ECONOMYNEXT – In Sri Lanka and in other countries with bad central banks like in Latin America, inflation and currency shortages are perpetuated by a series of false narratives repeated ad nauseum by the perpetrators until the public accepts them as true.

By these actions, inflationists escape accountability for money printing or the deployment of inflationary policy to trigger monetary instability by cleverly transferring the blame to the victims, which include not only the general public but also politicians who lose office.

In order to escape Sri Lanka’s 73 years of monetary instability which started with the setting up of the central bank and frequent trips to the IMF, it is important to examine the truth or otherwise of these claims.

This is the first of a series that will attempt to show how countries suddenly started to experience balance of payment deficits in the last century in peacetime and various narratives stopped any correction.

These red herrings were not developed in Sri Lanka, but by Western inflationists as ‘macro-economic policy’ advocated by US post-Keynesians in particular, undermined the Bretton Woods soft-peg system and the last vestiges of the gold standard were shattered.

The mis-labelling of monetary instability as macro-economic instability was also one of the ways the victims of central banks were misled.

But the most enduring and oft-repeated false excuse given by these inflationalist working within and without what were effectively ‘independent’ central banks of the West was that the budget deficit was the cause of forex shortages and inflation.

In Sri lanka in the year the central bank triggers the currency crisis, deficits have been stable or barely grown nominally, indicating that very small rises in rates early under a wide policy corridor would have prevented a currency crisis.

On the other hand, deficits tend to grow steeply in the year the balance of payments was brought back into surplus through a stabilization program, which tends to slow growth, push up rates, and the debt to GDP ratio.

In the next currency crisis, especially if there is commercial debt, the country tends to default.

The Deficit Lie/Fiscal Dominance

The false narrative around deficits goes like this: politicians expand the budget deficit and the central bank is subject to de facto (by the large deficit by itself) and de jure fiscal dominance through operational dominance by politicians or Treasury officials blocking rate hikes.

There are two problems with this claim. One is that there is no data to support this claim, especially in Sri Lanka, especially after the end of the civil war.

The other is that Treasury Secretaries in Sri Lanka have almost always been ex-central bankers, therefore, it is a problem of economists and not politicians or the general public anyway. Politicians are clueless in third world countries and when they had a clue, they did not interfere.

A close examination of recent currency crises shows these trends. Some of these trends are also present in older crises before the civil war started as well as in many countries including Latin America that experience peacetime currency collapses and default.

Trend One: the deficit expands in the stabilization year when currency crises are eliminated and the BOP returns to surplus. This deficit apparently is not subject to ‘fiscal dominance’ either de facto or de jure.

Trend Two: In the year the currency crisis is triggered and money printing suddenly expands, the deficit to GDP sometimes falls and nominally the increase is small.

Trend Three: The money printed in the year that the central bank triggers crises is disproportionately higher than any nominal increase in the deficit, compared to the previous year when there was monetary instability. This is because central banks trigger BOP deficits not by printing money for the current year deficit, but by printing money to buy back government debt held by banks from deficits decades ago to target the call money rate initially and then sterilize outflows as panic sets in.

The Recent Crises

In the 2008 crisis, which happened in the middle of an intensified war and the Great Financial Crisis, some of these factors were present, but it was also driven by capital flight within a stable exchange rate, but monetary policy was tight.

In the 2001 crises, which also took place in the middle of a war also some of the characteristics can be seen, though the currency collapse was steeper.

This column is prepared to make some allowances for war, since, even in classical liberal days, private central banks like the Bank of England got into trouble in wartime. It also must be kept in mind that the country that did not print money or printed the least was usually the victor. But there can be no excuse for peacetime monetary instability.

The trend of expanding deficits in stabilization years holds true even in war years. In 2001 for example, when monetary stability was restored and reserves were re-built with a BOP surplus of 219.8 million US dollars, the deficit went up steeply from 9.5 to 10.4 percent of GDP.

The nominal deficit went up from 119.4 billion rupees to 146.7 billion rupees, yet money printing was reversed by 5.7 billion US dollars.

In 2009, a stabilization year, the budget deficit went up from 309.6 billion rupees to 476.4 billion rupees, yet the BOP was in surplus with higher interest rates.

In peacetime currency crises came in rapid succession as money was printed to keep rates down as the economy recovered.

The Crisis year

In the 2011/12 currency crises the central bank triggered a BOP deficit of 1,059.4 billion rupees without a war as the economy strongly recovered and private credit recovered. The deficit in the crisis year of 2011 went up only by 5.2 billion rupees from 445 billion rupees to 450 billion rupees.

This deficit could have been easily managed if interest rates were allowed to move up a little. But the central bank printed 184.6 billion rupees that year to keep rates down and effectively finance the private sector.

In 2015, however there was a substantial increase in the deficit due to Yahapalana salary and subsidy hikes, where an excuse can be made that there was de facto or otherwise fiscal dominance.

However, the central bank started injecting money from the third quarter of 2014 before that government even came to office to suppress rates. As the deficit went up by 238.3 billion rupees the central bank printed 80.4 billion rupees, according to the rise in credit to the government, which however did not tell the whole story.

In 2016, when the deficit was reduced by 189.2 billion rupees to 640.3 billion rupees, the central bank printed 183.0 billion rupees.

Then, in 2017, the stabilization year, the deficit went back up to 733 billion rupees or 93.2 billion rupees and the central bank reduced its credit to the government by 188 billion rupees. In terms of GDP also the deficit fell marginally.

In 2018, in another currency crisis year, the budget deficit went up by only 27.3 billion rupees but the central bank printed 247.7 billion rupees as massive amounts of money was injected to target the call money rate and then sterilize interventions when foreigners fled re-financing the private banks to buy the debt.

In 2018 as well as in other crisis years, the budget deficit could have been easily bridged by a 100 or 200 basis point rate hike and reducing private credit or boosting savings, as the difference in deficits of the two years show.

Instead of which rates were cut in that year, just like in earlier crisis years. As a share of GDP, the deficit fell from 5.5 to 5.3 percent of GDP in 2018.

In 2019, the stabilization year, the budget deficit went up to 6.8 percent of GDP but the BOP came back into surplus. In rupee terms the deficit went up to 1,016 billion rupees from 760 billion rupees, but 109.6 billion rupees in central bank credit was reduced.

It can be very clearly seen that the budget deficit was not the problem, for the external deficit in the previous year as it was lower.

No Escape under Data Driven Monetary Policy

Then what is the problem?

The problem is data driven monetary policy, or the belief that rates can be cut with printed money to get easy growth, when inflation falls.

In 2015 when the deficit went up, the central bank had no business cutting rates. The central bank was already printing money from the third quarter of 2014 and running forex shortages.

Yet the agency cut rates in April 2015 suicidally and injected money to target the call money rate claiming inflation was low.

Based on this argument it was justified in doing so under data driven monetary policy, where econometrics triumphed over laws of nature.

In 2018 it cut rates while the deficit was down. The excuse at the time was that fiscal policy was tight, therefore monetary policy must be loose to boost growth.

That is the time it was quite evident that Sri Lanka had no future. The central bank would print money whether the deficit expanded or narrowed. The people and the economy had no escape from monetary instability.

To suggest that Mangala Samaraweera or Eran Wickremeratne was putting pressure on the central bank to print money does not hold water. Harsha de Silva publicly asked rates to be raised.

Whatever the fiscal authorities did was not relevant, the central bank would cut rates and trigger currency crises as soon as private credit recovered.

And post the currency crises, 12-month inflation tends to fall around the same time as private credit recovers, giving excuses for a fresh round of money printing.

Why does all this matter?

There is a further complication for a reserve collecting central bank. To collect reserves, a country must finance the deficit of a third party reserve currency country.

If Sri Lanka buys US securities, then the American deficit is financed. Raising taxes and reducing the deficit domestically is not enough, domestic investment must be curtailed sufficiently to build reserves (finance a reserve currency country deficit).

So why does all this matter?

This matters because it shows why deficits and debt go sharply up in countries with bad central banks. The deficit and debt (including the rupee value foreign debt) go up for reasons that have nothing to do with fiscal policy.

While good fiscal policy is important, no amount of fiscal fixing will help if the central bank is triggering monetary instability and depreciating the currency, because repeated stabilization cycles will destroy growth and fiscal metrics.

The reason for spikes in bad loans in the private sector and bad fiscal metrics is virtually the same – it is bad money.

This is also important for another reason, which these columns have explained before.

Mistargeting of rates is the reason IMF programs fail in the second year. It is important because Sri Lanka is now about to make the same mistake again under data driven monetary policy.

This is what happens in peaceful Latin American countries and it is what happens in Sri Lanka and in all IMF countries.

Politicians in particular must take note.  Ranil Wickremesinghe and his ministers must not put pressure on the central bank to cut rates.

Already the writing is on the wall. Noises are coming about ‘high real interest rates’.

It is when private credit gains momentum that the real problems will begin. Under a flexible exchange rate, even a small pick up like in 2018 can create havoc.

The IMF itself has warned that the pace of reserve collection has slowed. And no wonder. The central bank started injecting money on a gross basis in May. From June the external sector started showing signs of instability.

But the IMF warning about reserve collections is disingenuous.

The IMF itself is at Fault

It is the IMF that promotes econometrics (data driven monetary policy and the monetary consultation clause that promotes money printing as soon as inflation falls) that go against laws of nature well described by classical economists to avoid balance of payments troubles.

The IMF suggests there is monetary financing. There was minimal monetary financing of the deficit, except after 2020. There is however ‘monetary financing’ of banks consistently (by repurchasing old bonds from prior year deficits), which is way higher than the deficit.

This mistake did not happen in classical days. Financing of banks (or discount houses initially) was through bills of exchange and it was clearly visible.

Hence classical economists, some of whom got themselves elected to parliament to bring laws against central banks, easily made the distinction between financing of ‘merchants’ and the ‘government or the King.’

Unlike the IMF or present-day economists of third world central banks that go for bailouts frequently, classicals had a deep knowledge of note issue banking operations.

As the data shows above, in the crisis year, the reason large volumes of money – much higher than the increase in the deficit is printed – is because the central bank is actually financing the private sector.

In Argentina for example crises are driven by the failure to roll-over BCRA’s own sterilization securities like (Leliqs).

In Sri Lanka it is the re-financing of banks by either outright, term or overnight purchase of securities from banks, through inflationary open market operations claiming inflation is low.

That is why IMF programs are destined to fail and second or third defaults happen in many cases.

4-6 pct inflation targeting is an invitation to disaster

All this matters because of a third reason.

An examination of the data table in Sri Lanka shows that all post war currency crises had taken place by targeting a 4-6 percent inflation range.

What the numbers show is that targeting 4-6 percent failed to stop currency crises, which eventually led to growth shocks and spikes in debts as the monetary brakes were hit.

The post-2020 “macro-economic policy” deployed had tax cuts on top of money printing. During that crisis also inflation was relatively low initially despite large volumes of money being printed.

Sri Lanka’s problem and that of other African and Latin American countries is that monetary regimes are fundamentally flawed.

There is a propensity to deploy macro-economic policy despite the existence of a reserve collecting central bank in the legal and operational frameworks themselves, despite such actions defying laws of nature.

Sri Lanka, Africa and Latin America and unstable countries in East Asia like Laos are in the same universe as stable countries with 2 percent targets and subject to the same laws of nature described by classical economists when BOP deficits and monetary instability were absent.

No amount of reforms in other sectors, including in budgets which are undoubtedly required, can help a country, if monetary stability is denied by targeting 5 percent inflation and failing to defy laws of nature, repeatedly. (Colombo/Oct23/2023)