over as paper.

The central bank must negotiate with banks to settle the maturing swaps with paper (T-bills) which are third party obligations and not its own paper (bank notes). Or it must structure the deal in such a way that the final outcome is a paper transaction, which does not involve disturbing the liquidity of third party banks.

Sri Lanka’s banking system can stand a liquidity shock of about 15 to 20 billion rupees. But anything bigger will create a ripple and then a storm.

Sri Lanka has a proven way of raising dollars to repay foreign loans. Keep rates a little higher, mop up inflows, build forex reserves, (effectively) sell the reserves for Treasury bills to the finance ministry, sell down the Treasury bills, put the brakes on domestic credit, mop up more dollars. And so on.

If there is a true floating rate this cannot be done. Then the government will not have any foreign reserves to use. It can only be done by running a peg tighter than a currency board.

If the Liability Management Act allows the central bank to manipulate rates with new money and in any way undermine the rolling over of paper it is a new risk to the economy.

If the Public Debt Department wants to cut interest costs, then it must sell more short term debt and reduce longer debt sales.

The forced bond sales are also a new risk to the economy. Auctions must be allowed to work. If forced bonds are bought with printed money through lender of last resort windows, and rates forced down delaying the flow real money into bond markets, there will be pressure on the external front.

The tax difference between bonds and bank deposits is a new risk to the economy.

Mercantilist Dangers

If Sri Lanka has to repay foreign debt on a net basis, interest rates have to be a little higher, economic activity has to be a little slower and therefore the external current account will end up being a little narrower.

This will generate the resources to repay debt. Curtailing imports such as cars, which bring massive tax revenues is not the answer. It hurts the ability of the country to repay debt by hitting the budget. Dollars will be diverted to imports with lower taxes. This is an own goal.

Neither will curtailing gold smuggling. If that was the case it should have put pressure on the currency in 2017.

Anyone who is smuggling gold to India has to get money back from India to make a profit. Any money he parks abroad will only be the profit. To get working capital for the next shipment he has to get the money back from India.

Gold imports are simply the same working capital being re-cycled with part of the profits accruing to Sri Lanka.

Whether this money appears officially in the trade account or not is irrelevant. To say that gold is imported legally and is not reflected in exports is not economics reasoning, it is Mercantilist unreason. As predicted now the imports of gold is also smuggled.

Sri Lanka should forget about gold smuggling, it is an un-necessary distraction.

Mercantilism is a danger to the stability of this country and the lives of her people.

Whatever is done to the trade account, as long as there are liquidity injections by the central bank, the balance of payments will be negative by that amount.The exchange rate will also fall.

The exchange rate fall has huge fiscal costs, to explain this will take too long in this column. There are also matters like the Tanzi effect, especially on income tax.

But one reason people are misled into thinking that currency falls are good for budgets is that depreciation cost are not brought into the numbers.

While it is not necessary to bring the currency loss of all outstanding loans to the budget (Sri Lanka does not do accrual accounting budgeting which keeps thing pretty simple and clear), at least the cash cost involved in the repayment of foreign loans in the current year must be brought in the budget under cashflow based budgeting.

This will reveal the cost of depreciation.

In Sri Lanka where the currency is falling permanently, depreciation is a permanent cost, which is anyway reflected in outstanding debt.Unlike a floating rate, the rupee does not appreciate. It is not allowed to appreciate back on Mercantilist considerations, even when inflows are steadily sterilized like in 2017.

There is no path to prosperity in currency depreciation and monetary policy should not be used for trade outcomes but for domestic stability.

This time it is different

All efforts must be made to get the exchange rate back on line. A float will help restore confidence quickly and end the stalemate of sterilizing interventions. Prolonged liquidity shortages are extremely bad for credit system and businesses in general.

If under the current framework, there is a need for a ‘flexible exchange rate’ the only way to do it is to kick up short term rates, sit tight for two to three weeks and allow tight liquidity spread though the system and then, only then, float.

The Central Bank giving dollars to the Ceylon Petroleum Corporation under the counter will not help a float work.Buying dollars from the Treasury will not help any float.There is no need for this country to go into a meltdown.

But it must be borne in mind that the 2018 currency depreciation is not the same as 2011/2012 and the 2015/2016 crises, where a credit expansion was fired without depreciation for months on end after a downturn had ended driving a bubble up boosting consumption and property.

There is no expanding property bubble now. There are empty shopping malls. Construction firms are not doing well.

There is a National Medicinal Drugs Regulatory Authority. Big business groups involved in health care have been hit by the NMRA amid currency depreciation. It can have a cascading effect on other related businesses and their loan repayment abilities.

The health ministry is planning to bring price controls to hospitals, which will hit that sector as well, probably triggering bad loans and halting new hospitals and any growth. Sri Lanka has an ageing population and the country needs more hospitals.

When the currency is falling it is not a time to impose any price controls and kill another sector.

The health ministry can have a website where patients can put up costs, so that people will see the hospital and (more so the younger doctors who are fleecing patients) and allow them to choose. There is one new hospital that is notorious for charging 150,000 rupees minimum for anyone that enters it. But that is not an excuse for price controls.

Those in political power must talk to the health ministry. NMRA must give reasonable price increases based on at least a part of the fall of the rupee to drugs where margins have disappeared. It must stop new price controls in new drugs. Pharmacies are also seeing margins going down.

Business failures are the last thing this country needs right now.

The strategy must be to get more hospitals to come and let competition and price transparency keep prices in check.

The construction sector was slowed, which was fine. Currency depreciation will not help fill empty malls or supermarkets. They will be completely depended on tourists.

Nor will it help sell apartments, unless people are abroad.

But 2018 should have been the year of recovering with gently rising rates, not depreciating with a REER index in line with India after trying to manipulate rates down.

But India is at a different stage of their economic cycle. It is coming off a high.

If the Vietnam Dong collapses in the next year, despite rocketing exports, their people would have got many benefits during the decade long boom.

Sri Lanka is at the bottom, and was just starting to recover from 2016 bust when the depreciation hit again.It is one thing to have a boom-bust. It is quite another to have a bust-bust.

This time it is different.

The Federal Reserve is tightening rates. The US dollar is floating with private sector sterilization, which is unusual, and has led to unusual volatility. Fed is committed not only to pulling liquidity out but also hiking rates.

Trump is an extraordinary source of instability.

Meltdown

There is no need to panic. This country need not go into any meltdown whatsoever.

But there are enough countries that went into a meltdown in situationsclose to the current one.When there is a soft-pegged central bank with a depreciating currency, where the authorities do not understand the dangers of liquidity injections, conditions can change very fast.

An entire country can be turned into jelly in a matter of months. The April liquidity injections, that came thick and fast from all directions makes this columnist shiver in his boots. What happened in August makes hair stand on end.

It must always be remembered that there are valid reasons for harsh punishments for counterfeiting. Germany counterfeited fivers to undermine the British economy. (The UK Treasury was doing a good job of it on its own of course).

Classical economists who advocated free trade also advocated sound money. The two are inextricably interlinked. The result of not doing it can be seen now.

A monetary policy framework centered on domestic stability must be devised as an urgent measure. Mercantilist monetary policy giving subsidies to exporters and producers at the expense of society is not good for a country facing debt repayments.

This is a problem with IMF programs in general. Sri Lanka’s 1980s open economy experiment did not take off also due to monetary instability.

Ecuador is a country to keep in mind. It also had a lot of foreign loans. Conditions are not exactly the same as in Sri Lanka but it is close. It was an oil producer that lost tax revenues as exports fell. There were socialist policies and state enterprises requiring credit.

Oil producers dependant on petroleum taxes need to either cut costs and have labour market flexibility (civil service salaries in particular) or have a sovereign wealth fund to remain stable.

In Ecuador the soft- peg started to fail as oil prices fell. Currency depreciation hit domestic demand which was already suffering.

Currency depreciation does not increase tax revenues, as some people claim, because in the short term people’s nominal salaries do not go up. Owners of export businesses will get some profits. A lot of money will just disappear in inflation and working capital. Even some of the profits of exporters will be eaten up in working capital. That is also how floating rates work in one sense.

That is why imports fall when currencies fall and economies and living standards collapse. There is no linear short term relationship between nominal tax revenues and currency falls. The suspension of market pricing of diesel and kerosene and possible cutting of taxes is an example.

Even if taxes are not cut, CPC will borrow. The effect is the same on the credit system.

Ecuador suspended market pricing of fuel, cooking gas and electricity as the Sucre currency fell.Ratings were downgraded.

Electricity generators went bust. Other businesses went bust. Banks were bailed out with government bonds. The central bank printed Sucre to discount bailout bonds.

The exchange rate melted.

Ecuador defaulted.

Ecuador had Brady bonds from a previous soft-peg crisis.

This need not happen to Sri Lanka. Any falling of oil prices that comes from a strong dollar is good for this country. But if the currency falls, that advantage will not be available to the finance ministry.

Dollarization

Ecuador dollarized in 2000, dumping the Sucre.

Usually countries dollarizes after hyperinflation. But Ecuador dollarized when there were some central bank reserves left: at one dollar to 25,000 Sucre.

The IMF came into help. And they did. A liquidity management facility was given for banks with some residual central bank dollars. Bad debts were resolved. Loans were re-scheduled.

IMF’s First Managing Director Stanley Fischer said later that if Ecuador had asked, IMF would have said the economy cannot be dollarized based on their reasoning. He said IMF should rethink their thinking.

But even now the IMF’s analysis on ‘overvalued exchange rate’ of Ecuador is a joke.

Interest rates and inflation collapsed in Ecuador, while people watched.

Inflation collapsed in Ecuador after dollarization

Poverty which was about 50 percent has now fallen to about 22 percent despite some socialism. Many people in the mountains are still poor. But the central bank can no longer make them poorer.

GDP growth in nominal terms has been variable in Ecuador, which may mislead people. But per capita GDP has is now over 6,000 dollars 18 years later from around 2000 dollars before dollarization. This is not even a generation.It is the time it takes someone to complete school.

In a sea of turbulent soft-pegs in the region Ecuador is an oasis of stability.

Like Pananama. Like the Falkland Islands, where people just fish there but have developed country living standards and where the exchange rate has not shifted for a century.

China has already bailed out Sri Lanka with a billion dollar below market rate loan. It seems they are willing to give more. This means Sri Lanka probably does not have to go down the meltdown path.

But the big problem is China does not put conditions on loans to pull oneself out of the bootstraps like Western countries or the IMF does. Western countries have experience in giving loans and defaults that come from mis-management and corruption. China is learning now.

Sri Lanka will have to do the corrections on its own since China itself does not seem to know. Sri Lanka’s Finance Minister seems to be willing to do the right thing.But the soft-peg is his Achilles heel.

Dollarization and currency boards are options to explore. And to be ready in case something happens and rating agencies act and investors panic amid the Trump effect.

There is no point in blaming rating agencies.

Rating agencies do not really understand about soft-pegs or the idiosyncrasies of individual countries, particularly Sri Lanka, this columnist would be the first to agree.

There seems to be an excessive focus on Sri Lanka as well. Our own policy makers who harped on the debt may be to blame.

The events in Ecuador also seem to expose a problem with statistics, which may need more study. GDP growth is highly variable but percapita GDP in dollar terms have grown faster than some countries with higher (real) GDP growth. Rising non-oil tax revenues seem to show that this is real.

Inflation indices lie. They are re-based frequently to lie. When re-basing is extended backwards we know that both the old and new cannot be true.

REER indices are meaningless for much the same reasons and more, not least because it is produced by government agencies, with shifting bases.

GDP and GDP growth lie, – may be not even intentionally. Vietnam produces a GDP number before the quarter ends.

That is honest too in a way, because GDP is a rough and dirty calculation. As long as the same method is applied it does not really matter.It is like an accounting policy. One has to measure something in a consistent way so that the same errors if any is made year after year.

But exchange rates cannot lie. The exchange rate is not produced by the government. It is produced by the market, based on the amount of money printed by the state.

This column is based on ‘The Price Signal by Bellwether‘ published in the November 2018 issue of the Echelon Magazine. It was written before the current political crisis added to the external risks. 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.