ECONOMYNEXT – Sri Lanka’s short term market rates, the call money rate in particular and Treasuries yields in general, are determined by the net international reserve target of the International Monetary Fund program, not inflation.

If a reserve collecting central bank cuts rates on an inflation index number as private credit recovers, and enforces them with inflationary open market operations, forex pressure will emerge quickly and the currency will fall.

It has happened repeatedly in Sri Lanka in the recent past, it happens in all countries that go to the IMF frequently and it happened in the US in the run up to 1971 and in the UK up to 1979.

In Sri Lanka, the so-called ‘flexible inflation targeting’ with output gap targeting, eventually drove the country into external default within and without IMF programs, due to faster transmission of monetary policy after the end of a 30-year civil war.

The same phenomenon can be seen in Pakistan, Bangladesh, Africa, Latin America and Laos in East Asia where the IMF has clout to push the doctrinally flawed flexible inflation targeting/flexible exchange rate style regimes.

The value of money is destroyed and people are impoverished by repeating a false doctrine that was developed in the last century using econometrics and rejecting laws of nature by inflationist macro-economists at Cambridge (J M Keynes), Harvard (Alvin Hansen), MIT (Paul Samuelson) among others.

The gold standard collapsed, newly independent nations became basket cases, millions were pushed into poverty, had to flee their native lands and market access countries defaulted, due the false doctrine propagated by these macro-economists which was enabled by sterilizing central banks.

Why do currencies fall?

Currencies, whether pegged or floating, fall (and strengthen) due to central bank action. When a reserve collecting central bank (pegged) buys any domestic asset from any party, or transfers profits to the Treasury, rupee reserves of commercial banks will go up.

The central bank will also inject money in most transactions it does with the rest of the world, including paying salaries or pensions. That is why central banks should be lean organizations with minimum expenses and staff.

Usually, Sri Lanka’s central bank buys Treasury bills from banks to target the call money rate, not to monetize debt in the current year deficit.

The newly injected money will be loaned to private investors who will invest them in buildings or machinery which will then trigger imports above dollar inflows, triggering forex pressure. That is why in 2020 to 2022 even when car imports were banned, the rupee came under pressure and reserves were lost as investment goods imports soared.

Does Sri Lanka have a pegged exchange rate?

Yes. Definitely. Without a pegged exchange rate, there cannot be BOP deficits or BOP surpluses. There also cannot be foreign reserve collections or foreign reserve losses without a pegged exchange rate.

In a floating exchange rate regime, there are no BOP deficits or surpluses.

The reason there are BOP deficits in Sri Lanka and other flexible exchange countries is due to flawed pegged arrangements, which have a variety of labels but their common denominators are forex shortages and exchange controls (free flow of capital is barred).

There cannot be an IMF foreign reserve target (a BOP surplus) without a pegged arrangement, however flawed.

How are reserves lost?

Reserves are lost permanently when dollars are sold by a pegged central bank to commercial banks to redeem rupees created through open market operations (printed money), which have been loaned to customers or used to buy Treasury bills and boomerang as imports.

When credit demand is high, reserves sold to facilitate investment imports in particular can lead to liquidity shortages. Under a flexible inflation targeting arrangement or soft-peg or managed float, this liquidity shortage is again filled (sterilized) with newly printed money, worsening reserve losses and further expanding the BOP deficit, fixing the interest rate and preventing a correction in credit.

Because there is no confidence in the flexible exchange rate, when it starts to fall, exporters and importers panic, capital flight begins and rating agencies downgrade as happened in 2018 and other years.

In the past Sri Lanka’s state banks also used to borrow printed money from standing lending facilities of the central bank (artificially keeping down the interest rates in the process) and loan to the CPC or CEB or to the Treasury as overdrafts, creating forex shortages with the excess rupees.

When dollar reserves are sold for rupees, liquidity should go down, eliminating the ability of banks to give new loans, automatically pushing up rates and reducing credit and bringing the external sector into balance. This was the case around the world before 1920s when balance of payments deficits were absent.

However, if the policy rate is targeted with new money from open market operations or standing facilities, there will be no correction of credit and the rupee will fall and more reserves will be lost as money is injected. This employment of inflationary open market operations to inflate rupee reserves of banks is called a sterilized foreign exchange sale.

This is why reserve collecting monetary authorities with unsterilized or mostly unsterilized interventions are able to have fixed exchange rates or mostly fixed exchange rates and those that sterilize, collapse and run into currency crises.

To collect reserves and meet IMF reserve targets this process has to be reversed.

If the central bank is barred from targeting interest rates with open market operations and interest rates are forced to fluctuate, with a wide policy corridor or no corridor, like in stable East Asian countries, the currency will not depreciate, the money will have a stable value, and economic activities will grow steadily. The resulting stability and confidence will draw foreign investors and not make them run away, like in a flexible inflation targeting regime.

How does an East Asian fixed exchange or UAE monetary authority maintain reserves?

Reserves are maintained by operating open market operations to keep the balance of payments in balance. In a pegged exchange rate, the BOP determines the interest rate.

In countries like Vietnam or China before 2005, deflationary open market operations were used to build reserves exceeding the reserve money of the country.

If the interest rate is determined by econometrics, either to target growth or to target inflation (to push up inflation when it is low), there will be external instability as reserves are lost and the currency is depreciated.

Currency boards or fixed exchange rates have stable reserves, which match the reserve money supply, and no BOP crises because interest rates match domestic credit and also the credit cycle of the anchor currency, through the same mechanism.

How are reserves built?

In order to build reserves, domestic credit has to be reduced by a little more than it would have been to keep the exchange rate fixed by deflationary open market operations. That is to say interest rates have to be a little higher than the market clearing interest rate of a currency board or fixed exchange rate.

In order to build reserves the central bank has to sell down its domestic assets stock and withdraw liquidity from banks as dollars are bought. In a float, dollar purchases or reserve building does not happen.

In order to be able to purchase dollars, domestic investments will have to be curbed by a market clearing interest rate that matches the net international reserve target. The rate will be higher than that needed to keep stable reserves matching the money supply (a fixed exchange rate) where reserve run downs (a currency crisis) was avoided originally through a moving policy rate.

In order words, the monetary authority has to sterilize or offset its international operations in the opposite direction through domestic operations compared to when it was creating a currency crisis. Open market operations will therefore have to be deflationary, not inflationary like in 2015, 2016, 2018, 2020, 2021 or 2022 up to July.

Related Sri Lanka is recovering, Central Bank threat looms: Bellwether

Is rebuilding reserves austerity?

You could call it that. Cutting state spending or deficits is not austerity obviously. Any cuts in state spending leaves more money in the hands of private citizens to spend or invest and interest rates will also tend to fall. Cutting state spending will boost private citizen growth.

But under an NIR target capital is exported and loaned to developed nations. Capital that would have been invested domestically will have to be appropriated by the central bank, and loaned to the US. As a result, in the reserve re-building phase, growth may be lower than in a fixed exchange rate or a floating regime. If the exchange rate is stable and confidence is built among foreign investors there may be a lot of investments and this condition may be mitigated to some extent. But under a flexible exchange rate, which depreciates permanently, confidence will be weak.

In order to build reserves, interest rates in the country will have to be higher than in a floating exchange rate regime or a currency board that does not sterilize interventions in either direction.

Both currency boards and dollarized countries and floating exchange rates have very low interest rates. All of these regimes operate according to laws of nature, roughly described by the impossible trinity of monetary policy objectives.

Cutting rates based on an inflation target (data driven monetary policy) without a floating rate, goes against the laws of nature and these countries suffer monetary instability. If they have market access and credit ratings are low, they can quickly default again as investors sell down bonds as the currency falls, pushing sovereign dollar yields up.

If interest rates are cut and money is injected like in 2015 and 2018 and 2020, the same results will be seen in the near future when private credit recovers this year.

As soon as interest rates are out of line with the BOP, net foreign assets of the central bank starts to fall (see blue line in above graph).

That is why countries with flexible inflation targeting regimes end up in BOP crises and default as pegged countries that tried to target a money supply and depreciated their currencies in the 1980s defaulted.

What happened in Sri Lanka is not new. Only the labels are different. The anchors may be different but the conflict is the same.

The Fed’s ‘lean against the wind’ policies of the 1960 (also a type of output gap targeting) based on econometrics and not its actual anchor of gold, led to high inflation, soaring gold prices and the eventual collapse of the Bretton Woods.

Many poor countries without a doctrinal foundation of sound money started to have very high inflation after the collapse of the Bretton Woods, in the 1980s as the Fed tightened because they were encouraged to depreciate by Western inflationists – including inflationists within the IMF itself.

In order to survive a Fed tightening, reserve collecting countries have to run the same credit cycle as GCC countries and Hong Kong now does. Or they should have an independently floating exchange rate with an entirely different credit cycle like Australia or New Zealand.

As a result of inflationism or macro-economic policy, there was an epidemic of social unrest from the mid 1960s and into the 1970s (except in Germany and Japan) and a sovereign default epidemic in the 1980s.

Is the strength of the currency anything to do with the strength of the economy?

No. The causation runs in the opposite direction. Currencies can strengthen when economic activities collapse due to shrinking private credit as long as money printing is contained with higher rates. This is what happened in Sri Lanka over the past year.

The currency will fall generally when economies do well and private credit picks up and central banks employ open market operations to target the policy rate or call money rate or economic growth.

That will happen to Sri Lanka soon if rate cuts are enforced with open market operation as private credit recovers as it happened in 2018 and in 2021 in the post covid recovery. Pakistan and Bangladesh were also hit by the post covid recovery.

There is only one agency that can drive the rupee down and that is the central bank, which enables private credit with printed money.

What about the new monetary law? Will that prevent a crisis and second default?

There is nothing really to prevent a second default. The new monetary law has three anchors.

The central bank is empowered to target the exchange rate (exchange rate policy) it is empowered to print money to keep artificially low interest rates as in the past in direct conflict with the exchange rate policy mentioned above (inflation targeting) and it is also empowered to print money to target growth (a potential output arrived at by econometrics).

Furthermore, it is also empowered to depreciate the currency when all these targets inevitably conflict and confidence disappears (flexible exchange rate).

Is there anything in the IMF program to stop a default of restructured debt?

The IMF program has a ceiling on domestic assets of the central bank, which can serve as a check on money printing. However, it is not directly complementary to the reserve target and there is room to print money for open market operations and bring the rupee and the economy down.

“For the program monitoring purpose, government securities acquired through purchases of government securities, solely for monetary policy purposes (e.g., standing lending facility and short-term open market operations) and emergency liquidity assistance (ELA) operations, on a temporary basis with an agreement to reverse the transaction in less than 90 days, will be excluded from the CBSL’s claims on the central government,” according to the IMF program.

Based on past performance it takes only about 4 to 6 weeks for open market operations money to boomerang on the exchange rate when private credit has recovered. Three months is an eternity.

While there is some complementarity in the ceiling on domestic assets there is a fundamental conflict between the NIR target and the inflation target which is described by a monetary consultation clause. The conflicting targets come from a weak understanding of operations of pegged central banks.

Any reserve collecting central bank with discretionary open market operations unchecked by law, can and will trigger external instability if they try to boost growth by printing money. In the case of a flexible inflation targeting country, both money printing for growth against currency stability, and currency depreciation is sanctioned by law.

However legislators may be able to curb the central bank’s room to de-stabilize the external sector with a very tight consumer inflation target of 1 or 2 percent.

Related Sri Lanka legislators should deny high inflation goal independence to the central bank

Is currency depreciation an economic or legal phenomenon?

Currency depreciation is a monetary phenomenon. However, if a pegged central bank is barred by law from targeting interest rates with open market operations (like in Hong Kong or Singapore or Dubai to a great extent) and is compelled to allow short term rates to fluctuate, the currency will not depreciate, money will have a stable value, and economic activities will continue over the long term without currency crises intervening in the middle, interest rates will collapse close to the level of the currency of the country that domestic money is pegged to (the anchor currency).

Whether the rupee falls or not is therefore a matter of law in a manner of speaking, not ‘economic fundamentals’ as claimed by inflationist macro-economists. Blaming economic fundamentals also allow inflationists to transfer the blame away from themselves. As a result, the problem of forex shortages, lack of free trade or imposition of capital controls, does not get solved.

If the parliament permits inflationists to target the call money rates while domestic credit picks up, the currency will depreciate and the ruling regime will become unpopular and be ousted.

Is reserve collection always austerity?

Reserves can be collected by deflationary open market operations and sequencing credit (delaying credit until banks raise deposits) in a stable exchange rate by taking the voluntary savings of the people, like in East Asia. It can be done slowly at relatively low rates, not a shock re-collections like an NIR target.

In East Asia these reserves were recycled back in the form of import demand from the US where the reserves were invested. In effect the US government borrowed from East Asia and triggered imports as Sri Lanka borrows from China and the World Bank or ADB to trigger imports.

Reserves can be built by depreciating the currency and forcibly destroying the purchasing power of the people and lowering their living standards by force like India’s RBI is doing or like Sri Lanka did in the 1980s at the risk of social unrest and nationalism.

This is the preferred method of the IMF after 1980, hence the political instability and social unrest that is associated with countries that frequently go to the IMF after rejecting classical economics as well as East Asia or Dubai or Oman style monetary policy.

However, it is a shame upon all macro-economists that a country with a 20 percent domestic private savings rate cannot build reserves and depreciates the exchange rate with BOP deficits, imposing a regressive inflation tax on the poor. It is perhaps a reflection of the success of Cambridge-Harvard inflationist dogma.

Can reserves be used for imports?

No. That reserves are needed for imports is a myth or a lie repeated by macro-economists in countries with flawed soft-pegged or flexible exchange rates. If reserves are used for imports, the central bank ends up re-financing the private sector through open market operations in the course of fixing the policy rate. Neither floating exchange rate central banks, nor fixed exchange rates (currency boards) give any reserves for either imports or capital repayments.

Because Treasury bills are used for open market operations to mis-target rates, private sector re-finance is then blamed on the budget deficit, one the statistic that claims on government went up.

READ MORE Sri Lanka use of reserves for imports is a deadly false choice: Bellwether

A floating exchange is also very stable and strong. That is why they are called hard currencies.

The IMF’s ARA metrics (Assessing Reserve Adequacy) and the so-called ‘external financing gap’ are also based on false doctrine. If a country is building reserves and is financing the US deficit or is financing the US mortgage market by purchasing agency debt, there cannot be an ‘external financing gap’.

The only ‘gap’ comes from inflationary open market operations to target an output gap. Sri Lanka and IMF-prone countries in general pay a heavy price for these mistaken ideas. (Colombo/Aug14/2023)