Sri Lanka goes from “boom-bust” to “bust-bust” with soft-peg

STABILITY MAY NOT BE EVERYTHING, BUT WITHOUT STABILITY, EVERYTHING IS NOTHING: KARL SCHILLER

Sri Lanka is going from “boom-bust” to “bust-bust” in this credit cycle, despite the injection of excess demand into the economy by the central bank, with currency depreciation and capital outflows taking their toll and a Weimar Republic-style default looming due to the soft-peg. Sri Lanka has had boom-bust cycles in the past, primarily due to the central bank’s failure to allow rates to rise as credit demand picked up in the recovery period. The Federal Reserve (Fed), however, is raising rates as the economy is picking up.

But the Fed has a floating rate and does not intervene in forex markets and print large volumes of money (like quantity easing) even if it did cut rates. This is because the US has a floating exchange rate with no convertibility undertakings, explicit  or otherwise. As credit recovered, the Fed has, in fact, been reducing the excess liquidity created during quantity-easing after credit collapsed.

BOOMS
Sri Lanka’s budgets have been blamed for generating boom-bust cycles by the central bank. It has accepted no responsibility. But boom-bust is an inherent side effect of all credit cycles.

This belief that budgets are a source of excess demand is a dangerous misconception. A budget cannot infuse a lot of excess demand unless the credit system is contracting and the excess liquidity it uses comes from a private credit contraction. A budget will simply transfer spending power from buyers of bonds to the Treasury. If at all, state spending, which may involve putting other people’s money in low-return projects, will reduce long term growth.

SL’S BUDGETS HAVE BEEN BLAMED FOR GENERATING BOOM-BUST CYCLES BY THE CENTRAL BANK

The central bank has to avoid boosting any recovery with new money to make the boom worse with pro-cyclical policy (through open market operations or purchases of Treasury bills at auctions), and allow market rates to take care of the problem and minimise its effects. Having said that, there is evidence that some central banks have been able to reduce the boom quickly (Canada, Australia, New Zealand) as the Fed is trying to do now. The secret may be a good consumer (headline) inflation index that does not hide inflation.

Even in the free banking days, there have been credit cycles around the world, although they were not as bad as the ones that came after the creation of the Federal Reserve.

However, there is no point in comparing the Fed to the Central Bank, because they operate regimes that are polar opposites. Sri Lanka is operating a soft-peg with explicit and implicit convertibility undertakings. In such a regime, any money created from domestic asset purchases, which has no foreign assets to back it, and make good the CU (convertibility undertaking) is printed money.

Last year, the central bank loosened policy and injected cash into money markets just as the economy was recovering.

“Sri Lanka is at the bottom, and was just starting to recover from the 2016 bust when the depreciation hit again,” this column said last year in Sri Lanka and Ecuador; a cautionary tale of the Rupee and Sucre.

“It is one thing to have a boom-bust. It is quite another to have a bust-bust.”

“If the Vietnam Dong collapses in the next year, despite rocketing exports, their people would have got many benefits during the decade-long boom.”

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BUST-BUST
In 2018, as the rupee came under pressure from excess liquidity, and credibility in whatever convertibility undertakings was lost, the recovery stalled and growth slowed. In the 2011/2012 “balance of payments” crisis, there was strong growth as money was injected through terminated term repo deals (a bit like the Central Bank of Argentina creating a secondary market for its own sterilisation securities to generate the latest Peso collapse). The Yellow GDP growth went up sharply with the printed money growth (net credit to government).

Growth was strong for two reasons. One was that the currency peg was kept until 2012, preserving the real value of the currency for people to invest or consume most of the printed money. The other reason for stronger growth was that foreign investors in bonds such as Templeton did not sell.

Foreign bond holders held back because the rupee was allowed to appreciate during the ‘bust’ period (credit contraction) that followed the liquidity injections in the 2008/2009 crisis. However, after the rupee fell to 131 to the US dollar in the 2011/2012 crisis and it was not allowed to appreciate, foreign investors had second thoughts. Plus, the UNF administration also got into a public spat with Templeton, which may have sent bad signals. In both the 2015/2016 crisis and 2018 runs on the rupee, foreign investors sold out strongly. Using the printed money from open market operations, banks then bought the bonds sold by foreign investors instead of giving credit, reducing the resources available for domestic players. Currency depreciation also destroys real purchasing power. For example, it costs more to build a house as building material prices go up due to depreciation. Meanwhile, potential buyers of houses or any other good will also find less money available as fuel or other costs go up. Growth is now slow, around 3 percent. Sri Lanka’s growth may look slow due to the changes made in the way it was calculated after 2015, when GDP was estimated to be bigger. But over time, it should balance out (but items like revenue to GDP will be lower). If the Census Department consistently undercounted GDP, eventually the total GDP will be low and GDP growth will show the ‘correct’ number because the same assumptions or errors will be made consistently.

THERE IS NO POINT IN COMPARING THE FED TO THE CENTRAL BANK, BECAUSE THEIR REGIMES ARE POLAR OPPOSITES

However, bust-busts have many other implications. If not for the halting of mopping up auctions in February and rate cuts and cash injections in April, Sri Lanka would be on a strong recovery cycle, backed by the end of the drought.

However, it was not to be, due to capital outflows and the currency collapse. But a more deadly result of a bust-bust cycle is that killing domestic demand with currency depreciation leads to business failures, resulting in bad loans. That is also why this columnist advocated open market operations or unsterilised defence to generate a liquidity short, hiking rates and quickly floating to re-establish confidence in the peg. Prolonged liquidity shortages have severe consequences. This is another problem with soft-pegs. Hard pegs which rarely have credibility, have such problems. While Hong Kong’s peg was hit by speculators in the 1997 crisis, the confirmation of its credibility resulted in excess liquidity during the 2008 global crisis, as resident firms and banks brought funds back home.

Sri Lanka’s rupee peg is non-credible. A REER target is going out of its way to undermine its credibility. Therefore, it is better to hike rates, allow the liquidity shortage to spread through the banking system and then float, and ‘get it over’, as the saying goes, each time a monetary policy error is made.

MULTIPLE RUNS
In February 2018, there were strong signs that the second run on the central bank had ended and the rupee was stabilising.

However, emerging data showed that even in January, the central bank had bought dollars. It is a mistake to buy dollars too soon. The rupee should have been allowed to appreciate like in India. The marginal cut in the money printing auction from 9.0 percent to 8.75 percent recently is also extremely premature. It is premature because 2019 has a lot of debt repayments. For the same reason, the rupee should be allowed to float cleanly and appreciate before the central bank purchases dollars.

In 2018, the central bank generated the second run after the rupee stabilised in August.

Weak private credit allows the credit system to stabilise faster than in earlier crises, when business confidence was stronger and the rupee had been stable for longer periods before that, preserving purchasing power.

SRI LANKA’S RUPEE PEG IS NON-CREDIBLE, WITH REER TARGET UNDERMINING ITS CREDIBILITY

What is happening now is that borrowers are acclimating to higher rates. To fix the next run, even higher rates may be required. Data seems to show that liquidity shortages are developing again in February, which is not a good sign.

DEBT REPAYMENT
What is happening to Pakistan should be a warning. It is a wrong strategy to repay foreign loans purely with new borrowings with a depreciating currency.

Sri Lanka’s rating is at now at ‘B’, which is too close to ‘CCC’ for comfort. Going for large borrowings at one go will spook investors. It is better to go for usual volumes and go to markets a second time, even at a higher rate, after investors get comfortable. Ever since the last regime ended privatisation, then re-nationalised agencies like SriLankan, expropriated others, bought back Litro Gas and generally had an unfriendly attitude towards free enterprises, and backed crony businesses with protectionism, this country had been going down the low growth- default path.

The infrastructure drive with Chinese loans would have made sense if more private investors were allowed to come in. Even on expressways built with public funds, private buses were not allowed.

A FOOL’S PARADISE
The REER pegging depreciation will also contribute to debt default pressure. It is a completely wrong claim made by the central bank and other official commentators that depreciation brings more revenues to the state.

Depreciation expands the budget. It is simply not shown as an expense despite depreciation being a cash flow rupee item. Why it is not done is not clear. During British colonisation, when Sri Lanka had currency board, depreciation was not a factor.

Even after the central bank was created and money was printed, the exchange rate was maintained with trade and exchange controls. It may have contributed to the way budget numbers are calculated. The IMF, which also tends to depreciate soft-pegs to re-establish credibility, would prefer not to take into account depreciation.

A similar strategy is followed with the so-called Primary Deficit. It is a target that keeps policy rate hikes off the table. It may make sense since policy rate hikes are needed to fix problems. But like depreciation, the interest cost is there.

There is no path to prosperity through depreciation.

MONETARY STABILITY
The first priority in debt repayment is to re-establish confidence in the peg.

Borrowing more dollars to repay debt is not the answer. It is also a mistake to think that there is some shortage of ‘foreign currency’.

There is no shortage of foreign currency to repay debt if the central bank maintains monetary stability, mops up a part of the inflows, and avoids debacles like in April and August. Such a strategy requires a slightly higher interest rate than the market clearing rate (like the currency board rate), to allow the domestic credit system to lend all the money it raises and therefore generate forex savings by keeping imports and the so-called current account below full potential.

It is not possible to shrink the entire external current account to repay all the foreign debt in one go and convert them to rupee debt. It may generate negative growth. But it can be done to some extent. Sri Lanka has been doing it for decades.

MORE CHINESE LOANS ARE NOT THE ANSWER TO FOREIGN DEBT REPAYMENT

After all, in the old days, the IMF loan was given for just that reason. IMF loans would re-build reserves and give immediate confidence, allowing reserves to re-built slowly without shrinking the current account too much. But the IMF programs in recent years have institutionalised the contradictory policy of soft-pegs with an inflation target coupled with a forex target.

This column said at one time before the 2015 liquidity injections that Sri Lanka cannot afford to take monetary risks with commercial foreign debt. It is even more so now. Trigger-happy domestic operations are even more dangerous with a B credit rating.

It is perfectly acceptable to have another quarter of low growth if the result is to push the peg to the strong side of the convertibility undertaking. Borrowing abroad will not help, if the central bank’s Domestic Operations Department keeps injecting new money for whatever reason, belief, ideology, or theory.

There have been some claims that a budget deficit injects excess demand. The Treasury cannot print money. It can only transfer purchasing power from purchases of bond holders to itself. Excess demand comes if the central bank accommodates the deficit with printed money.

NO FISCAL DOMINANCE
2018 proved beyond doubt that political pressure was not the reason for monetary instability. State Minister for Finance Eran Wickremaratne publicly said the central bank was independent.

Finance Minister Mangala Samaraweera slapped import controls and undermined the entire free trade strategy of the administration just to contain the negative effects of monetary instability. In addition, Sri Lanka had the extraordinary spectacle of Harsha de Silva, the State Minister of the ministry to which the central bank is assigned, pleading to allow rates to go up to the 8.5 percent policy ceiling.

Subsequently, policy rates were raised to 9.0 percent.

It is not clear whether any politician of a developing country had ever urged a central bank to tighten instead of loosening.

Having said that, 2019 is an election year. So the budget will not be helpful. It is imperative that monetary stability is restored soon as possible and rates match the deficit.

More Chinese loans are not the answer to foreign debt repayment. The Dawes plan did not help the Weimar Republic.

Neither will new Chinese loans help Sri Lanka or Pakistan. China itself will learn the mistakes of those who had to engage in gunboat diplomacy. It seems that the People’s Bank of China and China itself are having higher interest rates after the strong peg was broken. Let’s face facts. Keynes was wrong. Bertil Ohlin was right. Later on, Robert Mundell was right. Marcus Fleming was right.

There is no transfer problem. Keynes’ 1919 publication “The Economic Consequences of the Peace” may have been a runaway success with English readers, buts its core argument was flawed. Similar arguments are repeated in Sri Lanka. Foreign debt repayment will slow domestic economic activity, but export surpluses are not a requirement.

Bretton Woods collapsed with the Fed’s own peg collapsing. So did the pound sterling. It is then little wonder that the rupee collapses. A mountain of debt denominated in a stronger currency was not a problem for the US. But it was a problem for the Weimar Republic. And it is a problem for Sri Lanka and Pakistan.