Sri Lanka’s central bank has been playing with swaps for some time and the agency’s large Rs778 billion loss in 2022 on its foreign currency operations was directly related to swaps and other borrowings.
The Nick Leeson style losses came not only from swaps but also IMF borrowings taken during an earlier flexible inflation targeting crisis and borrowings from India through the Asian Clearing Union, which have since been converted to swaps.
A central bank is supposed to have foreign reserves, but with the invention of the policy rate, modern central banks engage in ‘macroeconomic policy’ or try to boost growth through money printing to suppress the policy rate and run out of reserves.
After the central bank ran out of reserves at least before swaps, macroeconomists were forced to allow market rates to increase to stop the currency from depreciating further.
But with the invention of the swaps, by the Federal Reserves when it started aggressive macroeconomic policy in the 1960s, a central bank can continue to print money with non-existent reserves and use them for imports (finance private sector activity).
The People’s Bank of China, bless its communist heart, at least had stopped the macroeconomists from busting the proceeds after reserves fell below three months of imports.
Otherwise, the central bank would have printed money, private imports would have gone up, some more instability would have continued and people would have suffered more like they did due to the misguided ACU loans to the Central Bank.
The entire doctrine of the ‘reserve adequacy metric’ of the IMF’s statistics is completely flawed as central bank reserves cannot be used to make private sector imports, which is enabled by liquidity injections made to sterilize outflows.
Whence this Perfidy?
The Federal Reserve was the culprit. The Fed which had a lot of gold reserves did not have a lot of foreign exchange, unlike other central banks.
When it printed money for ‘macroeconomic policy’ (boosts employment) and continued artificially low interest rates it had to get foreign exchange from somewhere. The Fed then went shopping in Europe, from the Bank of International Settlement, France and Germany. The initial ad hoc swaps started with Swin National Bank in 1960.
Charles Coombs, head of the foreign exchange desk at the New York Fed was the perpetrator who built swap facilities with counterparty central banks on a standing basis and eventually helped worsen the currency crisis in Sri Lanka and other countries by giving another tool to rate-obsessed macroeconomists to delay corrections.
When the Fed printed money above its gold holdings it was obliged to exchange them for gold (as were free banks in the old days through the clearing system). To prevent the dollar from boomeranging on itself it hit upon the idea of the swaps.
The forex taken from the swaps could be used to buy back the excess dollars from Germany, France, Belgium or whatever bank that did not print money.
Governor Brunet of Banque de France cottoned onto the trick and reportedly the Bank of England “thought that the American idea of organizing swap facilities around Europe for large sums indefinite in time was wrong in principle” because it allowed the United States to avoid going to the IMF to resolve “deep-seated difficulties” with the dollar. The ‘deep-seated’ difficulty was of course the bureaucratic policy rate.
France had greater monetary knowledge unlike the Anglophone macro-economists with the French Franc just being fixed by Jacque Reuff, who had argued with Keynes as far back as the 1920s and failed to convince him. It was wrong in principle in 1962 as swaps and it is wrong in principle now. France was right since the dollar and the Bretton Woods eventually collapsed against gold as the rupee collapsed against the dollar in 2022
Assuming Risk
One of the reasons that European banks agreed to swaps was that it acted as a forex hedge. When the Fed got Deutsche Marks and exchanged them for excess US dollars instead of giving gold, the Deutsche Bank was left with exactly the same volume of dollars as before.
However, this was under the swap and any dollar devaluation (against gold) will not affect the more prudent French, Swiss or German counterparty central bank.
The Fed eventually browbeat Deutsche Bank into accepting part of the forex loss. In 2022 when the rupee collapsed steeply Sri Lanka’s central bank made a 720 billion rupee loss on its forex operations and it was deeply in debt. Fast forward to 2024.
IMF Support for Swaps
This is what an IMF official told reporters in Colombo in response to a question about the central bank’s predilection for swaps. “Rebuilding reserves is a very important component of the IMF-supported programmes. One is what we call organic purchases by the central bank in the foreign exchange market. The other one is rebuilding reserves for engaging with swaps. This can either be swaps with domestic banks, or swaps with other central banks. The latter is a very important part of both global and regional financial safety nets.”
To be fair to the lady, Fed swaps recently including during the collapse of the housing bubble it fired, were aimed at giving dollars to other central banks as markets froze and everyone held on to cash of all kinds.
But what Sri Lanka’s central bank is doing is engaging in the 1960s style swaps and assuming enormous forex risks. Swaps with domestic banks simply allow them to convert dollar deposits (or foreign credit lines), lend them as rupee loans and the central bank will end up holding the baby.
What Can Be Done?
From the foregoing, it can be seen that swaps are deadly in two ways.
One: Central bank swaps allow macroeconomists in Sri Lanka to cut rates through open market operations and liquidity facilities and keep them down, making the eventual crisis worse. Two: It creates a forex risk and losses. Three: It creates a moral hazard for private banks as it allows them to dump the forex risk on the central bank which lends in rupees.
As banks are sitting on large dollar balances, the temptations must be irresistible to either swap them or borrow them and show them as ‘reserves’ to all and sundry and the IMF.
Sri Lanka’s politicians can move an amendment to the central bank’s inflationist and output-targeting monetary law to ban forex swaps. Or legislators can draw up an outside law like the classicals did with the Bank Charter Act, and impose restrictions on the central bank through a second law notwithstanding its inflationist output targeting IMF-backed monetary law. That will make it less easy for macro-economists to drive the country into default in the future.
Same story: All Geographies, All Centuries
For several years this columnist had warned that swaps would result in enormous losses for the central bank when the currency collapsed. The Central Bank of the Philippines had to be recapitalized. The Bank of Thailand got dollars from speculators and hit its own goals. So did the Bank of England in the ERM crisis. More recently Lebanon’s central bank borrowed dollars (took deposits) and eventually collapsed itself.
All this happens due to the policy rate.
Sri Lanka also has a history of this type of forex risk going back to a note issue bank before the current central bank.
The Eastern and Oriental Bank, one of two note-issuing (Chartered) banks that issued rupees in Ceylon closed its silver door in 1884 just like the Fed closed its ‘gold window’ and floated in 1971.
The Oriental Bank rupee collapsed 50% overnight and the Madras Bank’s rupee was held according to surviving accounts. The problem with the Oriental Bank was the same as Sri Lanka’s central bank.
Modern Saltwater/Cambridge central bank borrows dollars, sells them in the forex market, and then prints large volumes of money to sterilize the intervention by repurchasing Treasury bills from banks, worsening the cycle and leading to an eventual collapse of the currency.
The Eastern and Oriental Bank borrowed in Sterling and loaned in Silver. The rupee was silver-backed or silver-denominated. In fact, researchers who went into 19th-century ledgers of the Bank of England found that Oriental Bank was a top borrower at its discount window.
That is why this column advised that removing counterparty limits for borrowing through the standing facility or reverse repo auctions was a mistake.
The imposition of the counterparty limit was a key prudential move by the current management of the central bank. The Oriental Bank closed its doors not only due to a parity problem between Silver and Gold. Unfortunately, in almost 150 years we have learned nothing.
The Eastern and Oriental Bank did not just collapse due to exchange risk, but also because of its clients, the plantation companies were hit by falling prices (as the commodity bubble deflated) and could not repay loans.
The central bank which used Sri Lanka Government paper as collateral to print money into the banking system also ended up with a ‘bad loan’.
The restructuring of Sri Lanka’s government debt had left it with hefty losses. It must be noted that except when foreign debt is repaid with a reserve appropriation, or some deficit is being monetized, most of the money printed by potential output gap has nothing to do with the government.
Government securities already in the balance sheets of commercial banks are taken to the central bank to conduct overnight term or outright reverse repo injections.
Before the Fed, central banks did not discount government paper but actual trade bills (banker’s acceptances) from various good companies. The BoE researchers found that in the past when some of the bill brokers or banks went down, the Bank of England did not have much losses, as the paper it took was from strong companies.
Either way, the large mark-to-market losses of the central bank are from violating another classical central banking principle, the bills-only policy. This prudential practice was also violated in the general deterioration of policy after the end of the war, eventually ending in default.
In defence of the central bank, it must be said that it took a hit on its balance sheet, to protect the government securities market and it helped bring down rates faster.
There are banking practices that must be observed in running banks. There are even more stringent prudent rules to be observed when running a note-issue bank (a bank that can create its own reserve money or circulating medium as the classical greats used to say.
The IMF has weak knowledge of note-issue banks, that is why its patient keeps going back with increasingly worse symptoms. If the central bank is misused to target potential output, or if the domestic 5-7% inflation anchor rears its ugly head, a second default is not far away.
A peaceful country, which overcame a civil war, was driven to a default with flexible inflation targeting/potential output targeting, the latest spurious monetary doctrine of the Saltwater/Cambridge inflationist. Nothing of the ideology has changed, as can be seen with the IMF’s endorsement of central bank swaps.