ECONOMYNEXT – Sri Lanka’s recent removal of counterparty limits for access to central banks’ printed money as a standing facility is a mistake which will make banks overtrade and contribute to monetary and financial instability in the future.

Standing facilities should be the last among lender of last resort facilities.

The more liberal the LOLR facilities are, the more unchanging the rate, the more external instability there will be in the future, and more bank bad loans will pile up as stabilization policies are applied.

Essentially, standing facilities, term or permanent injections allow banks to lend without deposits, and trigger forex shortages in a soft-peg or flexible exchange rate.

The UK has a standing facility that prints money at 0.25 percent above the policy rate.

“The operational standing lending facility consists of an overnight lending transaction collateralised against high-quality, highly-liquid (Level A) assets. We apply a 25 basis point premium (0.25%) above Bank Rate for this facility.

“The operational standing deposit facility consists of an overnight deposit transaction. This currently returns 25 basis points below Bank Rate.”

Safer, More Prudent Times

In earlier times, before monetary policy deteriorated and when the BoE gave more stability to the country and lower inflation, and less social interest, these premiums including for longer term money, have been higher.

“We moderate upward spikes in overnight rates by being ready to supply overnight funds to our counterparties at 3.30 pm (against collateral) if the shortage of funds has not been fully relieved in our main 9.45 am or 2.30 pm rounds,” according to a paper by William A Allen, one time Bank of England who retired before policy was corrupted by quantity easing and easy money, leading to current troubles.

“At the end-of-day stage, our operations are concerned not so much with implementing the MPC’s repo rate as with the more routine task of squaring off any residual market imbalance in as orderly a manner as possible. The rate charged on 3.30 pm lending is penal – the official repo rate plus 100 basis points (though we can vary this margin) – in order to encourage banks to borrow in the market wherever possible.

“If, after the market has closed, the system is still out of balance, we will lend off-market to the settlement banks to enable them to square off their end-of-day settlement with each other, at an even more penal rate of the official repo rate plus 150 basis points (again, this margin can be varied).

“These facilities are designed to eliminate excessive spikes in overnight interest rates at the end of the day, and have been successful in doing so. They are akin to the ceiling in a corridor system of rates, but not exactly so for two reasons.

“First, they are not standing facilities available at all times to all market participants. Second, funds are normally limited to the amount of the remaining daily shortage (though we reserve the right to supply more).

The rationale for prudence and discouraging moral hazard was explained as follows.

“Both these limitations are motivated by our desire to ensure that banks are subjected to the discipline of having to finance themselves in the market to the maximum extent possible.”

All of these principles have now gone out of the window and the world is a less safe place for all, particularly the poor in unstable countries like Sri Lanka.

How do Liquidity Shortages Emerge?

In reserve collecting central banks with pegged or managed floats, liquidity shortages come from dollar sales.

In a floating exchange rate regime, liquidity shortages do not arise unless many market participants refuse to deal with each other in times of crises and deposit money in the central bank (private sector sterilization).

This also happened in Sri Lanka in the last crisis, with foreign banks depositing money in the central bank instead of buying government securities or lending in the interbank market.

In the absence of a policy rate, such deposits become foreign reserves in a reserve collecting central bank.

If there is ‘quantity tightening’ in progress, liquidity can fall in a floating rate environment.

The Bank of England is giving unlimited facilities in quantity tightening to help ease any liquidity shortages at the moment.

In many countries the quantity tightening is aimed at reducing excess liquidity created from quantity easing.

 Sri Lanka’s central bank is also engaged in ‘quantity tightening’ in effect, by selling down its Treasury bill stock, with no excess liquidity present.

As a result, there is no money in the market to buy large volumes of CB held Treasury bills unless there is liquidity generated from central bank dollar purchases.

Overselling Treasury bills in large volumes and giving liquidity overnight through overnight windows or term, encourages banks and primary dealers to depend on the central bank’s printed money for their operations.

The central bank should internally roll over most of the maturing securities and only offer to the market a volume that will keep the aggregate balance in the market plus or minus 20 to 30 billion rupees.

Now T-bills are sold and money is injected term and overnight to allow market participants to buy them.

Market participants should buy CB held Treasury bill stock from real deposits, not central bank credit. To do so is a type of self-deception.

Liquidity Junkies

More to the point it is a bad practice that will get banks used to borrowing from the window – de-stigmatizing the practice – so to speak.

When banks become liquidity junkies, eventually the country will suffer forex shortages when credit recovers.

In Sri Lanka several well managed foreign banks, (and one or two local ones also before the crisis) always deposit some cash in the central banks window.

These banks are usually net sellers in the interbank forex markets.

In fact, all banks, whether local or foreign should be encouraged to have a little excess liquidity above the reserve ratio.

If the central bank has painted itself into a corner on a belief that it cannot roll-over maturing bills internally under the monetary law, it has only itself to blame for coming up with an illogical law.

If that is a problem, the central bank can submit a non-competitive bid and allocate itself the volume at the weighted average bid for the auction.

The current system of selling bills and giving new money short term, can also lead to sterilization losses in addition to making liquidity junkies out of banks.

In the name of transparency all bills rolled over should be disclosed to the market. The bill holding, inclusive of those taken for term or overnight operations, should also be disclosed daily.

A small liquidity shortage filled at penal rate will encourage better banking.

However if the central bank wants, it can also allow some liquidity to build up from dollar purchases and allow short term rates to fall further in the near term, now that confidence in the currency has been restored fully.

Long-term rates will fall as real savings go up (the exchange rate appreciation helps but care should be taken not to overdo it) and budgets become better, as long as monetary stability is maintained for a few years.

If liqudity is allowed to be plus, from outright dollar purchases and not swaps, a wide policy corridor and a penal standing facility is absolutely required to prevent forex shortages from developing and the whole house of cards collapsing when private credit recovers.

East Asia

Most East Asian nations which collect reserves (with deflationary policy) have tighter liquidity facilities in their operational frameworks, unlike unstable countries like Sri Lanka and those in Africa. Some have penalty rates for intra-day liquidity.

Rates move quickly in case there is a credit spike and exchange rate is defended when there is a wide policy corridor.

A wide corridor or a high ceiling rate helps reduce the negative effects of the obstinate policy rate and allow the market to finance credit instead of central bank facilities.

When standing facilities – including intra-day facilities – are given at penal rates the ceiling rate goes up and widens the corridor, helping protect against currency crises.

In several East Asian central banks domestic assets are negative.

Thailand, which fell victim to hedge funds in the East Asian crises first due to its policy rate and swap operations, was an exceptional central bank even when the Bretton Woods collapsed, but whose policy framework was not up to dealing with a swap attack in 1997 due to ‘monetary policy modernization’.

The Bank of Thailand swiftly descended into inflationary policy under attack, which then shattered confidence.

Running deflationary policy, and building reserves (exports of capital) has not hurt East Asia because the stability the practice provided through a tight monetary standard led to even larger inflows of capital in the form of FDI or other flows than the reserves that were built.

Domestic capital was preserved with no depreciation to inflate away capital.

Countries with completely free capital flows, including Singapore and Hong Kong which have the best monetary frameworks in East Asia, have very low interest rates and do not have policy rates at all.

Sri Lanka also had developed country level inflation and interest rates, before the monetary framework was corrupted progressively under IMF tutelage and also the inflationist beliefs that swept the academic community of the US in particular, from the 1960s.

Monetary instability and currency depreciation that led to high interest rates in Sri Lanka which is unrelated to credit risk.

No Logic

There is no point in imposing statutory reserve ratios if liquidity is provided liberally through standing term and overnight facilities after banks short the SRR.

Given the lack of foreign reserves, and negative net reserves of the central bank, banks should be encouraged to raise deposits, reduce credit and buy central bank held securities from liquidity generated from central bank dollar purchases.

Any cash deposited by banks in the standing facilities over and above the SRR actually results in foreign reserves for the central bank, unless system liquidity is liberally filled with standing facilities.

Dollar net open position units of banks in fact should be tied to the net balance of their standing facilities and other borrowings.

Outright purchases of securities and the engaging central bank or market swaps to borrow dollars should be discontinued.

Central Bank Swaps are also Illogical

A central bank swap with a domestic market participant is the same as the Lebanon Central Bank dollar deposits, which proved its undoing.

In addition to Lebanon Central bank swaps is also the path of Argentina central bank’s dollar Leliqs.

Sri Lanka’s central bank also made large losses on swaps, ACU borrowings and IMF borrowing in this crisis, by using swaps to meet external payments and printing money to maintain an untenable policy rate.

Goh Keng Swee did not allow swaps and Singapore banks gave credit to foreigners to reduce the room for speculative attacks which make rates rise, though other currency board regimes like Hong Kong which have a fixed exchange rate had no such restrictions.

Speculators who tried to hit HKMA with swaps lost out as the interbank rates went up during the East Asian crisis, while they made hundreds of millions in profits from policy-rate central banks.

Soft-pegs which were hit in the East Asian crises including Malaysia and Thailand, also stopped attacks by closing the offshore swap market.

Sri Lanka’s and the problems in other countries with forex shortages and the depreciation and social unrest comes from the deterioration of monetary doctrine in the ‘age of inflation’ started from the Fed’s open market operations in 1920 to trigger the Great Depression.

The deterioration accelerated very sharply in the 1970s with the collapse of the Bretton Woods and IMF’s second amendment to its articles.

That is why budgets became unmanageable in Sri Lanka from the 1980s, despite J R Jayewardene cutting subsidies, ending price controls and administered prices as they were known then.

 John Law and the Policy Rate

There was no bureaucratic policy rate before the Fed was created as such action has been fiercely resisted in Europe and Great Britain which had a longer monetary history.

It was John Law who originally proposed to suppress rates with liquidity injections for ‘macro-economic policy’ rather than imposing price controls. Britain in fact had usury laws, which imposed ceilings on interest rates at the time.

“Some think if Interest were lower’d by Law, Trade would increase, Merchants being able to Employ more Money and Trade Cheaper. Such a Law would have many Inconveniencies, and it is much to be doubted, whether it would have any good Effect,” John Law wrote.

“Indeed, if lowness of Interest were the Consequence of a greater Quantity of Money, the Stock applyed to Trade would be greater, and Merchants would Trade Cheaper, from the easiness of borrowing and the lower Interest of Money, without any Inconveniencies attending it.”

That new money was not to have been backed cross border exchangeable assets like gold or silver, but a non-tradable domestic asset, land.

Though John Law’s ideas were not accepted in Britain, he was able to persuade the French to do so, leading to the Mississippi bubble. The Mississippi bubble proved that Law was wrong.

In this age of inflation, asset price bubbles, external default, rising national debt, exchange and trade controls, the policy rate and liquidity tools are taken for granted amid heavy propaganda by academic inflationists and other Mercantilists.

But before the ‘age of inflation’, and before 1920 it was not so.

It is also not in central banks with wide policy corridors and those that give tiered facilities.

No less than William Patterson, a key promoter of the Bank of England (which did not have a bureaucratic policy rate to manipulate interest rates in the beginning though it also got into trouble by giving excess credit from domestic assets in times of crisis) opposed John Law and the deliberate attempt to suppress rates with printed money.

Reserve Currency Inflationism

When the Bank of England was able to maintain the gold standard and the Sterling was the pre-eminent currency in the world, it had no policy rate.

The peacetime economic crises seen after World War II was a direct result of the bureaucratic policy rate and aggressive liquidity facilities of central banks, as was Sri Lanka’s currency crises and default since the end of the civil war.

Ironically, when the Fed started open market operations in April 1923, (New York Fed Governor Benjamin Strong who later triggered the Great Depression with rate cuts was on leave), it was to mop up liquidity and do ‘quantity tightening’.

John Law was proved wrong by the Mississippi bubble, and people understood the problem.

But the Great Depression did not prove Strong wrong and instead gave rise to Keynesianism and the age of inflation.

The Housing bubble did not prove Ben Bernanke wrong but gave rise to quantitative easing which is much worse than the Keynesianism that brought down the UK after World War II.

After more than a decade of repeated trigger-happy quantitative easing US budgets and US debt have been shot to bits. There are no good budgets with bad money.