Sri Lanka is heading for one of the biggest economic challenges in its history in 2021, with the central bank printing money like there is no tomorrow under Modern Monetary Theory, ordinary people strangled by import substitution and the threat of expropriation for plantations firms.

Meanwhile the state sector is being expanded with 50,000 unemployed graduates, and a 100,000 task force of unqualified unemployed. The state expansion and stimulus maniais coming after slashing value added tax at the beginning of the year. By August 2021, 74% of tax revenues were being used to pay salaries.

If taxes were slashed, then interest rates must go up as people’s savings are borrowed to pay state worker salaries. But it has not happened. Instead forex reserves are falling steadily. In most countries, currency collapses and also hyperinflation is triggered by money printed to pay salaries of state workers and the military.

THE WAR AND MMT

It is a telling factor that Sri Lanka managed to grow the economy despite a 30-year civil war with the central bank delivering some stability. At the risk of digressing it is important to lay the background.

In 2008/2009 Sri Lanka not only faced an internal war but the US monetary tightening that ended the Greenspan-Bernanke’s mother of all liquidity bubbles and triggered the Great Recession.But Sri Lanka survived with a temporary demand collapse despite higher interest rates. At the time the Governor Nivard Cabraal and Deputy Governor W A Wijewardene defied the Treasury and used multiple ruses to raise rates and avoid printing money.

The rupee was allowed to bounce back quickly to pre-crisis levels preserving domestic investible capital and the salaries of the working class. At the time a ‘bills only’ policy was in place for monetary policy and the central bank was prohibited from selling bonds.

After Wijewardene left, policy rapidly deteriorated. When A S Jayewardene was Governor (Wijewardene became Deputy Governor during that time) there was only one currency crises in 1999/2000 in the wake of burst tech bubble. Jayewardene drove policy from 1994 when he was initially Treasury Secretary (some critics called his first budget an ‘IMF budget’) and then later Governor. He also came under some pressure for having high real interest rates.

But in 1994 he inherited a very bad budget where the defeated UNP’s ‘election gundu’ budget with a 10.5% deficit. During ensuing period, Sri Lanka also had Nadeem ul Haque, a Chicago school economist as IMF representative in Colombo. Other than the late 2004 episode when the central bank was forced to print money under fiscal dominance and Jayewardene left the central bank, the rupee was kept stable and the country saved from a meltdown. Wijewardene left a little after civil war ended in 2009.

WORSE THAN WAR

When the war was on, people blamed the war for the country not progressing. But policy worsened after the end of the war, becoming severely pro-cyclical. In 2011/2012, Sri Lanka hit a balance payments crisis, because liquidity was injected pro-cyclically from around mid-2011 after a proc-cyclical rate cut around April.

In 2015, liquidity was also injected and there was a pro-cyclical rate cut. The 2015/2016 crisis was arrested partly with the help of the policy corridor, when then Governor, Arjuna Mahendran, suddenly called a halt to reverse repo injections and overnight rates hit the policy ceiling without a rate hike. Since the monetary board is notoriously unwilling to raise rates, a wide policy corridor can save the country and the people and any economic program the incumbent administration cares to run.

Without a policy corridor (a currency board has no ceiling rate), the country is completely exposed to the Monetary Board’s wrong decisions. The currency collapses, exchange controls, import substitution is ample evidence for the Monetary Board’s wrong decisions.

Two monetary policy changes were made after 2016 that put the country in worse danger than the 30-year civil war. One was the abandoning of the corridor and the targeting of middle of the band. To target the middle of the corridor, large volumes of liquidity had to be injected. As a result, the central bank lost complete control of reserve money. This is why Argentina collapsed without a civil war. If money is printed (reserve money is made through purchases of Treasury bills) a floating exchange rate is needed and the foreign reserve collections has to be abandoned. There is no mixed-up system. A mixed-up system triggers balance of payments crises.

Under a floating rate the complete responsibility of rolling over debt becomes the responsibility of the Treasury. The central bank cannot collect reserves under a floating or ‘flexible exchange rate’ to repay foreign debt. This is something Keynesians do not understand and it will take too long to explain in this column. But the roots of Sri Lanka’s current default risk and low growth stemmed from the ‘flexible policy’.

INTEREST RATES AS A FINAL TARGET

Under Governor Indrajith Coomaraswamy, the central bank also targeted the Real Effective Exchange Rate and a potential output as part of the flexible policy. The International Monetary Fund gave technical support to Sri Lanka to print money and target a potential output, defeating their own economic program.

Under Governor Coomaraswamy a ‘bills only’ policy was abandoned, allowing the central bank to buy long term bonds and target longer tenors of the yield curve. Under Governor Coomaraswamy, not only the yield curve, but lending rates and also deposit rates were controlled.

It is now evident that while paying lip service to inflation targeting Sri Lanka was basically targeting interest rates as a final target through multiple means. That is why there is monetary instability.

The 2018, currency crisis was an important milestone because there was no fiscal dominance. Finance Minister Mangala Samaraweera raised taxes that were necessary (VAT) taxes that were not necessary (income tax and withholding tax) to reduce the budget deficit.

Oil prices were also market priced. In 2004 and 2008, credit taken for oil subsidies were a key problem. In 2018, there were no fiscal problems.

The central bank created the entire debacle by targeting call money rates on its volition mis-using the central bank independence given by that administration to target. In order to target interest rates as a final target, the monetary authorities were willing to sacrifice stability, inflation and eventually growth itself. In simple terms, the central bank de-stabilized the credit system and external sector when the Treasury ran a primary surplus. That is what call money rate targeting/ REER targeting did.

THE  2015 AND 2018 MONEY PRINTING FOR ‘STIMULUS’ OR ‘TARGET AND OUTPUT GAP ‘ TRIGGERE DCRISES AND KILLED OUTPUT.

MODERN MONETARY THEORY

Modern Monetary Theory is much more dangerous and the loss of control of reserve money is even greater. In 2018, April excess liquidity injections under Call Money Rate targeting was about 60 billion rupees or about 5% of reserve money. In other words, a loss of control of reserve money was 5%. If credit was stronger, then more money would have been required to keep call rates in the middle of the corridor.

All available tools were deployed to create the 2018 monetary instability. Overnight reverse repo, the term reverse repo, the buffer strategy (rejecting bonds auctions and overdrawing state banks which in turn to go the window). Dollar-rupee swaps of the style used by speculators to hit East Asian pegs were also used to create liquidity and hit the peg. That is something that the founder John Exter did not envisage perhaps in his famous report.

The same thing is now happening under Modern Monetary Theory. In 2020, under MMT excess liquidity is about 20% or more of reserve money, defined with or without excess liquidity. This is much worse than the reverse repo and dollar swap injections made in 2018. Bond and bill auctions are being rejected wholesale, in worse policy than the last regime.

There is nothing modern about any of these theories. MMT and output targeting dates back to John Law. The entire Cambridge economics debacle is also a type of John Law operation. It is all ‘stimulus’ in refurbished clothes.

The 2015 and 2018 money printing for ‘stimulus’ or ‘target and output gap’ triggered crises and killed output. Then taxes were cut in 2019 by the new administration. So, things are even worse now. Money is printed to cover taxes. And now, import controls have been placed while money is being printed.

So why does this happen? How come policy is so heavily weighted towards Mercantilism and Cambridge economics? How come central bankers do not know classical economics?

CLASSICAL KNOWLEDGE

A run through the history of the Central Bank shows, that had not always been the case, even in the worst of times. The 1970s was one of the worst money printing periods in the history of the country which led to draconian exchange controls and fining and punishing innocent people for breaking exchange controls and price controls. But there had been some classical knowledge at that time. A Central Bank publication on the agency’s 25 anniversary shows that there was a pocket of economic knowledge within it. That it was also approved for publication also shows that at higher level, economic knowledge existed.

“The Treasury had to finance its expenditures increasingly by resort to Treasury bills despite the fact that no significant tenders forthcoming to absorb the successive issues of Treasury bills,” the unknown classical economist wrote. The responsibility of absorbing the unsubscribed portion of the Treasury bill issue fell on the central bank.

“A major drawback in financing of budget deficits with central bank credit is that while the process involves an expansion in the money supply, it is not necessarily accompanied by an expansion by a corresponding increase in national product.

“Consequently, increased demand emanating from central bank financing of budget deficits had to be satisfied by increased recourse to foreign supplies with resulting pressure on the country’s external payments. Thus, though the Government fiscal problem and the balance of payments deficits were two distinct problems, they were nevertheless inter-related, in that the balance of payments deficits and loss of external assets arose partly out of the method by which the government sought to finance its deficits.

“With the continued loss of reserves and the accumulation of external liabilities, the ability of the Central Bank to maintain the international value of the rupee was gradually undermined.”

It will be interesting to find out who in fact wrote this section in 1975. No one appears to have read this section or highlighted it in the media. Even as this was written in the broader economy, exchange controls were in place, there were price controls and innocent traders who were trying to make markets work amid inflation were branded black marketeers and punished by the state which was creating the same problems. Import substitution was the order of the day in the 1970s despite knowledge about money printing existing at some corners of the central bank.Imports were blamed for balance of payments troubles then, during the Yahapalanaya regime, and imports are being blamed now.

In 2018, when the central bank stopped gold imports, and stopped cars and other imports, there apparently was no one in the central bank who either knew this or was willing to point it out. Maybe it shows the widespread indoctrination by Cambridge economics. In the years after the war, people who challenged Keynes were people like Hayek or Bertil Ohlin. An Austrian-German and a Swede had to battle Keynes in a language foreign to them.

MMT IN 2021

Fast forward to 2021, import substitution is still happening. Treasury bill auctions are being oversubscribed but bids are being rejected. Again, it seems to be an obsession with low interest rates. For this central bank rates are final target.

The central bank has made a public statement that it wants the rupee at 185. That is perfectly fine as long as the monetary policy is there to support the rate. In fact that is how most of East Asia ran in their growth phase, China did from 1993 to 2005, Taiwan and Hong Kong still do, the high performing GCC countries still do and so on.

Sri Lanka is having a soft-pegged exchange rate. The wild variations of domestic and foreign assets show that very clearly. Now domestic assets (representing printed money) is rising fast. Meanwhile foreign asset growth is negative. Interventions will push foreign assets faster into negative territory. Interventions (unsterilized) will also kill some of the liquidity

But what about MMT? Can MMT be done with a peg? Governor Lakshman had said that under MMT debt is being rolled over. That is precisely the problem. Debt is not rolled over. Debt securities are being turned into reserve money, which are exchangeable for goods and dollars. If bids to bill auctions are being rejected, and money is being printed, it is not possible to hold the exchange rate at 185 to the dollar without losing more reserves.

However, it is also wrong to print money and not defend the peg. That is the fast track to a meltdown.

An exchange rate is not ‘market determined’ as Mercantilists would have us believe, or determined by some abstract interest rate differential with some other currency such as the dollar, as if the exchange rate was some sentient being which was aware of an inflation index in some country half way across the world. The value of the currency is purely determined by the monetary policy. If there is excess issued of domestic money, the currency will fall.

It is laughable that the rupee bonds were blamed for the currency falls of 2015 to 2018. Mercantilists believed that without the rupee bonds in foreign hands the rupee will not fall. Now they are learning the lesson. In fact, the rupee bond holders fled to due to the currency instability from the ‘flexible exchange rate’ and ‘disorderly market conditions’ rule.

At the moment credit is not very strong. However, if economic activity picks up, and credit begins to move, the excess liquidity in money markets will hit the forex market and more foreign reserves will be lost when the currency is defended against the excess liquidity. In 2020 reserves were draining because of government debt repayments and also private banks finding it more difficult to roll over foreign credit lines.

Reserve losses are accelerating under MMT. But it was Call Money Rate targeting that put country on an almost irreversible path to doom. Reserve backing of the rupee has not recovered to 100% of the monetary base after call rate targeting. The numbers are overstated because in Sri Lanka excess liquidity is not considered part of reserve money.

The credit system was put in on an irreversible downward track by a combination of call money rate targeting, operation twist and term reverse repo injections. The steady pressure on reserves and the inability to mop up inflows is reason that foreign debt suddenly ballooned under REER targeting/call money rate targeting.

Now claims are being made that foreign debt is falling and domestic debt is rising. While it is true that not much new foreign debt is being raised, most of the debt is being repaid through reserve losses and selling bills to the central bank.

MELTDOWNS

When countries run out of reserves either the rates are raised or the currency falls when it is finally floated. Already net foreign assets are about 3.1 billion US dollars. At some point either rates will have to go up or the currency will have to be floated. Usually both happen in Sri Lanka.

If excess liquidity remains and the currency falls further credit tends to move. This is not because there is any new business, but because prices go up and businesses need more money to hold on to their existing stock. It is the first step in a meltdown.

Economic growth fallingto 2 or 3% a year after a 10% fall in the currency like in 2018, is nothing compared to what may happen in a total meltdown. When currencies fall and stock holding costs go up, credit will move up and more money will have to be printed even as people buy less goods.

On top of that state energy utilities will see their costs rise. If prices are not adjusted, more money and credit will go to those firms. In fact, in Latin American pegs, energy utilities are a key driver of meltdowns.

As currencies fall, people will buy less goods. Then more businesses will fail. When businesses fail, banks will fail. If people demand their deposits, more money will be injected through lender of last resort windows. The central bank will then find it difficult to control reserve money. Then people will try to buy dollars with the printed money. This is why it was difficult to control the currencies of Indonesia during the East Asia crises and also more recently Lebanon.

Already there is a capital flight in several ways. The rupee bond holders are gone, stock investors are going, bond holders are demanding high yields and banks are finding it difficult to extend foreign credit lines. In such countries it can become difficult to even get imports. Eventually the country will be dollarized involuntarily.

GIVE FREEDOM

But sovereign default does not have to lead to all this in the absence of a Latin America style central bank. In a dollarized country for example sovereign default may lead to a steep contraction in output, and state austerity – salary cuts and the like. But people’s deposits, pensions etc will be intact. But in a meltdown, all that security will also be melted.

Sri Lanka does not have a War. Sri Lanka did not have a war in 1950s and 1960s. Sri Lanka does not have rupee bond holders anymore either. What Sri Lanka has is a bad ideology involving monetary instability, regime uncertainty (policy uncertainty and expropriation) and nationalism. Under a currency board, Sri Lanka did exceptionally well before independence.

In short Sri Lanka’s problem is illiberal ideology. REER targeting and stealing the real salaries of the working classes through currency depreciation is illiberal. Import controls are illiberal. Expropriation is illiberal. Sudden policy changes are illiberal. It is very difficult for businesses or people to survive in such an environment. Cronies may be able to survive. But countries cannot grow fast based on cronies alone.

After the war ended, expropriation and monetary instability has worsened. It has been the experience in Sri Lana that the larger the working majority of the government, the worse the denial of freedoms to the ordinary people. Already plantations are being threatened with expropriation. After the war privatization has been reversed and the re-taken firms are adding to the losses. The last regime also did nothing much in the way of privatization, to fix the public sector.

Import substitution has worsened. The last regime blamed the problems of the country on real exchange rate appreciation and non-tradable sector. The biggest export power houses after World War II was the US, Germany and later China after its currency was fixed in 1993.

CONFIDENCE KILLER

Unsound money is never a solution to anything. The ‘flexible exchange rate’ which gave absolute discretion to the central bank killed all credibility and destroyed confidence. When there is no credibility of the peg, serious problems occur, including default.

Foreign investors fled rupee bonds from around the time of REER targeting, call money rate targeting. There was 450 billion rupees or three billion dollars of foreign investments in rupee bonds. That is one reason for the expansion of dollar debt under the Sirisena-Wickremesinghe administration as well as a general mis-understanding about the ‘transfer problem’ based on Cambridge economics.

A country with credible monetary framework (either a hard peg or pure floating rate) will end up with free capital flows and interest rates fairly comparable to the rest of the world subject to risk premiums.

In the past, balance of payments crises in Sri Lanka have happened in times of strong economic growth, strong credit, and strong imports fired by printed money from a central bank unwilling to allow rates to move up. It was also partly due to a closed capital account.

But now, reserves are falling depressed conditions due to severely eroded confidence, from the tax cuts in 2019 (stimulus) and rate cuts and injections from January onwards (monetary stimulus) and building upon earlier REER targeting, call-money-rate targeting. Net foreign assets are falling precipitately, as can be seen in the graph below.

All of this is happening, at a very basic level, due to the unwillingness to pay the correct interest rate. It was the problem during the 2015- 2019 administration and it is the problem now. Unfortunately with confidence at CCC it is very difficult to recover. Our policy framework is flawed and our world view is false and has nothing to do with the real world. When reserves run out painful depreciations and painful rate hikes, painful economic contractions will be the consequences.

The Cambridge economics, over, valued currency world view that drive the Sirisena-Wickremesinghe administration and the MMT that drives the current administration will have to same consequences. valued currency world view that drive the Sirisena-Wickremesinghe administration and the MMT that drives the current administration will have to same consequences.

SRI LANKA HAS HAD SEVERAL SERIOUS ECONOMIC CRISES IN THE PAST. UNFORTUNATELY, THEY HAVE NOT LED TO A RESETTING OF POLICY.

It is the world view on monetary policy that made Sri Lanka a strong trading nation, during the British period (Silver currency board) or Dutch period (Silver Rix dollar) or the time of the ancient kings, when Sri Lanka was using gold coins such as Kahavanu.

The supreme irony is that Sri Lanka in the past has done monetary reform in India. According to Culavamsa, after King Parakramabahu I general Lankapura took Pandya territory from the King Kulasekera he fixed the monetary system.

“The then far-famed one started forth came to Niyama and free the whole province from the briers (of the enemy),” says the Culavamsa. “He introduced into the country everywhere for trade kahapanas which were stamped with the name of the Ruler Parakkama.”

It is not possible to govern a country without fixing the monetary system. Almost 1,000 years later, Sri Lanka is on a dangerous path after REER targeting, call money rate targeting and now Modern Monetary Theory, which involves massive quantity easing type of injections.

This column has gone to great pains to show that Sri Lanka’s policy is far removed from those followed by successful countries. The dire warnings are made, not in the hope that they will come true, but in the hope decision makers will realize that illiberal policies have to change.

It is unfortunate that many of the warnings in these columns have come true. Sri Lanka has had several serious economic crises in the past. Unfortunately, they have not led to a re-setting of policy. What Sri Lanka needs is a complete reversal of policy towards sound money, better property rights, and policy stability. Less nationalism the better.