Sri Lanka’s recent removal of counterparty limits for access to central banks’ printed money as a standing facility is a mistake which will make banks overtrade and contribute to monetary and financial instability in the future. Standing facilities should be the last among the lender of last resort (LOLR) facilities.
The more liberal the LOLR facilities are, the more unchanging the rate, the more external instability there will be in the future, and more bad loans will pile up in banks as stabilization policies are applied.
Essentially, standing facilities, term or permanent injections allow banks to lend without deposits, and trigger forex shortages in a soft-peg or managed float.
The UK has a standing facility that prints money at 0.25% above the policy rate. The operational standing lending facility consists of an overnight lending transaction collateralised against high-quality, highly liquid (Level A) assets. The Bank of England (BoE) applies a 25 basis point premium (0.25%) above the Bank Rate for this facility. The operational standing deposit facility consists of an overnight deposit transaction, and currently returns 25 basis points below the Bank Rate.”
Safer, More Prudent Times
In earlier times, before monetary policy deteriorated and when the BoE gave more stability to the country lower inflation, and less social interest, these premiums including for longer-term money, have been higher.
“We moderate upward spikes in overnight rates by being ready to supply overnight funds to our counterparties at 3.30 pm (against collateral) if the shortage of funds has not been fully relieved in our main 9.45 am or 2.30 pm rounds,” according to a paper by William A Allen, one time Bank of England who retired before the policy was corrupted by quantity easing and easy money, leading to current troubles.
“At the end-of-day stage, our operations are concerned not so much with implementing the MPC’s repo rate as with the more routine task of squaring off any residual market imbalance in as orderly a manner as possible. The rate charged on 3.30 pm lending is penal – the official repo rate plus 100 basis points (though we can vary this margin) – to encourage banks to borrow in the market wherever possible.,” Allen noted.
“If, after the market has closed, the system is still out of balance, we will lend off-market to the settlement banks to enable them to square off their end-of-day settlement with each other, at an even more penal rate of the official repo rate plus 150 basis points (again, this margin can be varied),” Allen said.
These facilities are designed to eliminate excessive spikes in overnight interest rates at the end of the day and have been successful in doing so. They are akin to the ceiling in a corridor system of rates, but not exactly so for two reasons. Allen says, “First, they are not standing facilities available at all times to all market participants. Second, funds are normally limited to the amount of the remaining daily shortage (though we reserve the right to supply more)”.
The rationale for prudence and discouraging moral hazard was explained as follows: “Both these limitations are motivated by our desire to ensure that banks are subjected to the discipline of having to finance themselves in the market to the maximum extent possible.” All of these principles have now gone out of the window and the world is a less safe place for all, particularly the poor.
Liquidity Shortages
In reserve-collecting central banks with pegged or managed floats, liquidity shortages come from dollar sales. In a floating exchange, large liquidity shortages do not arise unless many market participants refuse to deal with each other in times of crises or money or domestic money flows out of the country.
Or there is ‘quantity tightening’ in the process. The Bank of England provides unlimited facilities for quantity tightening to help ease any liquidity shortages. Sri Lanka’s central bank is also engaged in quantity tightening effect by selling down its Treasury bill stock.
However, there is no money in the market to buy large volumes of CB-held Treasury bills unless there is liquidity from dollar purchases. Overselling Treasury bills and giving liquidity overnight through overnight windows or term, encourages banks and primary dealers to depend on the central bank’s printed money for their operations. This addition to central bank money is a key problem in Sri Lanka and all unstable countries.
East Asia
Most East Asian nations which collect reserves (with a deflationary policy) have tighter liquidity facilities. Rates also move in case there is a credit spike and the exchange rate is defended. A wide corridor helps reduce the negative effects of the obstinate policy rate and allows the market to finance credit instead of central bank facilities. Standing facilities – including intra-day facilities – are given at penal rates in better-managed countries.
In several East Asian central banks, domestic assets are negative. Thailand, which fell victim to hedge funds in the East Asian crises first due to its policy rate and swap operations, was an exceptional bank, whose policy framework was not up to dealing with a swap attack due to monetary policy modernization. It swiftly descended into an inflationary policy under attack which then shattered confidence.
Running a deflationary policy, and building reserves (exports of capital) has not hurt East Asia because the stability the practice provided through a tight monetary standard led to even larger inflows of capital in the form of FDI or other flows than the reserves that were built. Domestic capital was preserved with no depreciation to inflate away capital.
Countries with completely free capital flows, including Singapore and Hong Kong which have the best monetary frameworks in East Asia, have very low interest rates and do not have policy rates at all.
Sri Lanka also had developed country-level inflation and interest rates before the monetary framework was corrupted progressively under IMF tutelage and also the inflationist beliefs that swept the academic community of the US, particularly from the 1960s. It was monetary instability and currency depreciation that led to high interest rates in Sri Lanka which was unrelated to credit risk.
Liquidity Junkies
The central bank is now selling down its Treasury bill stock and trying to rebuild reserves. However, there is no money in the system to sell large volumes except for dollar purchases. The central bank should internally roll over most of the maturing securities and only offer to the market a volume that will keep the aggregate balance in the market plus or minus 20 to 30 billion rupees.
Now T-bills are sold and money is injected term and overnight to allow market participants to buy them. Market participants should buy CB-held Treasury bill stock from real deposits, not central bank credit. To do so is a type of self-deception.
More to the point it is a bad practice that will get banks used to borrowing from the window – de-stigmatizing the practice – so to speak. When banks become liquidity junkies, eventually the country will suffer forex shortages when credit recovers.
In Sri Lanka, several well-managed foreign banks, (and one or two local ones also before the crisis) always deposit some cash in the central bank’s window. These banks are usually net sellers in the interbank forex markets.
All banks, whether local or foreign should be encouraged to have a little excess liquidity above the reserve ratio. If the central bank has painted itself into a corner on a belief that it cannot roll over maturing bills internally under the monetary law, it has only itself to blame for coming up with an illogical law.
If that is the problem, the central bank can submit a non-competitive bid and allocate itself the volume at the weighted average bid for market bids. The current system of selling bills and giving new money short term can also lead to sterilization losses in addition to making liquidity junkies out of banks. In the name of transparency, all bills rolled over should be disclosed to the market. The bill holding should also be disclosed daily.
No Logic
There is no point in imposing statutory reserve ratios if liquidity is provided liberally through the standing term and overnight facilities after banks short them.
Given the lack of foreign reserves and negative net reserves of the central bank, banks should be encouraged to raise deposits, reduce credit and buy central bank-held securities from liquidity from central bank dollar purchases.
Any cash deposited by banks in the standing facilities over and above the SRR results in foreign reserves for the central bank, unless system liquidity is liberally filled with standing facilities. Dollar net open position units of banks in fact should be tied to the net balance of their standing facilities and other borrowings. Outright purchases of securities and the engaging central bank or market swaps to borrow dollars should be discontinued.
Illogical Central Bank Swaps
A market swap is the same as the Lebanon Central Bank dollar deposits, which proved its undoing. Sri Lanka’s central bank also made large losses on swaps, ACU borrowings and IMF borrowing in this crisis, by using swaps to meet external payments and printing money to maintain an untenable policy rate.
Goh Keng Swee did not allow swaps and Singapore banks gave credit to foreigners to maintain exchange rate stability, though other currency board regimes like Hong Kong which have a fixed exchange rate had no such restrictions. Speculators who tried to hit HKMA with swaps lost out as the interbank rates went up. Other soft-pegs which were hit in the East Asian crises also stopped attacks by closing the swap market.
Sri Lanka’s and the problems in other countries with forex shortages and the depreciation and social unrest come from the deterioration of monetary doctrine in the ‘age of inflation’ started from the Fed’s open market operations in 1920 to trigger the Great Depression. The deterioration accelerated very sharply in the 1970s with the collapse of the Bretton Woods and IMF’s second amendment. That is why budgets became unmanageable in Sri Lanka
John Law and the Policy Rates
There was no bureaucratic policy rate before the Fed as it had been fiercely resisted in Europe which had a longer monetary history. It was John Law who originally proposed to suppress rates with liquidity injections.
“Some think if Interest was lowered by Law, Trade would increase, Merchants, being able to Employ more Money and Trade Cheaper. Such a Law would have many Inconveniencies, and it is much to be doubted, whether it would have any good Effect,” John Law wrote.
“Indeed, if lowness of Interest were the Consequence of a greater Quantity of Money, the Stock applied to Trade would be greater, and Merchants would Trade Cheaper, from the easiness of borrowing and the lower Interest of Money, without any Inconveniencies attending it.”
That new money was not to have been backed cross border exchangeable assets like gold or silver but by a non-tradable domestic asset, land. The Mississippi bubble proved he was wrong.
In this age of inflation, asset price bubbles, external default, rising national debt, and exchange and trade controls, the policy rate and liquidity tools are taken for granted. But before the ‘age of inflation’, and 1920 it was not so. It was also not in wide policy corridor central banks and those that give tiered facilities.
No less than William Patterson, a key promoter of the Bank of England (which did not have a bureaucratic policy rate to manipulate interest rates in the beginning though it also got into trouble by giving excess credit from domestic assets in times of crisis) opposed John Law and the deliberate attempt to suppress rates with printed money.
When the Bank of England was able to maintain the gold standard and the Sterling was the pre-eminent currency in the world, it had no policy rate. The peacetime economic crises seen after World War II were a direct result of the bureaucratic policy rate and aggressive liquidity facilities of central banks, as was Sri Lanka’s currency crisis and default since the end of the civil war.
Ironically when the Fed started open market operations in 1923, (New York Fed Governor Benjamin Strong who triggered the Great Depression with rate cuts was on leave), it was to mop up liquidity and run East Asia-style deflationary policy.
John Law was proved wrong by the Mississippi bubble, but the Housing bubble did not prove Ben Bernanke wrong in this age of inflation and false monetary doctrine of multiple liquidity facilities.
In conclusion, Sri Lanka’s recent decision to remove counterparty limits for access to central bank liquidity facilities raises concerns about potential financial instability and moral hazard. By adopting a more prudent approach to liquidity management, guided by lessons from well-managed central banks elsewhere, Sri Lanka can mitigate risks and promote long-term economic stability. Upholding disciplined monetary policies and encouraging market-based financing mechanisms will be crucial for navigating the challenges ahead and safeguarding the country’s financial resilience.