Sri Lanka’s most urgent task is to restore monetary stability by moving away from the broken peg to a working monetary regime so that imports can be made and wealth can be transferred from rupees to dollars for imports.

It is easy to break a peg by suppressing interest rates but not easy to restore. Sri Lanka’s interest rates will not fall unless a working monetary regime is restored. The easiest way to restore monetary stability is to float. A float is not the same as a devaluation.

WHAT IS A FLOAT

A float is a complete suspension of convertibility where reserve money is neither created nor destroyed by central bank sales or purchases of dollars. Under a float, the reserve money gets fixed except for ATM withdrawal and inflation.

For a float to work successfully the central bank has to abandon the surrender rule where forced dollar sales are made for new rupees. Until the float gets established dollar sales for oil also have to stop so that international operations do not alter the rupee reserve money. However dollar sales against Treasury bills, while leading to a loss of reserves, will not alter reserve money.

In the past, Sri Lanka has managed to float and restore monetary stability and restored the ability to import in a few days or weeks. If a float is not successful the corrective interest rate is higher and the economy has to be severely smashed, like now to restore exchange rate stability.

HALF-HEARTED FLOATS WILL NOT WORK

Given Sri Lanka’s tendency to float half-heartedly including in 2012 and floating with excess liquidity in 2015, this column warned that care should be taken for it not to happen. Even this columnist did not count on the deadly surrender rule, which is very much worse than ‘floating with excess liquidity’.

“However any kind of half-hearted Treasury bill and bond auctions, partially failed bond or bill auctions with some volumes of printed money will lead to progressively higher interest rates but the reserve losses and currency depreciation will continue,’ this column warned in August 2021 (Sri Lanka’s monetary meltdown will accelerate unless quick action is taken).

Soft-peggers are not good at floating. Partial interventions (flexible exchange rate) will lead to even higher interest rates and more losses of confidence.

In Argentina, short-term rates went up to 60% due to the ‘flexible exchange rate’ (which is neither floating nor pegged) that had caused so much damage to Sri Lanka since 2015 coupled with an unsterilized disorderly market conditions (DMC) rule, which also lacks credibility.

The high interest rates can kill many businesses. The high rates from partial floating can kill finance companies and banks. When dying banks are bailed out with printed money, it is generally even more difficult to control the exchange rate.

If money has to be printed for other expenses, the float will not work. That is why the deficit has to be reduced to some extent. If not, the whole burden will fall on the interest rate. With no growth, it will be a vicious cycle. If money continues to be printed the currency fall will not stop with a float. A float will also not stop defaults, even if it works and halts the depreciation.

If money is continued to be printed the currency, will continue to fall as it did in 2015 when the central bank ‘floated with excess liquidity’ and Indonesia’s central bank floated with bank bailout money during the East Asian crisis. A severe currency fall will lead to an inflationary blow-off like in Argentina which will lower government cash expenses and salaries of state workers and the unemployed graduates that were hired.

Unfortunately, private salaries and pensions of old people will also go up in smoke in the same way. All this shows that stimulus, MMT and soft-pegged central banks are not a joke.

All this has happened.

INTEREST RATES WILL FALL AFTER MONETARY STABILITY IS RESTORED

The current high interest rates will not fall permanently until monetary stability is restored. Every time in the past currency crises rates have started to fall only after a working peg or floating regime has been restored. If not capital flight will persist. Panic and uncertainty will persist. Exporter holdbacks will persist. Importers scrambling to cover will persist. And high interest rates will persist.

The ending of panic and the rush to take money out of the country will end. Of course, the IMF program will also unlock some budget financing from other lenders which will also help ease the situation.

If Sri Lanka can maintain a credible peg for 10 years or more and abandon the flexible exchange rate and aggressive open market operations interest rates will fall to world levels and deficits will come down. The bunched-up yield of the three-month bills where the yield curve is flat is testimony to existing monetary instability.

The longer it takes to restore monetary stability the longer higher rates will prevail. The longer higher rates prevail the bigger the hit on the economy and the bigger the hit on banks. Already high rates have been in Sri Lanka for about three months and there are no signs of its falling as yet. There are emerging signs that reserve money and broad money are slowing with the economy coming to a virtual standstill. However, bank bailouts with printed money could reverse it.

That is why it is important to get a working floating regime in place. It will be re-pegged later under an IMF program to meet the Net International Reserve targets.

MONETARY STABILITY

Most economists in Sri Lanka got the sequence wrong. The priority is to restore monetary stability. Default will not restore monetary stability. People who thought it would be under a delusion. It would have been better to restore monetary stability before default as this column advocated repeatedly. This is what the column said.

If default comes, there will be a ‘sudden stop’ of external financing. That means no import credit, no DA/DP. Everything will have to be paid upfront. So imports are going to be even more difficult. Most analysts are talking about government foreign debt. But there are other private loans. There are supplier credits. There are suppliers credit to the CPC for example.

Unfortunately, all this has happened. The supplier’s credit issue to the CPC had blown up. It has happened due to putting the cart before the horse. At the moment interventions are made with surrendered dollars and Indian ACU money. Indian ACU money should only be used to repay multilateral lenders and not for oil.

BIGGER BARRIERS TO FLOAT

There are significant barriers preventing a clean float quickly as had happened in the past. One is the negative net open position of the banks. In the past banks had positive NOPs and when the float succeeded they sold heavily, sometimes going negative NOP.

There are also backlogs of importers and foreign investor money waiting to go. The ACU dollars themselves are a barrier. Sri Lanka is due to get this money at least until the end of the year.

The lack of foreign reserves is not a problem to import freely. Foreign reserves cannot be used for imports as mercantilists in Sri Lanka believe. There was a cacophony of calls to stop repaying debt and engage in monetary financing of imports. Monetary financing of imports will prevent a float from being established. It was excessive monetary financing of imports that pushed up imports over $2 billion by December.

No bridging finance is needed for imports if there is a working monetary regime to transfer wealth in rupees to dollars. Nobody need worry about Undiya or open account imports. Or keeping track of export proceeds.

It is extremely unfortunate not to say unfair to scapegoat foreign guest workers and blame them for policy errors of the central bank.

INDIAN UNDIYAL CREDIT LINE

The central bank and other talking heads are wrong to blame foreign workers for sending money through Undiyal and say it is part of the problem. Food importers are still able to do DA imports due to long relationships.

Undiyal transfers only take place because the central bank is creating forex shortages and dollars not going to the people who are willing to pay and parallel exchange rate premiums develop. Open account imports also do not create any problems. It is simply a priority allocation method.

There is a real transfer of goods to the country. Whether the settlement is net or gross does not matter. The Indian 1,000 billion US dollar credit from the State Bank of India also works in an Undiyal fashion. This is the operational detail of the Indian credit line.

The Sri Lankan importers pay the Treasury in rupees based on the trade documentation involving the invoice and shipping documents, like someone trying to settle send a child education fees via Undiyal. Sri Lanka will then owe a US dollar amount to India.

The Indian importers will be settled in Indian rupees by the state bank of India. A foreign inward remittance certificate (FIRC) will be issued to the Indian exporter to enable him to claim the Indian rupees as export revenues.

The only difference to Undiyal is that Sri Lanka will owe the money to India in a loan denominated in the currency of a third country, the US Fed. The Sri Lanka rupees will be used by the Treasury for its own purposes. India could very well have denominated the loan in Indian rupees.

In any case, family members of foreign workers get money in US dollars. That money is used to import food or other items. Whether the Middle East worker sends the money in US dollars or Dirhams and it is given to food importers by banks is not relevant if the food comes to the country through the open account. There is a real transfer of wealth and a real transfer of goods.

The priority as always is to float and have a working regime. Restoring the peg without a clean float requires excessive smashing of the economy. That is why in most IMF programs a float is a prior action