Sri Lanka can end the steady deterioration of foreign reserves and head off a severe monetary meltdown in just a few days by sharply hiking rates and floating the rupee and putting the end to the ongoing misery of trade and exchange controls. Sri Lanka should hike rates by 200 to 300 basis points before a float to make sure that the currency does not fall too far.

This columnist would not predict a post-float exchange rate but kerb rates and Undiyal rates are already around Rs240/250 to a US dollar. Many importers are experiencing severe difficulties and that is why the rate is at those levels.

Results of lifting price controls are at an end

The lifting of price controls has done what it can do and with the central bank not accepting one year bills and injecting money at 6% there is little prospect of a further improvement of bond markets. The wholesale monetization of bonds is no longer taking place. Selling large volumes of three month bills by itself is not a bad strategy since high rates will disappear quickly once monetary stability is restored.

However, it is clear that the central bank cannot sell down its Treasury bill stock permanently without restoring the spot market. At the moment, any bills sold from its permanent portfolio ends up as collateral in the overnight liquidity window. The conversion rules also tend to undermine pegs which are already weak by creating liquidity.

In Sri Lanka, the central bank is liberally giving rupees at 6% – which is better than printing money to target a middle of the corridor – but not much. In Sri Lanka most dollars flow into the better managed foreign and local banks which generally do not borrow from central bank windows.

Bill yields have settled down at 6% and no further improvement in rates can be expected.

Why the conversion rule will make the situation worse

However, the larger negative fallout will be that the new conversion rules will also reduce inflows to the country. If there are no dollar deposits, state banks which have loaned dollars will not be able to raise dollars to fund their dollar liabilities which were financed with borrowings. The correction of the net foreign assets position outside of the central bank which was happening due to exporter deposits will also end.

Commercial bank negative net foreign assets position fell to Rs563.4 billion by end September from Rs824 billion a year earlier. With tighter conversion rules kicking in therefore, the situation will stop improving as more and more people will hold dollars outside the country and many other service related inflows could dry up. Swap premia are moving up again, showing stress.

BELLWETHER EXPLAINS

Are fixed or pegged exchange rates artificial? Are they inherently unstable?

Not at all. Fixed exchange rates are not artificial or unviable or unstable. That fixed exchange rates are unstable seems to be a myth spread by Keynesians and other Mercantilists who are unaware of monetary history and banking in general after the stimulus broke pegs.

A fixed exchange rate is simply a type of monetary system with a particular type of anchor. They have used false econometrics such as real effective exchange rates (REER) to attempt to link currency to trade. That such ideas are misguided can be readily seen in the ‘undervalued’ exchange rates Sri Lanka now has and ‘overvalued’ exchange rates of currency boards and almost all East Asian nations.

A fixed exchange rate is so-called because it is fixed or anchored to some asset that does not inflate fast and therefore limits and preserves its value. Throughout history sound paper money has been pegged to a valuable non-inflating (relatively rare) asset or the asset itself has been circulated. The best one found so far in human history seems to be gold, but silver has also been successfully used. The Indian and Ceylon Rupees were originally silver or pegged to silver, which is another way of saying that paper money has been issued like a cheque against a bank account balance of silver or gold, just as a person in the present day may issue a cheque against the current account balance.

What about a float?

Yes. A float will work in a severe loss of confidence. Floats work every time, unless there is a DMC (a Disorderly Markets Conditions rule where the central bank is allowed to intervene) as in IMF programmes. Then the float can fail as it did in Argentina. That is why the 2012 float failed until the currency fell to Rs131 to a US dollar before stabilizing as opposed to a quick fall to 120 in 2009 followed by a rebound, which is a classic float of a peg. Large volumes of dollars were given for petroleum bills in 2012 and liquidity was injected to sterilize them.

However, for a float to stabilize the exchange rate, interest rates have to be sufficiently high for bond auctions to work and prevent further money printing to pay the salaries of state workers. At the moment, deposit rates have not adjusted. Floats also have the advantage that interest rates will not shoot up unlike in unsterilized sales in a situation of weak confidence. The currency can be re-pegged at a weaker rate later, but for there to be credibility all interventions have to be unsterilized after that.

WHY A VAT HIKE

The budget has raised taxes. Due to politics and the reluctance to reverse a VAT cut, the tax system has got complicated and large companies have been hit. This column has said several times before that a hike of VAT to 20% is better for the poor. Such a VAT hike would have been preferable to a steep currency fall and very high inflation for the general public, especially the less affluent. It is still better to raise VAT to 20%. That will be steady revenues and will help prevent a too deep fall in the currency.

The budget has avoided raising income taxes and wealth taxes which kill future jobs, which is one bright spot.

Finance Minister Basil Rajapaksa had also acknowledged that the state workers are a problem, defying the JVP view that had dominated politics since 2004. He has also said that state enterprises were a national liability and not national assets as maintained by the JVP in 2003/4 and adopted as state policy since then.

However, his knowledge of note-issue banking is poor and the key problem of the central bank and exchange rate remains unsolved.

The budget has avoided raising income taxes and wealth taxes which kill future jobs, which is one bright spot

FLOAT

An IMF programme also works due to a float. The float stops interventions (suspends convertibility) and makes dollar holders sell. Under an IMF programme the currency is re-pegged – loosely – and the central bank starts buying dollars to rebuild reserves after paying for all imports.

The loose re-pegging sometimes results in very steep falls and a credible peg is not restored. That is why IMF programmes sometimes fail like Argentina did in 2018.

In order for dollars to be collected a credible peg has to be set up at a weaker rate which is accepted by the market. This exchange rate can be stabilized and reserves collected as soon as the central bank can buy dollars and mop up inflows.

RATE HIKE

However, this is not likely to happen with a policy rate at 6%. With a dysfunctional forex market without spot trading, it is not possible to buy dollars and collect reserves or enable CPC or the Treasury to buy dollars with rupee money raised, even if the 6% rate was high enough.

The budget deficit is already set at 10% for 2022. A 6% policy rate is not going to cut it. 2022 will not be pretty. A rate hike and a wider corridor are needed. A 200 to 300 basis point hike would be preferable before a float. As soon as bond markets get used to the rate, the currency should be floated.

An IMF programme will be better, but IMF programmes are also based on the same principles. That is why IMF programmes require a float as a prior action. Without a working forex market, all bets are off. An IMF programme can fail later due to the so-called “disorderly market condition rule” (DMC) with even unsterilised interventions (a currency board principle) which makes rates go up sharply. This is because unsterilized interventions are not made at a single exchange rate but at a flexible rate.

That is inconsistent. No credibility can be maintained on a flexible exchange rate even if there is a floating interest rate. Unlike Malaysia which fixed the rate after the East Asian crisis and maintained it, Argentina had failed due to unsterilized interventions made at different levels. Unsterilized interventions have to be made at a single credible rate.

Now interventions are sterilized at 6%. A float will end this.

TIME IS RUNNING OUT

This is what the IMF does to stop sterilisation injections, this is what the US Fed did in 1971, the Bank of England in 1933 and after declaring war in 1914.

However, IMF programmes have advantages.

1.  Even if a country does the correct things, it may not raise confidence among external investors due to dented credibility and the past record in bad policy and overt statism.
2. Instead of just selling land assets it is better to bundle privatizations into a private sector development support loan. The government can privatize Sri Lanka Insurance and a number of other state agencies.
3.  There are no specific IMF performance criteria that strictly enforces depreciation. Floats are required to end contradictory monetary policy and depreciation is kind of a byproduct. It is temporary if consistent deflationary policy is followed.
4. Since the REER index is below 100 there may be no insistence on depreciation given the impact on foreign debt obligations as well. Whether or not the exchange rate appreciates after a float is a matter of domestic operations.
5.  And a reversion to a 15-20% VAT is better for the poor than currency collapses and ongoing inflation.
6. Under an IMF programme, a clean floating exchange rate is out of the question as the agency required interventions to collect dollars. In other words, the currency will be pegged again. That peg has to be managed on classical principles like GCC countries and East Asia and not the ‘flexible’ snake oil peddled by US mercantilists.

Already pressure is being seen in energy. In the first quarter of 2022 droughts will come. It is better to float before the dry season in February when there will be more pressure to fund losses with credit.

This column has shown earlier how energy subsidies are a weak link in monetary stability both in Sri Lanka and Latin America. Very soon there may be no reserves to intervene. Fed tightening is also looming. Most pegs collapse when Fed tightens.

Already the net reserves are negative. That means the central bank is running on borrowed time