The tendency of Washington to blame China for the post2018 sovereign default wave in which Sri Lanka is also caught is a repeat of earlier exercises where Arabs and the ‘East Asia savings glut’ were blamed for its policy errors.
In the current default wave Argentina, which originally led the Keynesian ideological foundation of a sterilizing central bank which tries – and fails – to neutralize the balance of payments and crashes headlong into a currency crisis, was in pole position as it defaulted in 2019, as Fed tightened policy in 2018 with an IMF program in place.
The defaults or near defaults of countries like Pakistan with an IMF program in place is a result of worsening anchor conflicts and ‘monetary policy modernization advocated by the Fund itself where inflation targeting is foisted upon reserve collecting central banks.
EASY DOLLARS
This should serve as a warning to Sri Lanka’s politicians as policymakers who drove the country into heavy foreign borrowing in the easy default period with an output gap targeting undermining domestic stability present a law to legalize the flawed policies from 2012 to 2022 in the proposed new central bank law.
Under the gold standard or gold-linked standard, which was a relatively tight monetary standard that had much less or no asset price and commodity bubbles that were seen after 1971 purely fiat floating exchange rates, sovereign defaults were rare.
When Weimar Germany first defaulted and US money doctors came to help after World War II this understanding was partially there. But Keynes through his confused understanding of the balance of payments involving the ‘transfer problem’ put paid to this knowledge.
Like domestic banking crises, external sovereign defaults are essentially a problem of the country’s central bank but the initial run-up of debt – easy dollars – and the subsequent tightening of monetary policy by the Fed (later ECB as in the case of the latest Greek, Portugal and Spanish financial crises) are the key drivers.
Sri Lanka also loaded up on sovereign bonds when the going was good and Fed quantity easing kept the dollar taps open.
UN-ANCHORED DOLLARS
The mass Latin American defaults – as well as troubles in some East European countries like Poland, Romania and Hungary from 1980 in which the IMF was involved – Communist Russia collapsed – eventually collapsed – and came in the wake of Fed tightening.
Soviet Union was not a member of the IMF – despite attempts by New Dealer and suspected spy Harry Dexter White, the architect of the Bretton Woods soft-pegs and the IMF – to persuade Stalin.
The tightening under the Fed Chief Paul Volcker using a kind of Fischer equation ended the un-anchored monetary policy of the 1970s, which began in the late 1960s and eventually ended the gold standard in 1971.
An unusually honest IMF working paper explains the problem in this way.
“The early 1970s saw the disintegration of the rules-based Bretton Woods system. In 1971, the U.S. suspended convertibility of the dollar to gold, and by 1973, the system of commonly agreed par values between the major currencies had collapsed. In subsequent years, IMF’s responsibilities changed and expanded. As balance-of-payment imbalances grew, the frequency and size of IMF financing increased. And with fewer rules governing the international monetary system, the IMF’s surveillance role was greatly enhanced. These structural changes meant that when the 1980s Debt Crisis erupted, the IMF found itself at the core of managing the emergency.
“During the 1970s, the risk of sovereign default was not perceived as a major concern. Most “external arrears” generated by a country were created by exchange restrictions. For example, an importer might miss a payment because the authorities were slow to release foreign exchange. Sovereign default had not been a problem since the Second World War…”
As the dollar monetary standard dramatically worsened in the 1970s and commodity prices went up, Middle Eastern oil producers in the GCC areas which had currency boards like monetary authorities ended up with foreign reserves and sovereign wealth funds.
Countries with bad central banks like Iran collapsed and nationalists came to power. However, the monetarily stable countries invested their money in the US. Japan also had a surfeit of dollars after it floated and its currency began to strengthen.
US and Japanese banks loaned to Latin America, which was basically First World countries with market access, with bad central banks, which were kept in check due to the gold standard in the immediate post-World War period.
THE ARABS, JAPAN AND CHINA
They loaded up on debt, but Washington tended to blame the Arabs instead of their own banks, in sharp contrast to what they are doing to China now. The Washington narrative goes as follows: “Petro-dollars were “recycled” in the form of loans to cover deficits among oil importers. In many cases, oil importers were unwilling or unable to make the necessary adjustments to close these deficits.”
Countries with bad central banks, like Sri Lanka which borrowed heavily in commercial markets having got market access, are now defaulting and their currencies are collapsing after using aggressive open market operations to target inflation
Similar accusations were levelled against East Asian exporters with good pegs – mainly China – up to the 2008/2009 Housing Bubble collapse as Ben Bernanke misled Alan Greenspan to keep interest rates near zero and ran an 8-year Fed cycle compared to the usual 4, eventually triggering the Great Recession.
US mercantilists forced China to break the peg in 2005, falsely charging the country of ‘undervaluing’ its currency due to weak understanding of the link between external deficits and domestic policy that is usually found in Harvard-Cambridge economics. Breaking the peg failed to stop the trade deficit or Asian savings.
After the collapse of the Bretton Woods, the very same accusations were levelled against the Bank of Japan. Japan was also forced to appreciate the currency in the 1980s. But the strategy failed to stop the US trade deficits with China. Dollar liquidity was again plentiful in the aftermath of the collapse. At each quantity easing exercise of the Fed and also ECB, China’s foreign reserves also grew.
As China’s foreign reserves grew and returns from investing in the US were low, it struck on the apparent brilliant idea of giving Exim Bank loans and building a Mercantilist Belt and Road with state enterprises. In the 1970s and 1980s Japanese companies bought up US assets. Chinese companies – which were mostly state – were blocked by both the US and EU from doing it.
Countries with bad central banks, like Sri Lanka which borrowed heavily in commercial markets having got market access, are now defaulting and their currencies are collapsing after using aggressive open market operations to target inflation.
One reason for Latin American defaults was the depreciation advocated by a basket, band and crawl policy – now worsened under exchange rate as a first line of defence policy – where errors in mistargeting interest rates are compensated with more monetary instability. At each currency crisis after attempting stimulus – or output gap targeting – growth stalls and foreign debt becomes bigger.
Sri Lanka will shortly legalize output gap targeting under an IMF program giving a growth mandate that was previously not found in the central bank, on top of flexible inflation targeting, setting the state for defaults on the re-structured debt.
Politicians, if they want to avoid holding the baby and repeated defaults must control the economists in the reserve collecting central bank by taking away their powers to print money through discretionary and flexible policies or close the money creating state enterprise down.
NEW DEFAULT WAVE
The latest Fed tightening comes in the wake of Covid liquidity injections which had fired a commodity bubble just like in the 1970s. This time in addition to Argentina a whole lot of African countries and Sri Lanka have defaulted. Amid monetary policy modernization and flexible inflation targeting advocated by the IMF, several countries have defaulted.
The IMF is blaming fiscal metrics, but defaulting countries have a wide range of fiscal metrics and low debt-toGDP ratios. The IMF has now lowered its focus on debt to GDP ratio and is focusing on the Gross Financing Needs as countries with lower levels of debt but central banks default.
As currencies collapse under flexible inflation targeting and forex shortages emerge, foreign borrowings go up – as long as market access is there – and growth stalls under stabilization policies. Meanwhile, fiscal metrics rapidly worsen.
In Ghana, Surinam and Zambia, which have defaulted recently, fiscal metrics rapidly worsened under the first line of defence and inflation targeting with a peg. In Sri Lanka and Pakistan, the picture is the same. Sri Lanka also cut taxes to target an output gap, which is to be legalized in the deadly new monetary law.
CHINA AND CAMBODIA
China was wrong to lend to Sri Lanka and other market-access countries amid the excess dollar liquidity. ISB holders and China like the US and Japanese banks in the 1970s also made a mistake. In the early 1980s, the IMF did not favour debt restructuring. It came with the Brady Plan and IMF followed. At first, it was trying to make sure that US banks were paid. The IMF was accused of being a ‘handmaiden of commercial banks’ by some.
“When the Brady Plan was introduced in March 1989, the IMF reacted quickly to support it and to play a key role in implementing it,” says another frank IMF working paper, The IMF and the Latin American Debt Crisis: Seven Common Criticisms.
“For three years or so preceding that development, however, a variety of debt-relief proposals were floated by advocates including Bill Bradley, Peter Kenen, and Felix Rohatyn. During that period, the IMF kept a low profile on the issue, and a general perception arose that the institution was opposed, or at best indifferent.”
“As the leaders of major industrial countries proposed various debt-relief schemes in 1987 and 1988, the IMF responded positively; when the Brady plan culminated this process in March 1989, the Fund acted immediately to implement it.”
Whatever the debt relief offered however will not help countries with bad impossible trinity central banks as shown by Argentina, several other Latin American countries and Poland in the 1980s.
One country that China loaned heavily to was Cambodia. Cambodia had one of the worst central banks in the world. Monetary instability in the Indochina area brought Polpot to power. French Indochina got independence in the immediate post-war era and like Sri Lanka and Korea was a victim of Keynesian central banks, sometimes built with US help.
The petrodollar Gulf countries and the Maldives escaped as their monetary authorities were set up by British non-Keynesians at a time when problems with the central banks were already seen in the 1960s. In Cambodia, Polpot abolished money.
A new central bank did not do any better. In 1998 and 1999 Cambodia’s Riel collapsed to around 4,000 and the country was dollarized. It now has parallel currencies with the Riel and the Dollar used alongside.
With no central bank to create high inflation and high interest rates, the country is growing steadily. Its fiscal metrics are also better, with no central bank to help with deficit spending, trigger forex shortages, and depreciation which then leads to a collapse in consumption, investment and economic output as happens to flexible inflation-targeting countries.
Half of Cambodia’s foreign debt is from China. This country has good fiscal metrics. It is not because Cambodia’s politicians and bureaucrats are particularly brilliant. But its central bank cannot do monetary policy and mislead the politicians. As a result, even if China gave bad loans, it will still be stable. And stability will help the country grow.
Dollarization is the same as a currency board. Similar good metrics are also seen in Hong Kong, which has a currency board. Fiscal rules are unnecessary if there is a good monetary standard. The surfeit of macro-prudential rules advocated now is an admission that money is bad and mal-investments are taking place.
Inflation of the money supply has several consequences as understood by classical economists. It is not a statistical general rise in price levels that begins 18 months after the inflationary policy begins. Forex shortages emerge quickly if there is a pegged exchange rate. Then comes mal-investments which drive asset price bubbles.
Chinese lending and Latin American lending are mal-investments and consequences of inflationary policy. The inability to make external payments and sovereign default is also a consequence of inflationary policy.
If defaults happen in the dollar-pegged area, all of the immediate responsibility is on the soft-pegged central bank, but the inflationary policy of the anchor currency, in this case, the Fed is also a key driver.
The proximate cause of the monetary trouble of most of the African and South Asian countries comes from Covid re-finance – sanctioned by the IMF for the most part – and more damagingly the rate cuts that were made as private credit recovered from Covid in 2021.
In the first place, Covid should have been dealt with as a fiscal response, second, even if monetary loosening did take place, policy should have been tightened immediately as credit recovered in 2021. The opposite was done, including in Bangladesh. Blaming the Fed for bad policy is a copout. The ultimate responsibility lies with the economists of the country.
Politicians, if they want to avoid holding the baby and repeated defaults must control the economists in the reserve collecting central bank by taking away their powers to print money through discretionary and flexible policies or close the money-creating state enterprise down.