Sri Lanka is recovering, Central Bank threat looms
Sri Lanka is on a recovery path, and this is the time when commercial bank credit picks up, the Central Bank cuts rates and pushes the country into balance of payments trouble.
A serious added threat to stability could come from rupee debt operations of ‘liability management’ if the operations significantly disrupt the domestic monetary system or debt repayments are refinanced by newly created Central Bank money.
Concerns have already been raised about a so-called ‘buffer’ operation in April involving borrowing from the banking system, which could have contributed to the rupee collapsing after the Sinhala and Tamil New Year. It is ironic that the current administration, instead of raising money through bonds and avoiding bank borrowings, is resorting to bank borrowings to repay bonds. There seems to be a strong recovery in credit, with an unusually high Rs122 billion burst of loans in March 2018. The Central Bank said the loans were broad-based, and spread around sectors without any particular concentration. The unusual loan burst could be a result of money printing in March (Central Bank credit expanded Rs36 billion in March).
There are also other signs of an economic recovery. Consumer goods imports are picking up. That means individuals, whose incomes have been destroyed by the currency depreciation and inflation of 2015 and 2016, are now starting to pick up the pieces of their lives with salary increments later. Unfortunately for the long-suffering people of this country, the rupee was forcibly depreciated in 2017 as well. However, despite all the knockout blows delivered by the Central Bank, people are now getting up again.
As the currency collapsed and credit slowed, consumer goods imports fell, including food. After being in negative territory, imports were flat until the end of the fourth quarter of 2017. Then, it has started to pick up. Car imports (grey line) are seeing the biggest pick up, after a tax cut, but there is also a pick up in food and other items. The sharp pick up in food imports in the first quarter of 2017 was due to a drought. Imports are a reflection of domestic economic activity. Even in the case of cars, people who buy new cars will sell their old ones. Vehicles are an important source of tax, not just in terms of duties but also fuel and taxes. The activity is driven by an underlying pick up in credit. The blue area in the credit trend graphic represents private credit.
A look at credit trends shows that Central Bank credit (printed money) had also increased in March. A pick up in money printing means that the Central Bank will not be able to buy as many dollars this year as it did in 2017. Net credit to the government (printed money) given by the Central Bank fell from Rs410 billion in June 2017 to Rs210 billion in November 2017. Since then, it has climbed to Rs232 billion in January 2018, fell briefly to Rs225 billion in February and climbed back to Rs261 billion in March.
In January, the Central Bank collected $191 million from the interbank market. In February, it fell to $77 million, and was $98 million in March. In April, there was $77 million of purchases and $1 million in sales for the first time since credit started to decline and Central Bank credit contracted. In May, following a sharp expansion in printed money in April (the data is not in the graphic), about $130 million had to be sold to mop up excess liquidity, the Central Bank said.
Questions have already been raised whether the forex problem in April was compounded by bank borrowings to repay a maturing bond auction in April. The Central Bank has said it used an overdraft from the Bank of Ceylon to repay the bonds. If overdrafts are used to repay bonds, and borrowing is financed with the Central Bank’s liquidity windows, there is a shock to the monetary system. When ex-bondholders are repaid and their bids rejected, cash is given to them. This cash is then deposited in the bank of the bondholder, which may or may not be Bank of Ceylon (BoC). Since there is already a tax advantage in going to banks, he/she may negotiate a fixed deposit.
The ex-bondholder’s bank will now lend this printed money, while the Bank of Ceylon covers its short cash position with reverse repo money.
So what was in BoC’s statutory reserve is now money in the hands of a borrower in the ex-bondholder’s bank, which is buying up goods and services including imports, while a cash deficit (in name) exists in the state bank. This is the result of turning paper (bond securities) into Central Bank money. It is also the difference between Keynesian aggregate ‘macroeconomics’ and human action of actual individuals in the real micro economy.
THE WEIMAR REPUBLIC FACTOR
This column has previously explained that any money printed to repay domestic debt will create a net outflow of dollars, and Sri Lanka will not be able to service its foreign debt as well. This is an important point that people and mercantilists in soft-pegged countries do not understand.
This column warned of this last year (Sri Lanka’s Weimar Republic factor is inviting dollar sovereign default: Bellwether) when the Treasury appeared to be pressuring the Central Bank to repay domestic debt with printed money. What happened in April is a practical demonstration of that Weimar Republic phenomenon.
It was not war reparations that led to the collapse of the Reichmark in the 1920s, but the money printing of the Reichsbank. Keynes never really understood this phenomenon. Essentially, repaying foreign debt involves raising domestic resources. If there is a large volume of foreign debt to be repaid, resources must be raised either from the domestic economy (which will lead to a contraction of the current account deficit) or through foreign borrowings. Resorting to Central Bank money to repay bonds is a threat to the economy and the lives of small people in the country. The only difficultly in rolling over ‘bunched up’ debt is a higher interest rate. If authorities are unhappy with the rate, they have to roll over for shorter tenors, not printed money. The best option is reverse auctions, but that will have to be left for another column.
It means that the Central Bank will not be able to collect the same amount of foreign reserves from the market as it did in 2017 because domestic credit is now stronger. It does not mean that a BOP crisis will necessarily be generated. But the Central Bank’s forecasts on current account deficits and foreign reserve targets will fail, especially if there is a rate cut.
The increase in fuel prices will be a stabilizing factor. It will help keep interest rates and non-oil imports down, provided no new money is printed. Sri Lanka’s interest rates started to fall in the second half of 2017 as credit slowed. That was the ‘rate cut.’The minimum overnight repurchase rate fell from around 8.70% to 7.40%, towards the 7.2% policy rate floor. The wide policy corridor allowed rates to fall without upsetting the International Monetary Fund. It must be noted that IMF officials do not know the vagaries of different central banks that exist in different countries.
Their mandate is to keep soft-pegs going. And in any case, the IMF must get back the bailout loan it gave Sri Lanka, so reserves must be collected. The time for rate cuts was the second quarter of 2017. But despite the lack of an official rate cut, overnight rates fell. This may have allowed a quick recovery in the economy. It shows the usefulness of having a wide policy band.
If there is a peg, the Central Bank cannot cut rates when the inflation index falls. Rates can only be cut when credit slows. A look at domestic and foreign assets growth in Sri Lanka’s Central Bank clearly shows that it is, in fact, operating a soft-peg of extreme instability. A strong positive growth in the red line (the Central Bank’s domestic assets or the accumulating results of its money printing activities) shows a developing balance of payments crisis. This is accompanied by negative growth of foreign reserves (blue line). No central bank should attempt inflation targeting by targeting interest rates if it wants to grow the blue line (grow foreign reserves).
The relatively quick BOP crises seen in the last decade was not a result of holding the currency and preventing its depreciation. The currency fell in 2015 because the Central bank printed money, releasing liquidity and cutting rates, thinking that inflation was very low, even as the US Dollar appreciated. Inflation was not rising because the exchange rate was fixed. Inflation came pretty soon as the peg broke in the third quarter of 2015. What this graph shows is that Sri Lanka is unquestionably running a peg. Therefore, it cannot afford to run an interest policy that is in conflict with the peg.
The economy has no ‘memory’ to remember that the peg has been held for two or three years and keep count of an ‘overvalued’ exchanger rate. It also has no ‘memory’ to remember that the exchange rate is now undervalued based on some inflation and currency movement of some other central banks. As soon as money is printed, the peg will break and the currency will fall.
The current ‘undervaluation’ of the Malaysian Ringgit will not prevent a further fall. Neither will the 100 REER index of the Sri Lankan rupee. The Malaysian currency fell steeply when the US dollar appreciated as oil prices fell, as it kept interest rates steady and intervened heavily. This column noted at the time that the steep fall was making life difficult for people and bringing them to the street. Although the exchange rate appreciated somewhat in 2017 (not as much as the Singapore Dollar), it was too little too late. Najib Razak is out. It must be noted that the political stability of the best-performing East Asian nations came with currency stability or outright currency boards. A good central bank or a currency board that does not depreciate permanently will eliminate the ‘cost of living’ from the political equation. Now the pain of the currency depreciation in the last two years is being felt anew as oil prices rise. You can see how Singapore keeps people calm. They have superior monetary policy.
In 2015, when this administration came, the Saudi Aramco contract price for butane, one of two ingredients that make up liquefied petroleum gas, was $470 a tonne. Coincidentally, it was the same in April 2018. The rupee price of a tonne of propane was Rs62,000 in January 2015. It was about Rs74,000 in April 2018. In contrast, the Singapore Dollar price fell from $628 a tonne to about $618. Currencies of other inflation targeting countries can also appreciate, neutralizing the high prices that comes when the US Dollar floats down.
But no country conducts explicitly exchange rate-based policy like Singapore. It is difficult to gauge how the US Dollar floats. But a somewhat imperfect representation of the movement can be found by tracking the so-called Dollar index. The Singapore dollar is another good proxy for the US Dollar, since the country conducts explicitly exchange rate-based policy, which responds faster than an orthodox floating rate arrangement.
It is no accident that both graphs look remarkably similar. The 5-year oil price graph, on the other hand, goes in opposite directions. This is not a statistical analysis, and oil prices are also driven by other factors including supply, demand and political uncertainty.
However, broadly, a tightening of policy in a floating exchange rate regime is followed by an appreciation of the currency (against the dollar and traded commodities) with some delay.
Sri Lanka is running a peg with the rupee falling forever. If Sri Lanka was running ‘a flexible exchange’ rate, in truth, the rupee would have strengthened when the dollar weakened in 2017.
On the other hand, if rates are cut based on the premise that inflation is low, like in 2015 and in 2011, the credit system will move towards another balance of payments crisis in 2018.
Since Sri Lanka’s rupee is a softpeg with restrictions on capital movements, nominal interest rates have to be higher than the rest of the world. Since the rupee is permanently depreciating, it has to have higher nominal rates than currencies that are stronger even when foreigners are allowed to buy debt. Allowing rates to move in line with credit demand will not necessarily bring economic growth to a halt. The US has been steadily raising rates. It is still growing. In the last few quarters growth has been slow due to the credit contraction that occurs when forex reserves are rebuilt.
When money was printed and reserves were run down, economic activity also picked up. It can be seen happening both in the 2011/2012 BOP crisis and in the 2015/2016 one.
The nature of a pegged exchange rate is that, whatever said and done, the balance of payments determines the monetary base and interest rates. Whenever the Central Bank resists this pressure, all hell breaks loose. If money is printed to keep rates down (and prevent the monetary base from contracting, as credit and imports pick up), there will be a brief period of ‘growth’ as forex reserves are run down in a BOP crisis.
Later, when foreign reserves are collected (see blue line) and interest rates are kept artificially high with the floor policy rate, credit will contract, and so will economic activity. Inflation will also catch up, further slowing ‘growth,’ which is what happened in the last couple of quarters. Sri Lanka’s credit system now seems to be recovering, about 18 months after the peak of the last BOP crisis. It took about 26 months for credit to recover after the 2011/2012 BOP crisis. Whether this is happening due to the quick ‘rate cut’ owing to the wide policy corridor or due to rains that boosted agricultureremains to be seen. It may also be that the recent currency fall can kill the recovery as its effects hit consumers again. The problem from the Philippines to Sri Lanka is that economic theories and procedures developed by floating currency central banks are applied to what is clearly a very unstable pegged regime. Its results have been and will be dire, especially if the US continues to raise rates. Down that road lies more political and economic instability.