Narrower inflation target needed to stop stagflation, BOP crises: Bellwether


Sri Lanka is now in a quagmire of stagflation, with inflation at 7% and growth at 4% due to policy errors before and after the 2015/2016 balance of payments crisis. Usually, following a balance of payments crisis, inflation rises as the currency collapses, and then it tends to fall, partly helped by a re-appreciating exchange rate, although growth will also fall.

This time, however, while paying lip service to a flexible exchange rate, the Central Bank has bought $1.7 billion and resisted upward pressure on the exchange rate, which comes when credit weakens and liquidity is withdrawn from money markets. Amusingly, all this has been blamed on coconuts. The currency has been depreciated to target a real effective exchange rate index.

The 2015/2016 Yahapalanaya BOP crisis has provided important lessons. Sri Lanka’s recent balance of payments crises were mostly tied to rising oil prices, which were then subsidised with printed money. Electricity is also subsidised either via the petroleum utility or directly by the electric utility. This was the case in the 1999/2000 crises (Brent crude rose from around $10 a barrel in January 1999 to $26 by December 1999). The rupee collapsed, the government changed. Then, under the UNP-led administration, and with the Central Bank, under Governor A S Jayewardene, inflation fell to almost zero despite rising oil prices helped by an appreciating exchange rate and a fuel price formula.

Then, in 2004, as money was printed to subsidise oil and with Wimal Weerawansa asking for the World Bank plug to be removed (price formula), inflation rocketed and the rupee fell. From December 2003, there was a credit collapse after the tsunami, the rupee stabilised and a BOP crisis was avoided.

In 2008, Sri Lanka ran into another crisis as oil was subsidised and Brent crude shot up to $137 a barrel in the last gasp of the ‘mother of all liquidity bubbles’ fired by the US Fed. Brent crude, which was about $58 in February 2007 rose to $138 by June 2008. The 2011/2012 crisis was also connected to rising oil prices and a drought, which pushed up thermal generation. Brent crude rose from about $78 a barrel in September 2010 to $126 by May, with the drought pushing up oil imports further.

In 2011, the Central Bank cut rates despite rocketing credit growth driven by borrowings from petroleum and power utilities. The 2015/2016 Yahapalanaya crisis was unique in that oil prices were collapsing in that period. It was purely driven by money printed to accommodate a runaway budget and unchecked liquidity releases. This helped conclusively show that a 70-year-old, widely accepted Mercantilist myth that oil imports caused BOP crises in Sri Lanka was completely false. In fact, it is amusing to note that even the International Monetary Fund was saying in early 2015 that low oil prices would help the balance of payments. So did Fitch Ratings, showing that Mercantilist thinking is widespread.,_budget_by_Fitch;__BB___rating_confirmed-3-1598.html

In fact, oil prices have no effect on the balance of payments. If oil prices fall, non-oil imports will go up, as people divert spending to other goods (or save more, which is then loaned to others as credit by banks).

If oil prices go up and retail prices are also raised – absent subsidies and money printing – non-oil imports will fall. If oil retail prices are kept down, and money is printed, non-oil imports will continue unchecked or grow, while oil imports will also grow with printed money, generating a BOP crisis.

Like in 2011, there was a rate cut in April 2015 as private credit raged and the budget went off the rails. The Central Bank released Rs630 billion of liquidity and lost $4 billion of forex reserves in the crisis. In Sri Lanka, with foreigners now owning bonds, capital flight also starts as soon as the credibility of the soft dollar peg is undermined by the Central Bank, making for faster draw downs on foreign reserves. When rates are cut, foreign investors will also get profits if they cut and run. The four billion dollar question is, why did the Central Bank cut rates?

The recently released bond scam report presents a clue. To digress, the bond scam report shows that senior officials are remarkably, if not hilariously, clueless about what goes on in different areas of the country and the activities of other departments. Some officials are also astonishingly clueless about their own departments. How people can be so clueless is a mystery. But, it also shows why market participants are able to run rings around some of these officials.

To get back to monetary policy, the testimony of key officials to the Bond Commission is revealing in terms of the thinking and how the BOP crisis was created in the first place. It shows that fiscal dominance (pressure from the Treasury to print money) is not the reason for the BOP crisis and high inflation. Nandalal Weerasinghe, Deputy
Central Bank Governor and a senior hand in charge of monetary policy, was of the view that there was no need for rates to rise in February 2015.

“The witness stated that there was no reason to guide interest rates up. He stated that, if there is a need to guide the interest rates upwards or downwards, it should be done gradually, within the policy corridor,” the commission report said.

“In answer to a question from the Commission, the witness stated that the board paper submitted to the Monetary Board on 23rd February 2015 had no recommendation to guide interest rates upwards, and even in the event of being decided that interest rates should be guided upwards, it should have advocated the policy of gradualism.

A sudden shock to interest rates will create implications to the economy. The board paper suggested in February that that a 5% lower floor policy rate be removed, but that a 6.5% rate be cut to 6%. It was not done by the Monetary Board on that day, but a couple of days later, Governor Mahendran lifted the rate without going to the monetary board, eventually leading to the bond scam scandal. That Sri Lanka was heading into a BOP crisis was evident from late 2014 to outside analysts, provided that the Central Bank did not raise rates. And the Central Bank’s missteps were forecasted and chronicled both by this columnist and other reporters (as some of these headlines show: see page 32).

The April 2015 disastrous rate cut was followed by more liquidity releases, like some strategic carpet bombing of the banking system, putting Ben Bernanke’s helicopter drops to shame. After mumbling about many things for more than a year, the Central Bank finally raised rates by a measly 50 basis points in February 2016, after the horse has bolted, so to speak. In fact, the rupee was also floated in mid-2015 without a rate hike, in a remarkable turn of events.

The targeting of a core inflation index by the Central Bank may also have contributed to the latest crisis. In early 2015, Sri Lanka’s ‘core inflation’, a misleading inflation measure where many items such as oil and food are taken off, was low. Core inflation is particularly dangerous over short periods. Even Former Deputy Governor W A Wijewardene, a definite inflation hawk, told the Commission that he did not see a need to raise rates in February 2015 as core inflation was low.

Core inflation was indeed low.

In fact, a 2006 base index showed that core inflation was 2.1 % in January 2015, and fell to 0.8% in February. At the time, headline inflation was 3.2% in January and 0.6% in February, with the 2015 budget having cut fuel and other commodity prices. In ordinary times, a core index tends to show lower levels of inflation when the Fed fires commodity bubbles send oil and food commodity (and base and precious metals) prices up.

In Sri Lanka, after the CCPI index was revised later, the February 2015 core inflation (as well as headline inflation) showed a higher number, which was constantly rising. The question to ask is, would the Central Bank have raised rates earlier if the 2013 base core inflation index was used? The answer is, probably not. All this shows that Sri Lanka cannot even construct a useful inflation index, and using the existing indices are likely to drive the country into a BOP crisis; and then, high inflation after the currency collapses. Core inflation indices are misleading to use in any monetary regime. The US Fed, for example, targeted core inflation while commodity prices soared, generating the Great Recession. In a country with a managed exchange rate (softpeg), targeting a core inflation index is suicidal.

In fact, Ben Bernanke is a great proponent of another whopper: that so-called ‘supply shocks’ cannot be countered by monetary policy. Governor Indrajit Coomaraswamy, without doubt a highly capable and outstandingly honest person, has also fallen for this. He has blamed coconuts for 2017 inflation. No economist or Mercantilist of any repute has claimed that a part of inflation is caused by cost-push and the rest by demand. Mercantilists James Stuart and John Law onwards claimed that all inflation was caused by cost factors. They argued that money supply had little to do with it. Of course claims that ‘money supply has little to do with inflation’ are again creeping into the discourse as linear statistical relationships between chosen money supply variables and inflation become harder to find. Money supply, classical Mercantilists argued, adjusted to price increases, not the other way around.

Bernanke’s duplicity on supply shocks is easily revealed. While claiming that supply shocks cannot be contained by monetary policy, he and Greenspan conveniently printed more money amid productivity gains from technological developments, and muted commodity prices from 2000 onwards, helping create the mother of all liquidity bubbles and the Great Recession.

In other words, these central bankers are quite willing to print money with loose policy to create more inflation in the face of a ‘positive supply shock’. But, they are remarkably unwilling to counter a ‘negative supply’ shock with tight policy. It is through such deceptions that central banking is kept on. In any case, the price increase of one or two goods cannot cause the general price level to increase over any significant length of time, unless there is monetary accommodation. In general, large increases in the price of one or two goods will leave people with less money to spend on other goods.

If one accepts that a central bank can only contain core inflation and not the inflation that everyone feels (headline inflation), then inflation targeting should be abandoned altogether.

That is why the inventors of inflation targeting deliberately set a real inflation target in the form of so-called headline inflation, instead of an imaginary one like core inflation.

Another deception long practised by central bankers is to try to minimise the effects of depreciation.

When a currency falls, from say 100/$ to 200/$ for example, the price of exported and imported goods will double. If tea was priced in the export market at $2 a kilo (Rs200), before depreciation, and sugar at Rs50 a kilo, after depreciation, tea will go up to Rs400 in a short time. A kilo of sugar will double to Rs100 immediately. Eventually, price increases of traded goods will be passed on to non-traded goods and services, subject to any productivity improvements. Any currency appreciation can reverse the effects as well.

Although the price of the dollar has inflated 100% in rupees, just like the price of sugar inflated 100%, depreciation is calculated in such a way as to say it was only 50% (i.e the value of the rupee has halved compared to the dollar). If the rupee falls to 10,000 to the US dollar, the depreciation is calculated as 99% only. At 20,000 to the dollar, it is the same.

For example, from December 2014 to December 2017, the rupee fell from 131 to the US dollar to 152.8 to the US dollar, which is a rupee/dollar inflation of 16.6%. The December 2014 date is a pretty good date to start since the rupee has been stable for a long time prior to that and it can be assumed that most or all of the effects of the 2012 currency collapse had been dissipated by that time.

The CCPI (revised again) went up from 105 to 122.9 or 17.05%. In a hilarious development, the core inflation index went up from 106.1 to 124.9 points or 17.72%, which is higher than the increase in headline inflation. So what does that mean? The central bank is responsible for all the headline inflation and then some?

In a pegged exchange rate, total inflation that is created is the domestic inflation (from currency depreciation and demand pressure) plus the inflation created by the anchor central bank, in Sri Lanka’s case, the Fed. It is true that domestic demand pressure is now down. With dollar purchases being sterilised, the Central Bank cannot create any demand pressure per se. In fact, listed companies are seeing a narrowing of margins and gross profits, which shows that demand pressure is not there. However, inflation is still being created by currency depreciation by the Central Bank, and by the Fed. This currency depreciation, in a bid to target a Real Effective Exchange Rate (REER) index, can create full-blown stagflation and delay a recovery in credit as domestic purchasing power is destroyed.

Whatever pegged central bankers say, they cannot escape a self-evident reality. Whether the currency is defended to prevent it from weakening or to prevent it from going up, (like now), it is a peg. As a result – whether they like it or not – domestic money supply is going to be determined by the balance of payments.

When credit growth goes up, if the Central Bank resists interest rate hikes by printing money, a BOP crisis will develop due to the misalignment of the money supply with the balance of payments. This is why stable financial centres raise their policy rates when the US raises rates. In other words, if liquidity is released (money is printed) when credit demand goes up to resist rate rises in a peg, a BOP crisis is the result. This column has previously pointed out that, in March 2016, policy suddenly improved as excess liquidity was allowed to run and 100 plus sterilisation stopped. Until then, the Central Bank’s domestic operations department was injecting cash through reverse repo auctions and outright purchases, at volumes exceeding outflows, rapidly making the BOP crisis worse. The bond scam report shows that it was actually Arjuna Mahendran who gave the order to stop it.

“On or about 3rd March 2016, Mr. Mahendran had telephoned Mr. Rodrigo (head of domestic operations) and instructed him that the conduct of reverse repo auctions should be immediately stopped, so as to stop the injection of liquidity into the market through Open Market Operations.”

In this connection, Mr. Rodrigo said that the “Governor telephoned me in the morning, and said to immediately stop conducting of reverse repo auctions.”

When the Commission of Inquiry asked the witness why Mr. Mahendran had issued such instructions, he said, that Mr. Mahendran had mentioned that the CBSL had earlier increased the Statutory Reserve Requirement in an effort to reduce liquidity and that the intention of the CBSL was to “drain liquidity”.

Mr. Mahendran had said that, in this background, liquidity should not be injected into the market by CBSL and that the CBSL wanted interest rates to move up. Whatever Mahendran’s faults, and whatever the motivation, he was spot on regarding ending cash injections. Until then, the Central Bank seemed to have been unaware of what it was doing.

Whether or not the dollar peg is under pressure can be seen by the way the overnight interbank market interest rates behave. The overnight gilt-backed repo rate was a little above the 5% ‘lower policy rate floor’ until February 27, when ex-Governor Mahendran ordered its removal outside the monetary policy meeting. Rates then moved towards 7%, but in April, rates were cut back to 6%.

Until about March, the domestic operations department continued to pour liquidity to more than offset (over 100% sterilization) liquidity shortages coming from currency defence, keeping overnight rates near the 6% floor of the policy corridor instead of the ceiling rate. From March, rates hit the ceiling of the policy corridor at last, after the governor telephoned the head of domestic operations and told him to “immediately stop conducting of reverse repo auctions.”

Such is the fate of the people of Sri Lanka. Even then, cash injections continued through bill purchases, sterilizing 100%, but money was no longer in excess and some were borrowing through the window at the highest. A perusal of both the domestic asset stock (T-bills of the Central Bank) and the overnight rates shows that the 2015/2016 BOP crisis ended somewhere around May/June 2016. Now with rates hitting the floor of the corridor, the Central Bank is resisting a further fall based on market rates. It can cut rates without causing any damage to inflation. If rates are cut, the credit cycle will turn faster.

However, the Central Bank should also allow the exchange rate to appreciate a little to head off the inflation from the Fed. In fact, it could have done so many months ago.

External conditions are heating up. Stock markets around the world are hitting new records. Oil is rising. Oil at $100 a barrel and gold at $1,700 may return, unless the Fed tightens and withdraws its mountain of excess liquidity pretty fast. In the US, companies that are not much leveraged may be able to stand higher interest rates. Countries with better pegs like China and Malaysia are already allowing the exchange rate to appreciate against the dollar. Floating rates are floating up. Whether this phenomenon will moderate the REER index (through a fall in the nominal effective index) and reduce the need to depreciate and generate more inflation remains to be seen. One mercy of defending the peg, and having BOP crises in quick succession – even if the currency is not allowed to re-appreciate – is that banking crises are avoided.

If an inflationary crawling peg like 2001-2008, or the 1980s is operated (helped by REER targeting), bubbles will also become bigger, and finance companies and banks will get into trouble when rates are eventually hiked.

Sri Lanka’s planned modified inflation targeting regime is full of holes. It is not just the over-dependence on targeting core inflation that is troubling. There is also a plan to manage the exchange rate with forex auctions, indicating that a glorified peg will be operated.

A 4-6% inflation target will then give enough room for the Central Bank to delay rate hikes in 2019, sterilise the forex auctions and run headlong into another BOP crisis; and then an ‘overvalued currency’ will be blamed.