Sri Lanka’s International Monetary Fund programme has a series of long overdue essential reforms but its core monetary programme and budget support loans in particular can derail the rupee in an economic recovery and deny the stability needed to implement its structural benchmarks.
The budget support loans show troubling confusion about the balance of payments, foreign reserves, central bank operations, their impact on domestic credit and the balance of payments.
All IMF loans, even if they are disbursed to the central bank’s balance sheet directly, are budget support loans in the sense that it creates space in the domestic credit system for the government to borrow by reducing the need to collect reserves and lowers the break-even interest rate.
What are foreign reserves?
Any foreign reserves collected are savings made in the domestic economy by reducing domestic investments or consumption.
Collecting foreign reserves as a practical matter is the same as repaying debt and has a similar effect on the domestic credit system. In any country, the current inflows do not change much in a year or two. They are limited to the country’s goods or services export capacity and people working abroad.
In Sri Lanka, there are two types of official foreign reserves. The central bank has monetary foreign reserves bought by creating rupees (the reserve money supply) and the Treasury also has some dollars in a central bank account from time to time. These fiscal dollars are like a sovereign wealth fund.
Sterilization and currency crises
Currency crises happen when the central bank engages in inflationary policy and injects money to suppress interest rates, usually, through open market operations, overnight injections, term repo injections or outright purchases and by rejecting bids for maturing bills from past deficits at auctions.
The newly injected money then triggers credit without deposits and surging imports. The central bank then intervenes in forex markets and continues to inject money to keep the policy rate down by offsetting the intervention with new money, an action known as sterilizing outflows.
To keep the exchange rate the central bank has to stop the injections and give up its independence to print money (policy rate) and allow interest rates to go up. As long as money is injected into the banking system (rupee reserves are injected) the central bank will continue to lose reserves by a like amount at a given exchange rate.
East Asian countries build large volumes of foreign reserves by doing the exact opposite. The monetary authorities in these countries sell central bank securities into the banking system and suck up domestic money. In GCC countries the monetary authority sells certificates of deposits to withdraw domestic money, which in turn creates an excess of dollars in the balance of payments.
The sale of central bank sterilization securities (MAS Bills/Bank Negara Bills or Shariah-compliant CDs in the UAE) into the banking system reduces domestic credit by taking away domestic currency reserves in banks and keeping the exchange rate under upward pressure at all times.
To suck domestic money out of the system, and trigger an excess of dollars in the balance of payments, the interest rates have to be slightly higher than otherwise and domestic credit has to be curtailed.
A front-loaded IMF tranche drawdown is budget support
Therefore a front-loaded reserve injection into the central bank gives more space for domestic credit and allows interest rates to fall faster. In earlier programmes, the government was able to borrow more domestically by dipping into the space created by the tranche injection which allowed foreign reserves to be built slowly.
There is not much difference between IMF money given to the central bank’s balance sheet without disturbing domestic reserves (a transaction that has no reserve pass through) which gives space to borrow more domestically to a direct injection to the Treasury.
The old IMF veterans who designed these programmes knew this. The first IMF programmes were one-year stand-by programmes, where the IMF forced rates up, hiked taxes to further reduce domestic credit, lifted administered prices to stop losses in state enterprises and went away.
Of course, a few years later the central bank suppressed rates – for rural refinance, or other refinance programmes, or bought maturing bills at auctions to suppress rates as the economy picked up, or suppressed rates while energy utilities borrowed for subsidies and triggered a new currency crisis and social unrest.
In Sri Lanka, provisional advances to the government and transfers of central bank profits also trigger currency pressure when there is a strong domestic credit recovery.
It is easy to lose the credibility of the exchange rate. After everyone panics, very high rates are needed to kill domestic credit and restore credibility in the peg and get everyone to trust the exchange rate again.
Non-conflicting Policy
Governor Nandalal Weerasinghe operated a guidance peg very effectively with zero reserves by raising rates and reducing credit demand. Then banks also stopped giving loans and started to deposit liquidity in the Standard Deposit Facility of the central bank, effectively creating a liquidity trap or private sector sterilization. In this situation – where market rates were 30% – the policy rate was no longer effective and the transmission mechanism was dead.
Any purchases from the central bank which are not permitted by the underlying credit conditions will lead to a weakening of the exchange rate. This is where the IMF ‘budget support” loans will also pose a danger to the exchange rate and monetary stability
Governor Weerasinghe was right to operate an external anchor, using a not-so-credible peg, but a peg with fully complementary monetary policy. Inflation started to collapse ahead of IMF projections as if the country was dollarized.
In Sri Lanka, goods exports, remittances and tourism are the major source of dollar inflows. When these sums of money are spent by their recipients, imports take place.
IMF projections are based on the so-called flexible exchange rate, a type of zero credibility ad hoc peg which can go anywhere and market players can panic. This was seen soon after the surrender rule (a surrender rule pushes a currency down by creating liquidity) was lifted and the rupee appreciated. Then when banks were in oversold positions and were trying to buy back a few dollars – in thin volumes – the central bank did not sell as IMF discouraged selling.
A prior warning of things to come
And mild panic was seen in the market amid the ad hoc pegging process. This is a prior warning of things to come. The rupee stabilized later because the underlying credit conditions favour upward pressure on the currency peg due to weak credit.
Sri Lanka has to continue to peg the rupee to collect reserves and buy dollars from the market.
A NIR target is a surrender rule. But unlike a surrender rule, the new NIR target has no transparent price. Under the ‘flexible exchange rate,’ the surrender rule or NIR target can hit anywhere and market participants will have nowhere to run. This is in sharp contrast to IMF programmes before 1980 where consistency was maintained between money and exchange policies.
Any purchases from the central bank which are not permitted by the underlying credit conditions will lead to a weakening of the exchange rate. This is where the IMF ‘budget support” loans will also pose a danger to the exchange rate and monetary stability.
IMF budget support loans like hedge fund swaps
A part of the first 331 million IMF US dollar tranche had been used to repay an Indian loan of 121 million dollars. That does not create any disturbance in the domestic credit system or reserve money. However, if IMF money is sold to the central bank to generate rupees, reserve money expands.
As the Treasury pays domestic expenses the money will eventually hit the exchange rate as import demand builds up as cascading credit flows through domestic banks. The money, if kept in state bank accounts, can hit the forex market if used for private credit – say a loan given to build a hotel – even before the Treasury uses it.
The IMF budget support loan converted to rupees through a surrender to the central bank will have the same effect as swaps used by hedge funds to hit East Asian pegs in the 1997 crisis. It will also have the same effect as the Hambantota port sales which were swapped for dollars in August 2018.
To avoid the new money pressuring the currency the central bank will have to sell down its Treasury bill stock and mop up the money and block any domestic credit. This action will be the same as the IMF having directly given the reserves to the central bank and the government borrowing domestically. At the moment there is a liquidity shortage in banks to absorb the money.
When the liquidity shortage is gone and domestic credit picks up, it will be a different story. After the debt restructuring is done, foreign and other banks will begin to buy Treasuries with the money in the SDF window. Pressure will also come on the rupee if the money is not absorbed through a sell-down of central bank-held Treasuries.
Any money created from dollar purchases will pressure the currency unless the central bank is prepared to sell the dollar when the rupee comes up for redemption on the forex market. If the dollars are not sold at the time, the rupee will fall. Under IMF programmes, dollar sales are severely curtailed and the central bank cannot operate a consistent peg. Under flexible inflation targeting, the central bank is not obligated to sell down its domestic assets in line with net international reserve targets.
Money and exchange policies in conflict
The monetary policy consultation clause under ‘data driven’ flexible inflation targeting is in direct conflict with the net international reserve target. This is why IMF programmes fail in the middle of a 2-year programme and exchange rates unravel.
When the currency starts falling, and panic sets in the market, Sri Lanka will be back to square one. The depreciating currency will unravel inflation and impose a regressive tax on the poor by pushing up food prices.
The disinflation path of modern IMF programmes is weak due to the conflicting exchange and money policies that are inherent in the programme through the monetary policy consultation clause.
A year or two down the line, as soon as the economy starts to recover and credit picks up the currency will collapse under inflationary open market operations. That has been the case in Surinam, Zambia and Ghana.
Once the credibility of the exchange rate is lost in strong domestic credit it is difficult to regain it without steep rate hikes to kill domestic credit and growth. Then the debt targets and economic growth will go haywire. Sri Lanka will not meet the debt sustainability indicators.
Sri Lanka will default again just as a peaceful country defaulted after flexible inflation targeting and output gap targeting. If a central bank collects reserves, it cannot do inflation targeting or output gap targeting.
To avoid monetary instability the central bank will have to do the following:
- Use IMF funds only for external repayments that fall due.
- Avoid surrendering the dollars to create money and fund domestic spending.
- If any such rupees are not sterilized immediately, during the same week, be prepared to sell dollars to maintain confidence in the currency.
- Any IMF money can be sold in the market, which will put upward pressure on the currency and avoid any changes to reserve money.
- Sell down central bank-held treasuries consistently through gentle deflationary open market operations to always maintain a small liquidity shortage in money markets and keep the exchange under-appreciating pressure.
- If the IMF reserve target is too high, be prepared to keep rates high enough to curtail domestic credit in like amount.
- Any procrastination under data-driven flexible inflation targeting will lead to exchange rate pressure and a subsequent default.
A pegged central bank simply takes dollars in as ‘deposits’ and then lends it to the US and other countries. To stop the depositors – the persons to whom the rupees were given by the central bank from asking for the dollars back through spending – the pass books have to be taken away.
That is what happens when central-bank-held Treasury bills or sterilization securities are sold to banks or other customers and the liquidity is mopped up. It is very easy to maintain monetary stability, low inflation and exchange rate stability as long as open market operations are not inflationary. All the central bank has to do is avoid inflationary open market operations.
Sri Lanka will default again just as a peaceful country defaulted after flexible inflation targeting and output gap targeting. If a central bank collects reserves, it cannot do inflation targeting or output gap targeting.
In countries like Sri Lanka, as in East Asia where people have high savings rates, it is absurdly easy to fix exchange rates and also repay foreign debt or collect reserves.