ECONOMYNEXT – The tendency of Washington to blame China for the post-2018 sovereign default wave in which Sri Lanka is also caught up in, is a repeat of earlier exercises where Arabs and the ‘East Asia savings glut’ was blamed for US driven policy errors.

In the current dollar area default wave, Argentina, which originally led the Keynesian ideological foundation of a sterilizing central bank which tries – and fails – to neutralize the balance of payments with a fixed policy rate and crashes headlong into currency crises, was in pole position as it defaulted in 2019, as Fed tightened policy in 2018 with an IMF program in place.

The defaults or near defaults of countries like Pakistan with an IMF program in place and continued instability in Bangladesh with a program in place, is a result of worsening anchor conflicts and ‘monetary policy modernization’ advocated by the Fund itself, where unworkable inflation targeting is foisted upon reserve collecting central banks.

Easy Dollars, Bad Money

This should serve as a warning to Sri Lanka’s politicians as policy makers who drove the country into heavy commercial borrowing in the Fed’s easy money period with stimulus to close a supposed output gap undermining domestic stability, presents a deeply flawed monetary law to legalize the policies from 2012 to 2022, which eventually ended in sovereign default.

Under the Bretton Woods period, during what was a tight monetary standard despite its flaws, there were no big commodity bubbles and banking crises compared to what were seen during the post-1971 fiat floating exchange rates. Sovereign defaults were almost non-existent.

Even the notorious Latin American soft-pegs avoided default with having to keep a link to gold. However flawed and imperfect the Bretton Woods was, it was a much tighter monetary standard than positive inflation targeting.

It was also a much tighter standard than the deadly depreciation-on-top-of-positive-inflation-targeting floating rates that were initially advocated as BBC policy (basket-band-crawl) and are now called flexible exchange rates.

When Weimar Germany first went into a debt crisis and US money doctors came to help after World War I, this understanding was partially present and was seen in the Reichsbank reforms of the Dawes Plan. But Keynes through his confused understanding of balance of payments involving the ‘transfer problem’ put paid to this knowledge.

Like domestic banking crises, external sovereign defaults are essentially a problem of the country’s central bank but the initial run up of debt – easy dollars – and the subsequent tightening of monetary policy by the Fed (later ECB as in the case of the last Greek, Portugal and Spanish financial crises) is the key driver.

Sri Lanka also loaded up on sovereign bonds when the going was good and Fed quantitative easing kept the dollar taps open in the run up to the housing bubble and after.

Un-anchored Money

The mass Latin American defaults – as well as troubles in some East European countries like Poland, Romania and Hungary from 1980 in which the IMF was involved – Communist Russia collapsed also – came in the wake of Fed tightening.

The Soviet Union was not a member of the IMF – despite attempts by New Dealer and suspected spy Harry Dexter White, the architect of the Bretton Woods soft-pegs and the IMF – to persuade Stalin.

The tightening under the Fed chief Paul Volcker using a kind of Fisher equation, ended un-anchored monetary policy of the 1970s. Fed’s bad money began in the late 1960s and eventually ended the gold standard in 1971.

In the ensuing ‘Great Inflation’ period, oil prices were high and monetary policy was un-anchored.

An unusually honest IMF working paper explains the problem of the sudden onset sovereign defaults in the 1980s, in this way.

“The early 1970s saw the disintegration of the rules-based Bretton Woods system. In 1971, the U.S. suspended convertibility of the dollar to gold, and by 1973, the system of commonly agreed par values between the major currencies had collapsed,” The 1980s Debt Crisis working paper says.

“In subsequent years, IMF responsibilities changed and expanded. As balance-of-payment imbalances grew, the frequency and size of IMF financing increased. And with fewer rules governing the international monetary system, the IMF’s surveillance role was greatly enhanced. These structural changes meant that when the 1980s Debt Crisis erupted, the IMF found itself at the core of managing the emergency.

“During the 1970s, the risk of sovereign default was not perceived as a major concern. Most “external arrears” generated by a country were created by exchange restrictions. For example, an importer might miss a payment because the authorities were slow to release foreign exchange. Sovereign default had not been a problem since the Second World War.

“Therefore, the IMF’s policy framework was not equipped to confront the complications that arose in the context of the sovereign debt difficulties that emerged in the 1980s. In fact, it took until 1980 for the IMF’s Executive Board even to agree that a default on sovereign debt should also be covered under the external arrears policy…

As the dollar monetary standard dramatically worsened in the 1970s with un-anchored fiat money and commodity prices went up, Middle Eastern oil producers in the GCC area which had currency-board-like monetary authorities, built up foreign reserves and sovereign wealth funds.

Meanwhile oil producing countries with bad central banks like in Iran, collapsed, and nationalists came to power.

However, the monetarily stable countries invested their money in the US. Japan also had a surfeit of reserves after as the dollar collapsed 1971, and its currency began to strengthen, then started buying up US assets.

US and Japanese banks loaned to Latin America, which were basically First World countries with market access, but with bad central banks built by Raoul Presbisch or Robert Triffin.

Some were stable central bank originally built, among others by US money doctor Edwin Walter Kemmerer without a fixed policy rate, but were later corrupted by Triffin or officials sent from the Latin America division of the Fed.

Latin America was kept in check due to the gold standard in the immediate post World War Two period.

The Arabs, Japan and China

In the 1970s Latin America, which were virtually ‘First World’ countries which had originally voted to help the US start the Bretton Woods and IMF, loaded up on cheap commercial debt amid external stresses.

When they later defaulted, Washington pundits tended to blame the Arab petro dollars instead of their own banks, in sharp contrast to what they are doing to China now.

The Washington narrative goes as follows: “Petro-dollars were “recycled” in the form of loans to cover deficits among oil importers. In many cases, oil importers were unwilling or unable to make the necessary adjustments to close these deficits.”

“During the 1970s, two large oil price shocks created current account deficits in many Latin American countries,” goes another – perhaps more honest – narrative. “At the same time, these shocks created current account surpluses among oil-exporting countries.

“Latin American borrowing from US commercial banks and other creditors increased dramatically during the 1970s.

“With the encouragement of the US government, large US money-center banks were willing intermediaries between the two groups, providing the exporting countries with a safe, liquid place for their funds and then lending those funds to Latin America.”

“At the end of 1970, total outstanding debt from all sources totaled only $29 billion, but by the end of 1978, that number had skyrocketed to $159 billion. By 1982, the debt level reached $327 billion.”

No mention is made that it is bad Fed policy that led to the oil shocks. GCC countries collected large reserves as they had good pegs, compared to others like Iran with bad central banks.

No mention is made that Brady Bonds were also issued in the 1980s to Venezuela and Nigeria, which were oil countries with bad central banks.

Similar accusations were leveled against East Asian exporters with good pegs – mainly China – up to the 2008/2009 Housing Bubble collapse as Ben Bernanke misled Alan Greenspan to keep interest rates near zero and ran an 8-year Fed cycle compared to the usual 4, eventually triggering the Great Recession.

US Mercantilists forced China to break the peg in 2005 as the Greenspan-Bernanke housing bubble built up, falsely charging the country of ‘undervaluing’ its currency due the weak understanding of the link between external deficits and domestic policy that is usually found in Harvard-Cambridge economics.

Breaking the peg failed to stop the trade deficit or Asian savings. However it did show China that its forex reserves are not only useless but also a source of losses as the currency appreciated after the Yuan peg was broken.

After the collapse of the Bretton Woods the very same accusations were levelled against the Bank of Japan.

Japan was also forced to appreciate the currency in the 1980s in the false expectation that trade deficits in the US came from Asian ‘undervaluation’. But the strategy, predicably failed to stop the US trade deficits with either Japan or China nor Asian savings.

Dollar liquidity was again plentiful in the aftermath of the collapse of the housing bubble.

At each quantity easing exercise of the Fed and also ECB, China’s foreign reserves also grew.

As China’s foreign reserves also grew, and returns from investing in the US were low, it struck on the apparent brilliant idea of giving Exim Bank loans and building a Mercantilist Belt and Road with state enterprises.

In the 1970s and 1980s Japanese companies bought up US assets. Chinese companies – which were mostly state – were blocked by both the US and EU from buying assets in their countries.

Countries with bad central banks, like Sri Lanka and those in Africa, having got market access in the last decade, borrowed heavily from commercial markets like Lat Am did in the 1970s.

They are defaulting and their currencies are collapsing, after using aggressive open market operations to target inflation or output or both.

One reason for Latin American defaults was the depreciation advocated by basket band crawl policy and REER targeting – now worsened under exchange rate as a first line of defence policy – where errors in mis-targeting interest rates are compensated with more monetary instability instead of automatic rate hikes as in the pre-1971 period.

At each currency crisis after attempting stimulus – or output gap targeting – under flexible inflation targeting, growth stalls and foreign debt becomes bigger. Local debt also expands as an output shock from stabilization policies reduce taxes.

As long as the credit rating earned before fully fledged flexible inflation targeting was acceptable, the countries could borrow commercially as forex shortages emerged from inflationary open market operations.

Sri Lanka will shortly legalize output gap targeting under an IMF program giving a so-called growth mandate to the central bank which was not found in the existing law, on top of flexible inflation targeting, setting the stage for defaults on any re-structured debt.

New Default Wave

The latest Fed tightening comes in the wake of Covid liquidity injections which had fired commodity bubbles just like in the 1970s.

This time in addition to Argentina, a whole host of African countries and Sri Lanka have defaulted, amid ‘monetary policy modernization’ and flexible inflation targeting advocated by the IMF.

The IMF is blaming fiscal metrics, but defaulting countries had a wide range of fiscal metrics involving high revenue ratios and  moderate debt to GDP ratios.

In fact the IMF has now lowered its focus on debt to GDP ratio – in the Bretton Woods period debt ratios were low – and is focusing on the Gross Financing Needs as countries with lower levels of debt but big volumes of bullet repayment bonds default.

As currencies collapse under flexible inflation targeting and forex shortages emerge, foreign borrowings go up – as long as market access is there – and growth stalls under stabilization policies.

Debt and revenue metrics then progressively worsen with each flexible exchagne rate/soft peg collapse.

In Ghana, Suriname and Zambia, which have defaulted recently, fiscal metrics rapidly worsened under ‘first line of defence; style collapsing exchange rates and inflation targeting with a peg. Zambia and Ghana are also oil producers.

In Sri Lanka and Pakistan the picture is the same.

Sri Lanka also cut taxes to target an output gap, which is to be legalized in the controversial new monetary law.

China and Cambodia

China was wrong to lend excessively to Sri Lanka and other barely market access countries amid the excess dollar liquidity.

ISB holders and China – like the US and Japanese banks in the 1970s – made the same mistake.

In the early 1980s, the IMF did not favour debt re-structuring. Re-structuring found favour after the Brady Plan and IMF followed.

At first, the IMF was trying to make sure that US banks were paid. As a result the IMF was accused of being a ‘handmaiden of commercial banks’ by some.

“When the Brady Plan was introduced in March 1989, the IMF reacted quickly to support it and to play a key role in implementing it,” says another frank IMF working paper, The IMF and the Latin American Debt Crisis: Seven Common Criticisms.

“For three years or so preceding that development, however, a variety of debt-relief proposals were floated by advocates including Bill Bradley, Peter Kenen, and Felix Rohatyn. During that period, the IMF kept a low profile on the issue, and a general perception arose that the institution was opposed, or at best indifferent.

“As the leaders of major industrial countries proposed various debt-relief schemes in 1987 and 1988, the IMF responded positively; when the Brady plan culminated this process in March 1989, the Fund acted immediately to implement it.”
Now policy has come a full circle and domestic debt is also re-structured – a type of debt sustainability driven default – triggering a host of new problems including high interest rate and banking problems.
Whatever the debt relief offered however will not help countries with bad ‘impossible trinity’ central banks as shown by Argentina, several other Latin American countries and Poland in the 1980s.

One country that China loaned money heavily was Cambodia.

Cambodia had one of the worst central banks in the world. Monetary instability in the Indo China area brought Polpot to power.

French Indochina got independence in the immediate post-War era and like Sri Lanka and Korea were victims of Keynesian central banks, sometime built with US help.’

The petrodollar Gulf countries and the Maldives escaped as their monetary authorities were built by British non-Keynesians at a time when problems of the soft-pegged central banks were already seen in the 1960s.

In Cambodia, Polpot abolished money.

A new central bank did not do any better. In 1998 and 1999 Cambodia’s Riel collapsed to around 4,000 and the country dollarized.

It now has parallel currencies with the Riel and the Dollar used alongside.

With no central bank to create high inflation and high interest rates after failed output gap targeting, the country is growing steadily.

With no central bank to print money debt to roll-over debt, trigger forex shortages, depreciation which then lead to collapses in consumption, investment and economic output as happens to flexible inflation targeting countries and spikes in debt to GDP ratios, its fiscal metrics are better.

Half of Cambodia’s foreign debt is from China.

Cambodia’s politicians and bureaucrats are not particularly brilliant. But its central bank cannot engage in active monetary policy and bring down the politicians.

As a result, even if China gave bad loans, the country is stable compared to neighbours like Laos. And stability will help the country grow. Compared to Ecuador where ISB holders hit an own goal by discounting their own bonds, Cambodia has bilateral debt.

Dollarization has the same effect as a currency board. Similar good metrics are also seen in Hong Kong, which has a currency board, Latvia, Estonia and Bulgaria. In Ecuador, ISB holders essentially hit an ‘own goal’ by discounting their bonds and making it impossible to roll-over maturing debt.

Cambodia could be a Lebanon if ‘monetary policy’ succeeds

There are efforts to de-dollarize Cambodia and get monetary policy to work. If the IMF succeeds, Cambodia will be turned into a basket case like Sri Lanka and neighboring Laos.

Or more likely with heavy deposit dollarization Cambodia may become a Lebanon if IMF and domestic efforts to de-dollarize succeeds. Cambodia’s has almost exclusively foreign debt, but a Riel domestic market is now starting.

Vietnam has been assiduously resisting IMF flexible monetary and exchange rate policies and has so far managed to avoid a standing liquidity facility advocated by the Fund which will drive overtrading in banks and make currency crises easier.

Fiscal rules are unnecessary if there is a tight monetary standard. The surfeit of macro-prudential rules advocated now is an admission that money is bad and mal-investments are taking place.

If the monetary standard is tight micro-prudential rules are more than enough as there is less room for system wide banking crises that are now seen under positive inflation targeting.

Inflation is multi-faceted, prices are one side

Inflation of money supply has several consequences as understood by classical economists.

Inflation is not just a statistical general rise in price levels that begins 18 months after inflationary policy begins as claimed by Western Mercantilists.

Under inflationary monetary policy, forex shortages emerge quickly – as quickly as six weeks – if there is a pegged exchange rate, long before any statistical consumer price rises are seen.

Then comes mal-investments which drive asset price bubbles and eventually bad loans due to standing lending facility or open market operations money after the suppressed rates normalize. Stock bubbles may come as early as 9 to 12 months from inflationary OMO.

Chinese lending, Latin American borrowings are mal-investments and consequences of inflationary policy.

Exim Bank of China and China Development Bank and ISB holders are in the same boat as US and Japanese commercial banks were in the 1980s.

The inability to make external payments and sovereign default is also a consequence of inflationary policy in countries with bad money.

Domestic inflation may take up to a year or year and a half to develop, rate hikes can be delayed, as long as the central bank ignores the forex shortages and keeps policy rates down on the claim that inflation is low.

If default waves take place in multiple countries in the dollar pegged area, while the immediate responsibility is on the soft-pegged central bank, the inflationary policy of the anchor currency, in this case the Fed, is also a key driver.

The proximate cause of the current external troubles of most of the African and South Asian countries comes from Covid re-finance – sanctioned by the IMF for the most part – and more damagingly the rate cuts that were made as private credit recovered from the pandemic in 2021.

In the first place, Covid should have been dealt with as a fiscal response, not a monetary one. Second, even if monetary loosening did take place, policy should have been tightened immediately as credit recovered in 2021.

Instead the opposite was done, including in Bangladesh. Blaming the Fed alone for bad policy is a cop-out.

The ultimate responsibility lies with the economists of the country, who support bad monetary policy and applaud flawed monetary laws.

Politicians, if they want to avoid holding the baby and repeated defaults, must control the economists in the reserve collecting central bank by taking away their powers to print money through discretionary and flexible policies or close the money creating state enterprise down.

IMF can help stabilize a country after a crisis is created but it cannot stop the next crisis. The IMF through its flexible policies and flawed monetary regimes will lay the seeds for the next crises. That is why IMF countries are repeat customers.

(Corrections: Cambodia’s politicians and bureaucrats are not particularly brilliant/multiple typos).