Sri Lanka’s central bank should strip the coupons and sell some of its restructured bonds to operate deflationary policy in volumes big enough to generate reserves and help avoid a default.
Sri Lanka’s central bank is still running deflationary policy with coupons on its bond portfolio being deflationary when they are repaid by the government in cash. In the first half of the year, the coupons amounted to about Rs95 billion, which is a little more than about $310 million.
Central Bank Liabilities
However, the central bank has to repay about $500 million every six months to the RBI for the foreseeable future, not counting the IMF repayments. That means another Rs.70 to Rs.90 billion of deflationary policy has to be conducted if reserve money expansion is discounted.
That will be sufficient to meet the IMF net international reserve target, given that the central bank has about 2.5 trillion bonds at book value. After identifying around Rs200 billion of the bonds, the coupons can be stripped and sold outright as zero coupon bonds.
The bonds themselves can also be sold off as zero-coupon bonds.
Total Reserves and Swap Self-Deception
In addition to the Net International Reserve target, people are also looking at the gross reserve target. If gross reserves do not go up, bondholders will become concerned, and Sri Lanka will not be able to regain market access to at least roll-over existing bonds.
That means more central bank securities have to be sold down. Showing higher levels of reserves with swaps is a self-deception, and swaps are nothing more than a dangerous type of window-dressing.
If commercial banks use the rupees from dollar swaps for credit, imports will be generated, and the central bank will end up with a dollar liability if the currency is defended. If the exchange rate is not defended against the swap rupees, the rupee will depreciate.
This is what happened to many East Asian central banks with a policy rate during the East Asian crisis and also to the UK, during the ERM crisis. All this happens due to an incompatible policy rate.
In 2018, macroeconomists lit a fuse under the Yahapalana administration with dollar rupee swaps, using the proceeds of Hambantota port sale to create money, completely discrediting that administration’s economic programme, imposing gold taxes and vehicle LC restrictions.
Will the Central Bank Make Losses by Selling Its Bonds?
The core problem is that the current IMF programme does not have a requirement to sell-down the securities portfolio. As a result, the central bank’s ability to collect reserves is limited to the coupon receipts on its bond portfolio.
Whether the central bank makes a loss in selling down the bonds is not relevant. If it has to sell down bonds to build reserves (for net foreign assets to go up, net domestic assets have to be sold down. It is not rocket science) and the central bank will make a loss. It is not a problem.
The government will anyway end up bailing out the central bank, like the US government had to bail out the Fed for swaps.
Sri Lanka’s central bank recovered some of the losses from Indian borrowings, for example, because some of the borrowed dollars were sold after the rupee fell to 360, and it subsequently appreciated. Now, of course, foreign assets are positive, so depreciation will no longer result in losses.
The central bank has already made a provision for the bond portfolio, so the accounting loss would not be much or not at all. By having low coupons on the bonds, the central bank is de facto making a profit transfer to the government even now, which is not reflected in the non-tax revenues in the budget.
The central bank’s operating expenses must be limited to its earnings on foreign reserves in the future. Further, any profit transfers should be done by cancelling the long term bonds so that reserves can be built.
Later profits should be transferred to a sovereign wealth fund or a sinking fund, which was the way Sri Lanka (then Ceylon) operated before IMF’s Reserve Adequacy Metrics, which is another deadly Mercantilist trick that lands countries in trouble.
But that is another story.
Rates vs Deflationary Policy
Instead of raising rates to slow credit, by selling down its portfolio, the central bank can match the market interest rates precisely to the level that is required to build the reserves.
The central bank has revalued its rupee bonds recently. If reserves fall steadily or if rates are too low to buy dollars, and forex shortages emerge, confidence will be lost and the rupee will fall. It will require very high rates to restore confidence, and the current strong momentum in credit growth will have to be completely crushed.
The losses of the Central Bank, if any, will be small compared to the overall damage that will be done with the loss of confidence and the eventual depreciation and stabilisation crisis. Another crisis, as opposed to market determined interest rates from deflationary policy, will add huge fiscal costs, and there is also political instability to think of.
CB Bond Portfolio with a Face Value of Rs2.5 Trillion Carried in the Balance Sheet at Rs1.8 Trillion
Showing Higher Levels of Reserves with Swaps Is a Self-Deception, and Swaps Are Nothing More Than a Dangerous Type of Window Dressing.
Lack of Accountability
Sri Lanka’s central bank and all IMF Second Amendment central banks that depreciate currencies disclaim all responsibilities for providing a stable exchange rate.
It is a shocking lack of accountability when considering the situation before open market operations and the policy rate and the understanding of economics, at least up to the IMF’s Second Amendment in 1978, which then led to defaults in Latin America.
The central bank is responsible for maintaining the external value of the rupee, for which it has to conduct appropriate monetary policy, even if the agency has a fully floating rate — which in Sri Lanka’s case it does not — or appropriate exchange rate policy with monetary policy subordinated to maintain reserves and repay debt.
Floating exchange rate countries (which only conduct monetary policy) do provide strong exchange rates, but what they don’t do is intervene. That is to avoid anchor conflicts.
They have not disclaimed a responsibility to provide a hard currency, at least in de facto terms.
If reserves continue to fall, and also if forex shortages emerge, with the central bank still not creating forex shortages, this gives macroeconomists another excuse to escape accountability.
The current administration will be blamed for not doing reforms. Many governments have been blamed for ‘not doing reform’ and therefore going to the IMF.
It is an outright false narrative. When the central bank created the first currency crisis in 1952/53, Sri Lanka was a largely free trading country with some forex controls for the dollar area due to being part of the Sterling area.
John Exter himself described the country as export-oriented, with vast amounts of land, workers, and resources devoted to exports, as is the case with all East Asian countries now.
Sri Lanka was an outward remitting country at the time, due to the import of labour.
Scapegoating
Macroeconomists usually blame deficits (politicians), imports (general public), lack of reforms (politicians), and a lack of exports (businesses) after creating inflationary policy.
This column has also pointed out that the Treasury should start buying its own dollars, given the central bank’s inflation target (and reluctance to sell-down its bond portfolio) and the IMF’s lack of requirement to reduce domestic monetary assets.
One good thing is there is greater understanding, especially in Sri Lanka, of how a Second Amendment central bank triggers external (and internal) instability and default. As such, Sri Lanka should not go down the same path again. This very same knowledge existed before the 1920s in all countries, and in many countries up to the 1960s, including the East Asia export powerhouses and the GCC countries, even after the IMF’s second amendment.
For too long, the public (and politicians) have had to suffer the consequences of inflation and depreciation, and also assume the blame. However, the blame squarely rests on the liquidity injections and rate cuts on the part of the macroeconomists in the central bank, the Treasury, the IMF, or in the private sector who have rejected classical economics and support these actions.