Sri Lanka’s central bank has allowed the rupee to appreciate amid broadly deflationary policy generally, but the rupee has been volatile, amid wide fluctuations in overnight liquidity and unwillingness to defend the exchange rate with unsterilized interventions.
The unwillingness to defend the exchange rate with unsterilized interventions, which will make the overnight rate move up quickly, is due to an obsession with the policy rate and mid-corridor rate.
THE MONEY-PRINTING LIE
That the central bank is not allowed to print money is an outright lie, spread by macro-economists. It is like most lies through which central banks create forex shortages, impose exchange and trade controls, push up the cost of living and make the poor starve, continue to operate with impunity, and shift the blame from its deeply flawed inflationist ideology to its victims.
The central bank is allowed to conduct open market operations, buy bonds from banks and print money. It is through this mechanism that the central bank is preventing rates from hitting the ceiling policy rate, triggering instability in the exchange rate, and eventually triggering a currency collapse and Sri Lanka’s second default.
The IMF has already given technical assistance to bring the next default nearer with the single policy rate. As of the last week of October, the central bank has printed Rs70 billion at 8.63% for 7 days, which is below the central bank’s overnight rate of 9.25%. It has further printed Rs36 billion at 8.44% on average overnight to prevent banks from borrowing through the standard lending facility at 9.25%.
Excess liquidity deposited in the overnight window hit Rs192 billion on October 25, 2024. Of that, Rs106 billion was printed. The central bank is running out of Treasury bills to mop up liquidity permanently. However, it is getting interest coupons on its bonds portfolio, which came from restructuring Treasury bills.
Due to its inability to roll over Treasury bills internally, the central bank has earlier also been injecting money, perhaps not on a net basis. All of this is done to bureaucratically control the interest rate.
Open market operations were invented by the Federal Reserve on April 13, 1923, originally to conduct a quantity-tightening operation. But pretty soon open market operations were used to defend a policy rate (discount rate) injecting indiscriminate money triggering extended credit cycles, bringing the age of inflation, the age of balance of payments crises.
The extended credit cycles, when rates were eventually corrected triggered recessions or if the credit cycles were long enough fire a good enough asset price bubble, big financial crises and depressions. Both the Great Depression and Housing Bubble came from cycles that were around 7-8 years.
MOST SIMPLE POLICY
Maintaining a fixed exchange rate and giving long-term stability for exporters and investors is the most simple operating framework.
However, to do that the legal powers given to central bankers to print money through open market operations to operate the policy rate have to be taken away. Sri Lanka’s central bank lost its reserves and also lost borrowed reserves by trying to target its policy rate up to April 2022.
Because India allowed the central bank to run arrears on Asian Clearing Union balances, the correction in the balance of payments was further delayed and its reserves moved further into negative territory of $4.6 billion.
The central bank therefore has to operate an interest rate regime that allows it to curb domestic credit sterilize inflows (mop up liquidity from dollars to build up reserves to a positive balance.
The interest rate has to be such that it allows the central bank to absorb some of the savings of the public which it will export and buy foreign assets to build reserves, reducing domestic investments.
INTERBANK LIQUIDITY FROM DOLLAR PURCHASES
When interest rates are higher than is required to keep savings and investments in balance or banks are unwilling to lend due to the lack of credit demand after a currency collapse destroys purchasing power, outflows of dollars are less than inflows and the exchange rate comes under upward pressure.
The central bank then buys dollars with new money, which then builds up as ‘excess liquidity’ in money markets. In a floating exchange rate, there are no dollar purchases. The purchase of dollars, as well as the sale of dollars to stop a fall in the currency from a spike in credit, shows that there is no floating exchange rate and that the currency is pegged in one form or the other.
This build-up of liquidity (basically positive balances in the accounts of exporters or remittance families or tourism operations which gradually transfer to other customers as purchases are made) tends to reduce short term rates.
Interest rates will therefore move towards the lower floor of the policy corridor. The excess liquidity eventually turns into imports, either through the recipients of dollars buying imported goods like fuel or foods, or the money being loaned for investment projects (since the country has a net savings rate) which will generate imports like building materials.
The central bank will then have to sell the dollars to stop the currency from falling. Until private credit picks up, the liquidity from savings bought by the central banks may not be used up very fast. When credit or imports come, and the central bank then sells the dollars to maintain a fixed exchange rate, the liquidity will be used. Interest rates will also go up and banks will curtail credit and the system will come back into balance with hardly any disturbance to the system and minor changes to interest rates.
If the central bank sells its Treasuries stock into this liquidity there will be a steady surplus in the balance of payments and the exchange rate will not come under upward pressure. What if the central bank does not fully defend the exchange rate at a fixed rate when the rupee comes under upward pressure? Let us say when credit slowed in April and the rupee came under upward pressure, if the central bank did not fully defend the rupee, the rupee would appreciate. Then importers will at first delay paying off import bills and try to sell their goods and get some money and also repay their import credits.
This will create further upward pressure on the rupee and result in more dollars being bought. Banks may also run negative open positions, further selling dollars and worsening speculative behaviour. Exporters will eventually delay selling dollars and start to take packing credit to fund exports with interest rates also falling. If the central bank does not mop up or sterilize the rupee, and private credit demand is not very strong the exchange rate will turn.
What happens if the central bank does not fully defend the exchange rate when it comes under downward pressure? If the central bank does not fully defend the exchange rate, importers will start to cover quickly, exporters will hold back a little more and the exchange rate will swing in the opposite direction.
Banks will also cover their negative NOP positions and try to make profits. To the extent that the central bank intervenes and sells dollars, liquidity will reduce and interest rates will go up. If the central bank injects money to keep rates from hitting the ceiling rates quickly, the whole drama will continue for a longer period.
The correction may eventually come from rising 3 or 12-month Treasuries yields which is high enough to delay private credit. Due to the so-called transmission mechanism, there may be increases in long-term rates as well. However, all that is necessary for a correction if there was a fixed exchange rate, is for short-term rates to increase and liquidity to fall.
WHO BENEFITS
Macroeconomists in the age of inflation-creating central banks and the International Monetary Fund can satisfy their doctrinal or ideological desires. Other than that, banks benefit. The volatility causes them to quote big spreads for importers and exporters. Banks also profit by changing their net open positions and financing their position with open market operations.
When the currency is allowed to weaken they can use open market operations and run positive open positions for example. Banks also profit from selling hedging instruments to importers and exporters. Banks can also profit by giving credit to exporters who want to delay conversions.
The central bank can also make ‘profits’ if the exchange rate appreciates when foreign assets are negative, just as banks with negative NOPs can make money by covering at the strongest position. Once foreign assets are plus, depreciation brings nominal profits.
THE LOSERS
While exporters and importers can to some extent play a waiting game, remittance families usually cannot. They get slammed if the exchange rate appreciates only for a short time and then weakens again. That is because import prices do not come down.
The public generally loses because importers have to keep wider margins to cover themselves against exchange rate swings. Up and down movements in the exchange rate, however wide, are better than permanent depreciation, it must be made clear. Exporters can also lose out because there is a timing difference between the time a price is agreed upon and delivered. Sometimes exporters also give credit to win business.
If the exchange appreciates when dollars are converted, and part of the expenses are in rupees (wages, utilities, and transport costs), exporter margins can get hammered. It must be noted that in these days of global supply chains margins are thin. When the exchange rate is stable, importers do not have to use domestic credit to finance their stocks.
They can use supplier credit and delay payment until the stock is sold, and save money and sell their products at a lower price to consumers, reducing the cost of doing business. However, if the exchange rate is volatile, they will have to borrow and pay off the import bills as early as possible. This is why the industrial revolution thrived in fixed exchange rates.
This is why East Asian fixed exchange rates provided the backdrop for an export boom and supply chains. While a flexible exchange rate satisfies the latest ideology of the IMF and brings profits to banks, it adds costs to international trade and harms consumers.
Countries that fix exchange rates for long periods – by restraining monetary policy or running deflationary policy – see high levels of domestic stability, capital inflows and permanently low interest rates, as well as in-migration.