ECONOMYNEXT – Sri Lanka is starting the usual cyclical recovery after a currency crisis and depreciation that is triggered by rate cuts, destroying purchasing power and people’s real savings, with default added to the story.

At the moment the central bank is providing monetary stability seen in the exchange rate and inflation, allowing a battered, long suffering people to raise their heads.

It is not clear when inflationary rate cuts will start. Already 2026 bonds are being bought outright.

Sri Lanka has gone through easy money booms, involving private credit surges financed by central bank credit to boost growth, and the resultant forex shortages, tightening of exchange and import controls, all too often since the agency was set up in 1950.

That Sri Lanka cannot get away from the cycle of inflationary rate cuts, and cannot end exchange or trade controls, is a mute testimony to the false monetary doctrine that is dogging this country and rest of the ‘third world’ that is economically backward.

The IMF is good at imposing stabilization programs, by rate spikes, but is unable to stop the next crisis, or the generation of poverty from currency collapses or drip-drip-drip depreciation, due to flawed regimes it peddles, that encourage money printing for growth, now called potential output targeting.

Monetary Instability

Stabilization programs do not really ‘stabilize the economy’, but involves slowing economic activities steeply to restore the lost confidence of a currency monopoly.

It impossible for a country to grow steadily without monetary stability.

Extensive dollarization and currency competition which reduces the ability of a central bank to conduct monetary policy (print money), can reduce the chances of a next currency or economic crisis, better than any IMF program can.

Meaningful monetary reform, which eliminates potential output targeting (printing money for growth) and money and exchange conflicts inherent in a non-floating ‘flexible exchange rate’ which has been unfortunately legalized in the new monetary law, can eliminate future crises and the need for stabilization programs.

Whether it is drip-drip-depreciation or steep currency collapses, conditions are created in the country of their birth by the bad-money-central-bank to make it impossible for millions to make ends meet and drive them into currency-board-like regimes in the Middle East or East Asia, to the Maldives, or to other low inflation single-anchor, clean-floating countries, with higher real wages.

In the countries to which Sri Lankans leave their homes for, central banking is restrained by tighter laws and depreciation is legally difficult or impossible for potentially inflationist economic bureaucrats or the IMF to engineer.

IMF rhetoric peddled to countries without a doctrine of sound money, that currencies depreciate due to ‘economic fundamentals’ which must be matched by a flexible exchange rate, have no effect on countries where there are legal restraints against money printing.

“Selling FX should be limited to disorderly market conditions and not prevent the exchange
rate from moving in line with economic fundamentals,” the IMF told Sri Lanka in the December 2023, staff report.

All such Anglo-American inflationist talk disappears without trace, when faced with tight laws restraining bureaucratic rate cuts found in Dubai, Saudi Arabia, Qatar, Oman or indeed Hong Kong, who send money to the victim nation.

The sad truth is that, it is not ‘economic fundamentals’ that drive the value of a currency produced by a state-run central bank.

It works in the opposite direction, with the overproduced bad money of the SOE, which has been given a legal monopoly by misled politicians, driving countries into crisis and blasting economic fundamentals in to smithereens.

Who recovers first?

The consumers whose purchasing power recovers first, are the families of the people who have fled the country with the 5-percent-or-higher inflation targeting, ‘flexible exchange rate’, central bank, without a clean float.

In remittance receiving countries which cannot create jobs – or the real wages of whatever jobs are generated are destroyed with a 5 percent inflation target and a depreciating flexible exchange rate – a significant part of the labour force has been driven out by previous monetary instability based on similar ‘impossible trinity’ IMF-backed monetary regimes.

Currency crises – especially in peacetime – do not appear out of the blue, but are necessary outcomes of persistent beliefs in spurious monetary doctrines.

Therefore, there is an existent community outside the country, whenever rate cuts trigger the latest crisis. There is an ecosystem of job agencies, a network of friends and family who will help get into these countries through legal and informal means.

Most clean floating countries usually have tight work permits and visas, making illegal entry more likely.

In periods of extreme instability and deployment of macro-economic policy, there will also be boat people and people smuggling activities as well.

It is a shame upon all Saltwater-Cambridge economists to see this happen in a country at peace, as their stimulus mania (specifically printing money to target potential output under a flexible inflation targeting now), to see boat people.

Unlike wage earners in other sectors, remittance families get dollarized earnings from their family members outside, and their real incomes adjust automatically.

Sri Lanka’s Monetary Board or Monetary Policy Board cannot cut their wages impoverish them since their wages are denominated in a currency issued by a better central bank or currency board like regime, and not Sri Lanka rupees.

Farmers Also Recover

As long as there are no price controls – like those imposed on eggs leading to the closure of layer chicken farms – vegetable and grain prices go up with depreciation or inflationary policy.

Small holder tea farmers, whose green leaf prices are linked to export prices will also see incomes go up to pre-crisis levels.

Food is generally an item that people will consume even when incomes fall, so farmers will tend to get pre-crisis incomes quicker.

Farmers are also getting a boost from El Nino rains, this year, which is a silver lining.

However, next year conditions are less certain for farmers. If there is a bust in the US, commodity prices may also fall further.

Tourist Sector

If there are no price floors – minimum room rates – to drive out tourists to other countries in East Asia, tourism is also a sector that recovers with dollar incomes.

There is usually money to be paid as service charges or wages. Wages take time to adjust, but may be faster than other sectors.

Those engaged in transport and operation of small hotels and are business owners, will be able to fill their hotels and taxis – unless there are minimum room rates to worsen the off season.

The exodus of workers from the sector, where progressive taxes have also taken a hit on real wages, show that the recovery in wages is below pre-crisis levels. But a good season will help.

However small hotel and restaurant owners will get pre-crisis incomes as long as occupancy is maintained. A part of their incomes, especially in larger hotels with debts, will go to settle bank loans.

Wage Earners

The hardest hit are wage earners in other sectors, which are usually the last to recover. They are fully in the grip of a bad-money central bank.

Many small businesses, especially highly leveraged ones, will go down in the stabilization period when real incomes of people fall and their sales also drop in proportion.

Among the wage earners, the higher income categories are the first to get used to the high prices after depreciation and begin to spend.

This time, progressive taxation had also taken a toll on the recovery through that path.

However, in some of the larger companies, salaries have been raised to adjust for the higher income tax.

When income tax rates are raised – as opposed to giving an inflation adjustment to account to bracket creep – recovery to pre-crisis levels takes time.

It may take up to two years or more for prices and wages to adjust to a currency fall.

Typically, in bad-money-central-bank countries, by the time their wages recover, the agency would again be engaging in currency depreciation, would have depreciated some more, making workers either engage in strikes, bloating the ranks of unions or leave the country to other regions with greater monetary stability.

Even in the year that their salaries make a full real recovery, they are vulnerable to the seductive voices of economic charlatans of the right (nationalist) or the left, which will hurt the government in power. It may be moderated by who was responsible and who is carrying out the stabilization program.

Construction

The construction sector will be one of the last to recover. Construction and capital goods sectors are the ones that gain most from easy money (rate cuts from inflationary open market operations).

With outright purchases of bonds from the banking sector or term money injections, a flexible inflation and output targeting central bank or even a clean floating one will make it possible to finance projects that would never have been able to, if only real deposits were available for credit.

Since money created to cut rates and target potential output will end up as mal-investments, capital goods industries will take a hit when the bottom falls out of the market.

The current troubles in China, and the US housing bubble, that led to quantitative easing are also reflections of the same phenomenon.

The phenomenon was very well explained by Austrian economists.

“The Austrian theory further shows that inflation is not the only unfortunate consequence of governmental expansion of the supply of money and credit,” explains US economist Murray Rothbard, a strong critic of the Federal Reserve’s policy errors.

“For this expansion distorts the structure of investment and production, causing excessive investment in unsound projects in the capital goods industries.

“This distortion is reflected in the well-known fact that, in every boom period, capital goods prices rise further than the prices of consumer goods.”

So, there are also bad loans amid the downturn.

“The recession periods of the business cycle then become inevitable, for the recession is the necessary corrective process by which the market liquidates the unsound investments of the boom and redirects resources from the capital goods to the consumer goods industries,” notes Rothbard.

In 1980, when the unfortunate J R Jayewardene was opening the economy from the 1970s closure, and the central bank was triggering a crisis in 1980, Singapore’s economic architect Goh Keng Swee said, building materials was the fifth item to watch.

The first being the Treasury bill stock of the central bank where all troubles start, followed by foreign reserves (which will fall in proportion to the money printed very quickly), the exchange rate (which will also respond fast) and the inflation index. By that time the index responds, it may be too late.

READ How Sri Lanka rejected Singapore monetary advice and politicians, people paid the price

Default and Caution

The resilience of a long-suffering people will always lead to a recovery from an inflationary rate cutting crisis.

But there are several threats to the cyclical recovery.

Sri Lanka’s debt is being restructured and market access is expected to be restored after an ISB restructure, if all goes well.

Sri Lanka’s sovereign default has dealt a blow to confidence. Before the 2022 default, Sri Lanka’s flawless debt repayment record did inspire some confidence.

Having said that, there is usually no shortage of bond buyers for defaulting countries like Argentina, especially when US rates are low.

Repeated defaults do not seem to deter lenders, since default has become fairly commonplace in the wake of post-1980s intensive currency crises.

It may well be the case in Sri Lanka. However, it is also likely that ISB holders and other lenders who give credit lines to banks will be faster off the mark in the next cycle of flexible inflation targeting driven instability.

Sri Lanka will be more vulnerable to external default in the future as some of the lenders will remember what happened in 2022.

Stock market investors will also remember how they were locked in and were unable to remit money out.

Rupee bond holders also seem to be much more cautious now.

Sri Lanka’s recovery can also be slowed by reserve collections where part of the inflows are directed to the US or other reserve currency countries.

In East Asia deflationary policy has led to large reserve collections (below the line capital outflows) and even current account surpluses (total outflows), but the confidence from currency stability tends to bring in more capital and FDI.

As long as there is monetary stability and liquidity is not injected to suppress rates and bust the currency, consumer spending will recover and people’s lives will improve and the economy will grow as a result.

Eventually there will be a need to expand capacity. It is not just easy-money credit that drives growth.

External Threat

A big threat may come from a US and Western economic disruption.

Economist Steve Hanke, who accurately predicted Fed’s inflation based on money supply movements, among other indicators, has said a steep recession is ‘baked in the cake’ based on current broad money movements in the US.

In the last few years, a big volume of money printed by the Fed went into government debt, not housing mortgages like in the 2008 crisis.

People largely spent pandemic cheques, where the government was the borrower and not just private investors like in the Great Depression, when the fixed policy rate busted a country with a fairly benign situation after World War I ended.

A default of US debt seems unthinkable, but the country’s credit is weaker than ever before with downgrades. Confidence is fickle and can be lost in a hurry. The US political system is in disarray.

The effects of US and general Western disruption are already being seen in Sri Lanka’s export numbers, even though a recession is not official in those countries based on econometrics and definitions as yet.

An unusually bad disruption of the US and Western economies are possible whenever monetary ideologies deteriorate as was seen in the 1970s, in 2008/9 and the 1920 Great Depression.

Multiple Mandate Threat

The biggest threat in Sri Lanka, as always, is internal. The ‘flexible exchange rate’ or depreciating soft-peg and potential output targeting can destroy money here and de-stabilize the country within and on top of US problems.

The inflationist monetary regime, currently peddled by the IMF to unfortunate countries without a doctrinal foundation in sound money, can trigger an external crisis as soon as the economy recovers, as it had done before.

The 5 plus 2 percent inflation target is a big threat. It gives the leeway to the central bank to trigger crises easily with room to spare. After the war crises were created with a 5 percent target.

If the central bank can maintain monetary stability without printing money, a chance will be available for battered people to raise their heads.

However, the prospects are dim. In monetary policy statements, mentions of potential output figures larger than life.

“The Board arrived at this decision following a careful analysis of the current and expected developments in the domestic and global economy, with the aim of achieving and maintaining inflation at the targeted level of 5 per cent over the medium term, while enabling the economy to reach and stabilise at the potential level,” the last monetary policy statement said in the second sentence, rivalling Powells reference to employment, indicating that there is a very strong belief in a dual mandate and the supposed effectiveness of money printing (macro-economic policy) for growth, despite the carnage wrought in the past few years.

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The central bank also paused rate cuts. This is good. The rate cuts were not inflationary, and general interest rates have fallen due to low private credit, improvements in government deficit and state enterprise profits.

The exchange rate is also volatile but not depreciating so far. Exchange rate stability is an overt reflection of monetary policy.

If the central bank does not try to sell large volumes of Treasury bills above the dollar purchases and re-finance them overnight, rates will fall faster. Allowing some excess liquidity from dollar purchases to remain – while private credit is weak, will bring down rates faster.

There is no need to buy 2026 bonds and inject long term money.

But to keep the market marginally short is a good idea, especially as credit recovers.

If stability is provided for a few years, rates will fall as real wages and savings recover as seen in countries like China and hard pegged countries, Sri Lanka will never see a default again.

Because this country like most Asian nations has a high private savings rate it is easy to collect reserves or repay debt.

As mentioned before stabilization periods are also fertile grounds for nationalism to rear its head, despite economic conditions being not that bad as earlier.

It has happened in many countries from Nazi Germany to Sri Lanka.

When nationalists or authoritarians trigger a crisis, and more liberal reformists come to power, countries can progress.

The current President did not create this crisis, so like the Ordoliberals of post-World War II who inherited a messed up economy from the nationalists, there is a chance, provided stability is provided by the central bank.

As the Germans said, stability may not be everything but without stability everything is nothing.