Sri Lanka has to take quick action to restore lost confidence in the rupee triggered by liquidity injections and cascading policy errors to avoid an acceleration of a monetary meltdown with serious consequences for citizens.
Already, inflation is rising and difficulties in paying for imports are intensifying. Sri Lanka’s economy is doing as well as can be expected, like any other country that has been hit by Covid-19, and better than some, but the credit system has become dysfunctional due to a severe erosion of confidence in rupees issued by a monopoly note-issuing central bank.
Due to the loss of credibility of the peg, the government or importers are unable to transfer wealth out of the credit system in foreign currency. This column has warned that the central bank’s monetary stance would create severe problems as soon as the economy and private credit recovered.
When only one type of banknote is in circulation, policy errors of a note-producer affects the entire credit system, and therefore individuals and firms which we call the economy.
In a Latin American-style central bank, or where the central bank bureaucrats have a ‘Cambridge economics’ or lost generation world view, these policy errors will cascade into a mutually self reinforcing vicious cycle that accelerates rapidly in the last stages as market participants get panicky.
This column warned several times that while rating agencies do not understand central bank balance sheets, they understand reserve losses and currency falls which trigger downgrades. Downgrades add to the general unease.
The spiral involves steeply rising interest rates, depleting reserves, a steeply falling currency, trigger downgrades, and default, which in turn makes it difficult to import food and fuel and the value of all financial savings will evaporate and rising inflation will create social unrest and boat people.
Import credits are one segment that is usually hardest hit from a default. A collapsing currency will boost private credit as working capital requirements go up, even as the economy contracts. This is what sets the stage for hyperinflation.
The loss of confidence and the collapse of the currency come primarily from the inability to stop liquidity injections in a ‘flexible exchange rate’ or soft-peg due to the obligation to inject money to maintain the policy rate. This was seen in October 2021, when the overnight injections continued to mount, even when the central bank was able to sell down some of its bill stock.
The central bank is unable to sell down its Treasury bill stock to re-build reserves as the credibility of the peg has been lost. Instead, what it sells down has to be sterilized through an overnight injection. To restore confidence in the rupee and stop liquidity injections, rate hikes and credit contractions are needed. Any half-measures can lead to more confusion and loss of confidence requiring even higher interest rates and economic contraction.
This rate spiral to restore confidence in the legal tender note is far higher than is needed to balance private credit and drive savings to the budget deficit. The invoking of the ‘Stage II’ intervention of bond auction in October shows that the central bank is not capable of solving the problem on its own, or it is not serious about stopping the meltdown, or it has no idea of the seriousness of the oncoming crisis and social unrest. The very high rates (and deflated asset prices) are required to restore confidence in the currency of the monopoly note issue bank can be moderated through a currency float and parallel dollarization.
LEGAL TENDER AND NOTE – ISSUE MONOPOLY
Due to the legal tender monopoly in a soft-peg, the government finds it very difficult to get hold of dollars that come to the country. In a soft-pegged country (or hard pegged country), taxes are paid in domestic currency and domestic transactions happen in local currency due to legal tender laws.
The government first has to get hold of some rupees from taxes or borrowings and again exchange the money to US dollars, through a roundabout process via the central bank. In Sri Lanka, while state agencies like the Ceylon Petroleum Corporation or private importers can get dollars directly from exporters jumping through one hoop of the pegged system, the government has to jump through the hoop twice as the Treasury does not directly deal in the forex market, unlike other countries.
For the government to get hold of dollars, the recipients have to sell the dollars to the central bank, which creates more rupees. The government then has to get hold of some rupees and go to the central bank to get dollars. If the money is not printed, the private sector will be crowded out and there will be dollars to be bought either from the central bank.
However, if money is printed, outflows will exceed inflows as there is no crowding out, and the credibility of the peg will be lost. Once the credibility of the peg has been lost due to liquidity injections, it is difficult for anyone to exchange rupees for dollars. If the government tries to get dollars from the central bank with printed rupees, reserves will fall on a net basis.
People with dollars do not want to sell. Due to liquidity injections, the demand for dollars is higher than the supply pushing the exchange rate down. As a result, parallel markets develop. Savers do not want to hold the soft-pegged fiat notes nor hold assets denominated in rupees such as bonds due to fear of falling prices.
As a result, the government cannot raise debt and failed bond auctions result in more money printing which creates more forex shortages. To draw investors, rupees have to be sold cheaply and bonds have to be sold cheaply to discount the loss of confidence. This is why bonds could not be sold at controlled yields (high prices). Now people are buying bills. There is some demand for bonds from insurance companies and fund managers.
BOND AUCTIONS AND STERILIZED DOLLAR SALES
One way of getting out of the problem is to issue floating-rate bonds tied to the 3-month bill yield. Bond auction success is essential to ending forex shortages and reserve losses. Merely making bond sales successful will not restore the credibility of the peg which has been destroyed by previously failed bond auctions and liquidity injections.
People with dollars do not want to sell. Due to liquidity injections, the demand for dollars is higher than the supply, pushing the exchange rate down. As a result, parallel markets develop. Savers do not want to hold the soft-pegged fiat notes nor hold assets denominated in rupees such as bonds due to fear of falling prices
Even after auctions are successful, the central bank may be forced to give dollars to pay for petroleum or to settle loans in the process of maintaining a peg at Rs203 to the US dollar. Any such sales should be accompanied by a contraction in reserve money and rates have to go up. That means it should be unsterilized dollar sales that create a liquidity shortfall and rise in rates under some kind of formulae like in Singapore or a raw rate. However, due to the requirement to maintain a 6% policy rate, money has to be injected or the sale has to be sterilized. In other words, sterilized forex sales are almost similar to a bond auction failure.
As explained in last month’s column, in a pegged regime, reserve money is convertible. Without giving convertibility, a peg cannot be maintained at Rs203 to a US dollar. However, as soon as convertibility is given, overnight money is injected at 6%, worsening the problem.
That means even if bond auctions are working, if the central bank continues to inject money after providing dollars (as old gold standard central banks provided gold), more dollars would be lost in the process of trying to maintain the policy rate and the volume of reserve money.
David Ricardo explained it as follows, where there was a loss of confidence in the Bank of England peg to gold at the turn of the 19th century: “…But if the Bank assuming, that because a given quantity of circulating medium had been necessary last year, therefore the same quantity must be necessary this, or for any other reason, continued to re-issue the returned notes, the stimulus which a redundant currency first gave to the exportation of the coin would be again renewed with similar effects; gold would be again demanded, the exchange would become unfavourable…”
This knowledge was lost in the Cambridge Harvard-Oxford nexus, and particularly in the US which does not have a long history in central banking, unlike Europe. This then is the crux of the Latin American central bank policy error. Raoul Prebisch, Robert Triffin, and a host of US economists, in particular, thought it was possible to have a policy rate and peg.
The US Treasury and Mercantilists believe this and the also IMF operates on this principle though there is knowledge among some mission chiefs, who sometimes do a good job. There is no monetary policy independence with a peg. Anyone who tries it ends up in disaster. Anyone who tries half-measures (flexible exchange rate) similarly ends up in disaster as is proven in Sri Lanka. In other words, reserve money has to adjust to forex inflows (reserve money expands) and outflows (reserve money contracts) to keep the peg and provide convertibility.
There is nothing wrong with pegs as the IMF and Mercantilists (mainly American) would have us believe. It is perfectly possible to maintain pegs as long as there is no ‘stimulus’ or counter-cyclical policy. GCC area and East Asian economies, which have pegs designed by British economists have proved this time and again.
CURRENCY FLOAT
One way to get over the problem of the overnight injections and stop the alteration of reserve money from foreign exchange interventions is to float the currency. A float stops convertibility. The central bank no longer has to provide dollars. Because it does not provide dollars, it does not have to inject. Reserve money becomes fixed, interest rates also will not have to rise, provided the rate is good enough to sell bonds and prevent failures of bond auctions.
A float involves the float of the currency peg that reflects expectations on the previously printed money. So, the currency would initially fall. The magnitude of the fall will be arrested based on the interest rate structure. Therefore, rates should be raised, and bond auctions should be working well before the float.
A float always stops the slide of a currency after falling to one point. This is because at one point exporters will sell. At one point remitters will remit officially and the gap between official and unofficial rates will disappear.
It is eminently possible to fix the country with a 20% VAT hike, while a public sector hiring freeze and a wage freeze is already apparently on. A VAT hike of 15-20% is much more preferable to a fall of the currency to Rs250-300 to the US dollar
A float will stop the drain on reserves for current imports as it is happening when the central bank gives dollars at Rs203 to the US dollar peg. It is unlikely that this country has the political will to allow rates to go up to the level that is required to restore confidence in the peg. The exporter surrender rule will only have a limited effect and will further hit the peg through liquidity creation.
PARALLEL DOLLARIZATION
Another option that will reduce the corrective rate and the economic contraction required to stabilize the credit system is to allow progressive parallel dollarization. As explained, the problem with the government not getting dollars is due to the legal tender law forcing people to transact in rupees and pay taxes in rupees. As soon as this rule is removed a part of the problem is solved.
The central bank should not impose a surrender rule requiring dollars to be paid to the central bank (creating liquidity at zero interest rate in the process which harms the peg) but dollars should be paid directly to the government for existing rupees. One part of the surrender rule allowing exporters to buy SLDBs is correct. That will directly transfer dollars to the government without having to go through the rupee credit system.
In the same way, the exporters should be allowed to pay taxes in dollars. The government can give the same two rupee extra (a discount) for paying taxes in dollars now given to expat workers. Expat workers get this even if the dollars do not go to the government, which is a bit weird. But these are all part of the soft-pegging errors.
Exporters and hotels can also pay electricity bills in dollars. This will keep the power flowing to their factories and hotels. They can also pay dollars for fuel. This will keep fuel flowing to their factories and trucks.
If hotels and exporters pay their workers in dollars, they can save all their money in dollars and buy Sri Lanka Development Bonds. SLDB bond auctions should be held weekly like Treasury bill auctions. Governor Nivard Cabraal’s suggestion of allowing car imports for dollars and taxes to be paid in dollars is correct.
Latin America style sovereign default is a problem partly due to legal tender laws, and partly due to the soft-peg, but it is rarely a fiscal matter. In Sri Lanka, there is a revenue problem after the 2019 tax cuts, but Latin American countries including Mexico have defaulted purely due to the legal tender law and soft-peg (interest rate controls) with budget surpluses. Argentina defaults with 5% deficit and 50- 60%debt to GDP ratios. Parallel dollarization will also push some rupee out of circulation and allow the central bank to mop it up.
DEFAULTING SOFT PEGS
Most defaults happen with soft-pegs. It is not very common for free-floating countries to default. For a floating country to default, it has to be mostly a fiscal issue that makes people lose confidence in the domestic currency bonds.
This is not common. We can see this clearly in Sri Lanka now. It had also been achieved in Sri Lanka by the central bank through price controls and low rates. Domestic savers are not willing to invest in rupee bonds due to the rate. A 10% of GDP budget deficit is something this country has had before but certainly, interest rates had not been this low.
Dollarized countries also default rarely but its effects are for the most part not very devastating as a soft-peg when the currency collapses. And they recover quickly as soon as the budget issues are fixed. Ecuador defaulted last year but its bonds are now actively trading after a distressed bond exchange (DDE).
Ecuador’s Fitch rating went from B- to CCC to CC to C to (RD) restricted default and now has been upgraded to B- after the DDE with an IMF program pending. That is because the currency does not fall and it is the US dollar, issued by some other central bank.
This is far cry from the situation when Ecuador’s currency melted as a soft-peg, devastating its people, which led to dollarization. In 2000 the Ecuador Sucre crashed to 25,000 when the US hiked rates to 6.5%. Sri Lanka’s rupee also collapsed at the same time. The Sucre is rock solid now. Incidentally, the Cambodia riel is also rock solid. It collapsed during two Fed cycles earlier in 1989/1990 when Sri Lanka also had problems including with the JVP uprising.
IMF PROGRAMME
Sri Lanka could allow cars to be imported for dollars and taxes to be paid, and workers to be paid in dollars and their savings to be kept in dollar deposits and invested in SLDBs with or without a float.
However, the IMF does not like this much, due to mistaken opposition from the US Treasury, but it does the US no harm. But IMF programmes are useful in building confidence and therefore keeping the corrective interest rate low. The IMF also can do the numbers and convince foreign and other investors.
Whether these numbers are correct or not, does not matter (they are sometimes wrong, and their entire premise is also wrong as this columnist can attest) but that is not relevant. What is relevant is that it will restore confidence.
Once the IMF says that the debt is sustainable people will believe it. It is eminently possible to fix the country with a 20% VAT hike, while a public sector hiring freeze and a wage freeze is already apparently on. A VAT hike of 15-20% is much more preferable to a fall of the currency to Rs250-300 to the US dollar.
Unlike in the 1970s, everyone in Sri Lanka in 2021 knows what the central bank did. If the central bank is reformed to make it impossible to print money and withdraw money as East Asia does, it is possible to preserve domestic capital for investment and even export to the US
Mercantilists and the crocodile tears shedding anti-austerity brigade will oppose a VAT hike but will allow a currency collapse because the classical economic concept of sound money is no longer understood in the Keynesian/John Law religion which has replaced reason.
It is the tragedy of our times that has led to the failure of the Washington consensus and IMF programs and social unrest. Unlike VAT which only hits earnings that are spent, the depreciation will also hit savings and lifetime savings.
IMF programmes, however, will bring several benefits:
- As soon as the IMF determines that the debt is sustainable based on the policy framework, investors will believe it.
- When the currency is floated, sterilized interventions will end, and the currency will stabilize. It is important not to give any dollars for oil or sell dollars in disorderly market conditions (DMC). Stay put and allow the currency to fall and it will stabilize.
- It is a waste to sell land assets without an IMF programme.
- The IMF will give a fully financed programme.
- Land sales can be tied to a private sector development budget-supported loan
- Listing Sri Lanka Insurance and state banks, and removing the golden share of plantations could be tied to a private sector development budget-supported loan
- It may be possible to do SriLankan Airlines as well.
- Debt restructuring can sometimes be cosmetic, sometimes useful. The world is such that bond investors are now conditioned to a debt restructuring. They may even prefer a bond exchange to a default. Ecuador got a 98% agreement for its DDE. While they may appreciate Sri Lanka’s insistence on repaying debt, most may accept a bond exchange that will reduce mark-to-market losses.
Parallel dollarization will of course reduce the likelihood of a future default or a missed coupon payment in the future. Parallel dollarization will help banks repay dollar deposits with fresh inflows rather than depend on government repayments of SLDBS. In some countries failure to repay dollar and rupee deposits had led to the storming of central banks.
Unlike in the 1970s, everyone in Sri Lanka in 2021 knows what the central bank did. If the central bank is reformed to make it impossible to print money and withdraw money as East Asia does, it is possible to preserve domestic capital for investment and even export to the US.
It is possible with a currency board or a strong East Asia style deflationary peg, or dollarization to bring interest rates down to levels close to that of the US and over time slash the interest bill that has now been bloated by monetary instability.
It is possible to build a sovereign wealth fund with the EPF deposits as Singapore did. All these are possible as long there is a classical understanding of note-issue banking and Sri Lanka escapes drop the US centric-Latin American world view of central banks.