ECONOMYNEXT – Sri Lanka can cut policy rates now as private credit is negative, but should be prepared to allow interbank rates to go up as the economy recovers, to avoid economic reforms being discredited and the public from being pushed into poverty through monetary instability.

A slide in the currency will push up energy and food prices, denying monetary stability to the poor, make it difficult to run energy utilities, and lead to calls for subsidies as well as loss of investor confidence and capital flight.

Reformist governments are time and again ousted under International Monetary Programs and market economies are discredited due to monetary instability which come from anchor conflicts that worsened from the 1980s.

Denying monetary stability to a country through soft—pegging, or flexible exchange rates and covering them up with import and exchange controls have been the main plank of Sri Lanka’s economic policy frameworks in the post-independence era.

Such policies were rejected by Japan in the immediate post World War II era, China and Vietnam after its economy imploded in the 1980s, and were never followed by countries like Singapore or Malaysia.

There is no future in denying monetary stability to the people.

Sri Lanka’s central bank in recent months have been following good monetary policy with a slight hiccup in exchange rate policy up to now, allowing public confidence in reforms to build up as they did in the UK after 1979.

Can Sri Lanka cut rates now?

Yes. All rates should be cut this year. After private credit starts to pick up rate cuts should be avoided. Instead, short term rates should be allowed to go up temporarily as and when required.

How can the central bank avoid mis-targeting rates as in the past?

The best way is to cut the policy floor steeply and avoid cutting the reverse repo rate at the same pace. That way the policy corridor will be wide and rates will naturally fall towards the lower policy corridor as long as long as credit is moderate. This has happened in the wake of a successful float and re-pegging in past currency crises.

However, for that to work, some excess liquidity has to be allowed to be built up from dollar purchases. Then a part of the liquidity from dollar purchases has to be mopped up by outright sales of central bank held treasury securities.

As long as a part of the liquidity from dollar inflows are mopped up, the balance of payments would be in surplus.

But if there are temporary increases in credit and import or capital outflows, the central bank has to sell dollars.

If not, panic will set in the market as happened last month when the exchange rate went up violently from 290 to 320 due the lack of a consistent exchange rate policy.

The central bank was able to intervene minimally since the underlying monetary policy was deflationary and there was a BOP surplus due to sell-downs of central bank held securities.

But if underlying credit conditions are strong, rates have to go up with interventions. If not th

A wide policy corridor of about 5 percent or more is useful. A higher reverse repo rate will raise the costs of over-trading banks. Vietnam is now following a similar policy after putting the brakes on credit to stabilize the currency.

Since the central bank has been given a reserve target by the IMF, pegging cannot be avoided. The most-simple rule to avoid mis-targeting rates, and going for a second default, is to allow rates to go up if BOP deficits emerge.

Depreciating the currency and destroying purchasing power of the poor and trying to collect reserves have to be avoided. East Asian countries collected saving that people had already set aside at a fixed exchange rate.

The central bank is keeping the market short now. Isn’t that a better policy?

The central bank is now selling Treasury bills in fixed amounts. If dealers or banks buy them with window money or running reserve shorts, a liquidity shortage develops.

This shortage is then filled with term and overnight reverse repo injections. This action disturbs rupee reserves in individual banks and encourages banks to overtrade and trigger forex shortages later.

It may also prevent rates from falling faster, naturally. However it has worked so far.

The best course of action is to wean banks away from liquidity facilities and encourage them to follow the prudent practice of giving loans or buying securities only with deposits as is done in all successful East Asian countries with stable or absolutely fixed exchange rates.

The central bank should consider rolling-over its holdings and sell down marginal amounts at auctions.  Encouraging primary dealers or banks to borrow from central bank tools for anything other than overnight is not prudent.

At the moment complex open market operations are being done both ways, which can easily backfire as credit picks up.

What about longer term money?

Longer term money should not be given at the overnight policy rate. Longer term money should be given at a slightly higher rate, above the deposit rates, especially after credit picks up.

After credit picks up, injections should be avoided. If not, reserve targets will be missed, the currency will fall or both.

Did the IMF always deny monetary stability through depreciation?

No. The IMF was set up to maintain stable exchange rates in the post-World War II era. It gave stand-by facilities and advocated policies to minimize exchange rate depreciation while allowing some deviation from the original Bretton Woods rates when currencies were pressured from fixed policy rates or active macro-economic policy.

But the system was based on a flawed understanding of credit systems that developed in the 1920s primarily among Anglofone academics.

The Bretton Woods was set up after currencies started devaluing in the 1930s (went off the gold standard) mostly due to the fixed policy rate and it led to an epidemic of protectionism.

Under the Bretton Wood regime there were two independent but complementary anchors in the form of gold and the US dollar to work with. Until 1971 inflation and interest rates were in the single digits or low single digits.

After the collapse of the Bretton Woods in 1971 due to the rise of macro-economic policy (read non-market fixed policy rate) in the 1960s, the Western central bankers started to play around with money supply targeting.

Money supply targeting was relatively successful as long as there was a clean float and essentially helped end the Great Inflation of the 1970s that came from fiat currencies.

Positive Inflation targeting which emerged in the 1990s turned out to be easier to operate in practice than money supply targeting, but was a weaker standard than the targeting gold at zero.

Countries that tried money supply targeting while trying to collect forex reserves (without a floating exchange rate) ended up with forex shortages and depreciating currencies and high inflation as domestic and external anchors conflicted.

The UK also had similar problems in the 1970s – including within IMF programs – leading to wide public discontent and strikes.

The IMF is now promoting inflation targeting without a floating exchange rate leading to similar anchor conflicts as money supply targeting without a floating rate did before 1990s

Dual anchor conflicting regimes lead to the same consequences  – forex shortages and currency depreciation. Steep depreciation in the wake of liability dollarization will lead to a sovereign default.

Sri Lanka’s central bank has done well to allow the currency to appreciate, leading to wide public contentment as they see the early benefits of monetary stability flowing into their lives. The falling energy prices under Thatcher-Howe monetary reforms were similar.

The so-called Washington consensus failed because monetary stability was out of the reform frameworks.

If the currency starts to slide as in previous failed IMF programs due to the fixed policy rate as central banks went off the gold standard in the 1930s, and the collapse of the Bretton Woods later, the opposite will happen.

The situation in Surinam and some other countries including Pakistan and Bangladesh should be a lesson.

What about the flexible exchange rate?

The flexible exchange which is not a clean float but a flawed regime, is not backed by a  consistent set of policies.

Flexible exchange rates and flexible inflation targeting try to defy the law of nature discovered and described by classical economists like David Ricardo, David Hume and more recently by Robert Mundell and Marcus Fleming among others.

What was seen in the last month was that despite relatively good monetary policy, the rupee fell steeply. The resulting public reaction showed how easily people will lose faith in the IMF program and reformist administrations.

The central bank is nothing but an bank that collects dollars from the domestic economy and invests or lends them to the US via its reserves. As said before it is best to collect the savings people had set aside than destroying their purchasing power by depreciation.

Single anchor regimes, whether fixed or floating, leads to low single digit interest rates and low debt to GDP ratios. (Colombo/July05/2023)