Sri Lanka’s monetary meltdown will accelerate sharply and lead to default and sudden stop of external finance unless quick action is taken to stop money printing and restore deteriorating confidence. Sri Lanka’s current currency crisis started in August 2019 with liquidity injections to target an ‘output gap’ and was given a turbo boost with unsterilized profit transfer rate cuts and outright liquidity injections in 2020.
In most Latin American countries which default, it is purely a monetary phenomenon. Argentina for example has relatively good budgets (deficit of about 5-pct of GDP) national debt of about 60% of GDP. This is why in 2018 Sri Lanka ran into a currency crisis despite tax hikes and the budget deficit coming down. However, in 2019 Sri Lanka value-added taxes were slashed in a fiscal stimulus on top of income tax. This kind of blow to state finances is unheard of.
Since money printing and the attendant foreign reserve losses started in August 2019 it is now coming up to two years with no corrective action being made. This is the longest period of central bank policy errors tracked by this columnist, without any corrective action being made. Usually there is a BOP deficit from money printing in one year and corrective measures are made and the deficit falls in the second year.
But in 2020, Sri Lanka printed Rs650 billion and slashed reserve ratios twice, and did a Rs22 billion central bank profit transfer. Out of these, Rs156.8 billion was absorbed by an increase in real money demand (currency in circulation rose to Rs834.8 billion from Rs678 billion) which nobody can complain about. Another $2.3 billion flowed out of the credit system in the BOP deficit. And, Rs206.8 billion was left as excess liquidity, what is generally called remunerated excess reserves.
In the way, Sri Lanka calculates reserve money, remunerated excess reserves seem to be excluded, which is an unfortunate thing to do for many reasons. From now on, the monetary meltdown will accelerate rapidly unless quick action is taken to raise rates, cut spending and hike value-added tax. If a debt restructuring can be done with International Monetary Fund backing, to reduce the gross re-financing needs (GFN), Sri Lanka can get away with less of an economic implosion and business failures than otherwise.
A brief history of time
There was nothing really wrong with Sri Lanka or Ceylon as it was known then. This country’s problems started with the creation of the Latin America style central bank in 1950 and development economics. The development economists, who were trained by Western university dons who thought that newly independent peoples and communities in Asia and Africa were imbeciles who were not fit to make their own decisions and the omniscient state and the bureaucrats should make their decisions for them.
The US created the most mischief setting up Latin America-style central banks in the eponymous region and in the Middle East and Asia. They were copied by others. Russia’s central bank was a bad one from the begging (exchange controls were pioneered by the pre-communist central bank which probably created enough inflation and hardships to fire the Bolsheviks in the first place) so the Soviet bloc also suffered forex shortages, smuggling and black markets.
Some like Sri Lanka, Japan, Korea, the Philippines and South Vietnam were further backed by counter-cyclical Argentina-style central banks, pushed by the Latin America unit of the Fed or the Economic Cooperation Administration (the Keynesian Marshall Plan agency). Germany escaped first with the Ordoliberals and the Deutsche Bank replacing the Reichsbank.
Japan escaped shortly the Dodge Line stabilization and the fixing the yen at 360. Korea shut down the Sri Lanka-style US-built central bank in 1960 and reformed the monetary law around a dozen times and had long periods of stability (like Bangladesh and Vietnam now) and finally fixed itself in the early 1980s monetary reform and became an OECD country in 10 years. South Vietnam was subsumed by the North and fixed itself in 1989. The Philippines is still struggling. Malaysia which never really had a monetary problem had degenerated over a decade with a ‘flexible exchange rate’.
From now on, the monetary meltdown will accelerate rapidly unless quick action is taken to raise rates, cut spending and hike value added tax
Sri Lanka survived wars and uprisings unlike Latin America (which had a long history of foreign borrowings before the Keynesian central banks were set up) which collapsed like nine pins each time the Fed tightened policy. Sri Lanka survived – despite crony import substitution and unemployed graduates – partly because rates were hiked at the last minute and partly because there was no bullet repayment commercial debt.
On top of monetary instability, Sri Lanka also has nationalism and regime uncertainty (intervention, policy uncertainty, and expropriation) which is a part of state worship. When there is monetary instability and the economy goes into a downturn, nationalism ratchets up as was seen in 2019 and was also seen with Hitler after the Weimar Republic and Great Depression.
Ripe for Downgrade
But money printing on top of Latin America style crony import substitution, commercial debt and unemployed graduates bloating the state – which is a unique Sri Lankan problem – everything is coming to a head. A glance at the sharply accelerating central bank credit to the government shows that downgrades are around the corner.
Rating agencies do no really understand soft-pegs, money printing and liquidity injections, but they do understand the opposite side of the central bank’s balance sheet – foreign reserves. When foreign reserves fall, rating agencies downgrade.
A cursory look at the bits and pieces of the central bank balance sheet publicly available shows that domestic assets or the paper trail of money printing had risen about Rs300 billion. A glance at the sharply accelerating off the chart central bank credit to government shows that downgrades are around the corner (please see Graph 1).
Rating agencies do no really understand soft pegs, money printing, and liquidity injections, after all they also went to the same universities like Harvard, Yale, Cambridge or Oxford that peddle money printing, but they do understand the opposite side of the central bank’s balance sheet – foreign reserves. When foreign reserves fall, rating agencies downgrade.
Based on the changes to domestic assets it can be estimated that forex reserves fell by around $1.4 billion in July on a baseline case. Gross reserves would be around $3.5-3.6 billion on this basis. A little higher if some of the dollars that flowed into domestic banks are taken back by swaps. This is about two months of imports. Foreign lenders and trade creditors and other analysts get excited when reserves fall to these levels. The IMF SDR allocation would give another $800 million.
However what is more of a concern is that after deducting an existing International Monetary Fund loan of $1.3 billion and other liabilities such as $600 million in swaps, net dollar reserves could even fall to around $500 million or lower. While the SDR allocation is very useful, one can see that in terms of actual net cash, the central bank is scraping the bottom. Without the balance of the Asian Clearing Union and other liabilities it is difficult for outsiders to correctly estimate this number, but these numbers should give politicians and academic policymakers pause (please see Graph 2). Let’s hope that is not the case. But this is the case, the reserve position is not going to get better with this monetary framework.
Each time the economy recovers a little and private credit picks up, under the current framework excess liquidity is going to hit the BOP and more reserves will be lost. The June lockdown may have slowed things down a little.
Goldman Sachs has said foreign reserves will be $6.4 billion by the end of 2021. That is not going to happen. In any case, their calculations are flawed as it lumps private bank reserves, which are also invested domestically for the most part as forex reserves. All this shows the plight of investment banks and why they invest in Argentina and end up in debt restructuring again and again. However, it terms of months of imports is something they also understand. Soft-pegging is a big mystery to most people especially after Keynesian macroeconomics emerged as a profession.
Worst Case Scenario
So what is the worst-case scenario? The worst-case scenario is that nothing will be done and the central bank will continue to print money to keep the ceiling yield on Treasury bill yields. The simplistic thinking seems to be that printing money will keep interest costs down and therefore the budget deficit. Western floating central banks especially the Fed have not helped matters, with international financial media lionizing the agency and also modern monetary theory.
It seems that Sri Lanka’s policymakers do not know that when money is injected into a pegged monetary regime, foreign reserves flow out in equal measure depending on the type of item that is purchased. Printed money will cause immediate forex reserve losses if the foreign debt is repaid or when money is used to settle oil bills and import bills.
If printed money is used for domestic expenses such as salaries, their recipients will use them to buy some imported goods and local goods and keep the balance as savings. The savings may be loaned to others who will buy imported and domestic goods. The person who sells domestic items to a state worker may use the money to travel around using fuel and eat lentils or buy other items. Through several rounds of credit, all of the new money will hit the forex market in a few weeks.
This is why reserves fall and inflation goes up when private credit recovers, even though the problem is state worker salaries and other expenses paid with central bank credit. If the money deposited in state banks by state workers are back through a Treasury overdraft and used to settle foreign debt, it will also result in a faster reserve loss. In other words, money printing is another way of saying that the government is living off foreign reserves.
As reserves decline more economic controls will come. Eventually, the penny will drop that reserves are going to fall some more and the attempts made to boost reserves are not going to be very successful. At that time it, with depleted reserves it will not be possible to hold the currency peg. Mercantilists will say depreciate the currency.
People who understand will say raise rates and borrow real money for state expenses in order to stop printing so that outflows of currency will be limited to inflows. Others will say float the currency, which is also a remedy as floating also matches inflows to outflows. Soft-peggers however do not know how to float. They also do not like high-interest rates. What is likely to happen is depreciation, after which the rupee will be pegged at a lower level with partial interventions.
CAA, NMRA a big threat
When the rupee starts to fall the price controls will come. The Consumer Affairs Authority (CAA) has already stopped Laugfs Gas. It will impose many more price controls. Many more shortages will occur. It will be a big threat to ordinary people. People will be branded ‘black marketers’. The money printers are already getting ready to hike the fine on those breaking price controls by 4,000% to Rs100,000.
The National Medicinal Drugs Authority (NMRA) will be an even bigger threat. NMRA price controls will make it impossible for drug importers to operate. There may be shortages of some types of medicines. The import substitution cronies will do alright.
It is even possible that oil imports will have to be curtailed if more money is printed to pay state workers and meet other expenses. What happens to soft-pegs countries is that eventually the currency is floated because it becomes apparent, to the Keynesians driving policy that there is no way to rebuild reserves. When the rupee is floated price controls may again cause havoc.
Falling Rupee, partially controlled rates
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 higher interest rates but the reserve losses and currency depreciation will continue.
Whatever Keynesian or post-Keynesian economist that had been taught at university, reality will eventually hit. Keynesian models are fine in theory, but they do not exist in the real world. The Hicks-Hansen model (IS-LM) was dismissed by Hicks himself later. In any case, the central bank is likely to be insolvent on its dollar liabilities before the end of the year unless money printing is halted. Depending on how good soft-peggers are at floating, partial interventions will lead to even higher interest rates.
In Argentina short term rates went up to 60% due to the ‘flexible exchange rate’, or neither floating nor pegged that caused so much damage to Sri Lanka since 2015. The high-interest rates can kill many businesses. The high rates from partial floating can kills finance companies and banks. If dying banks are bailed out with printed money, it will be even more difficult to control the exchange rate.
Inflation and cash shortages will lead to a consumption collapse which will also destroy businesses. Low reserves will lead to a default on foreign debt as happened to the Weimar Republic. In the past, floats have always worked. That is because money has been printed in the past to sterilize interventions and keep the rate down.
Whatever the central bank says to the contrary budgets have not been the core problem in past crises. It is simply at too-low policy rate and purchases of maturing Treasury bills related to past deficits by the central bank to keep rates down.
The Hole in the Budget
However this time it is different. The tax cut – the value-added tax cut – in December 2019 was extraordinary. It is one thing to cut income tax and hope for investment but this kind of fiscal destruction in a low-rated country with a soft-pegged central bank is unheard of. The problem is not too much private credit at too low rates this time. This time it is clear. The government cannot meet cash expenses with taxes.
The rating agencies and investment banks are harping on interest expenses. What they do not understand is that interest costs are not a cash flow expense, except in sovereign bonds. In domestic debt, interest can be rolled over as paper. That is partly why the IMF focuses on the primary deficit. This is a difficult concept for people to grasp.
It was laughable to see the Yahapalana central bank talking about a low primary deficit while turning Treasury bonds and bills issued to finance past deficits into printed money as part of output gap targeting. Interest costs can be rolled over as paper.
As reserves decline more economic controls will come. Eventually the penny will drop that reserves are going to fall some more and the attempts made to boost reserves are not going to be very successful
However 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 no taxes are hiked and money continues to be printed the currency will not stop with the float. It 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. 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.
Of course, private salaries and pensions of old people will also go up in smoke in the same way. The preceding shows that stimulus, MMT, and central banks are not a joke.
Debt Restructuring
If a 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 is a supplier’s credit to the CPC for example. There are SOE loans. No country can actually continue to repay the debt on a net basis. Usually, countries and companies pay back loans but take new loans as they grow. Each year outstanding loans grow.
However it is possible to repay some amount. To do that the Gross Financing Need (GFN) has to be minimized. This columnist is of the view that it is quite possible to run a country without going back to sovereign bonds. A country with monetary stability (strong currency) can not only survive without going to capital market but also build reserves and export capital. Vietnam has $100 billion in reserves. Bangladesh $36 billion. So that is not a serious problem if the central bank is reformed.
But it becomes even more difficult to repay debt with a falling currency as all the domestic financial resources that are generated have diminished in value. So it is important to get GFN to a manageable level.
“Gross financing needs of the government in any year are defined as the sum of the primary fiscal deficit, the debt service (i.e. sum of principal and interest payments) falling due in that year, and any outlays to meet contingent liability materializations and/or building government financial assets,” according to the IMF. The IMF may not know much about peg (or has lost the knowledge as shown by the flexible exchange rate, flexible inflation targeting) and it may not know much about the best way to fix budget (see the failed revenue based fiscal consolidation which saw spending rise from 17-20% of GDP).
The IMF’s lack of knowledge on effective pegging and the lack of rule based monetary policy is the reason that soft-pegged central banks go to the IMF again and again. However IMF can give advice and experience to restructure debt and the clout. These are hair-cuts, maturity extensions, grace periods and interest rate cuts. It is likely that Paris club donor will agree to maturing extensions.
When there is an IMF program state creditors certainly fall in line and so do most private creditors. There will be a greater chance to reduce holdouts and messy court actions in New York with an IMF program. There are several ways the debt can be re-structured to reduce the annual cash outflows. The International Monetary Fund generally defines sustainable public debt as follows:
“Public debt can be regarded as sustainable when the primary balance needed to at least stabilize debt under both the baseline and realistic shock scenarios is economically and politically feasible, such that the level of debt is consistent with an acceptably low rollover risk and with preserving potential growth at a satisfactory level.”
Political Options
What is politically feasible? What is economically better for the poor? They are not the same. The vocal anti-austerity brigade and opposition will raise the rooftops if anything is done to contract the state. That is why ‘revenue based consolidation’ was so attractive to statists and leftists. When the current administration suggested that state workers make a relatively mild sacrifice to help with expenditure, the opposition leader protested vehemently.
a) A 10 percent hike in VAT – this will raise prices by 10 percent and reduce salaries by 10 percent of all wage earner and pensions, however it will keep the value of pension funds and bank deposits including of retirees intact
b) A steep fall in the rupee and an inflationary blow off- It will raise prices, it will cut real salaries, it will destroy bank deposits and pensions.
c) A cut in state worker salaries and a hiring freeze State austerity. It will leave the poor unharmed, but will affect state workers. However state worker bank deposits and pension funds will not be harmed.
The above will show that the anti-austerity brigade will oppose any cuts in state spending or hiring freezes (state austerity) and will also oppose taxes and market pricing of oil and other goods. In its place there will be depreciation and delayed inflation which the anti-austerity brigade does not really understand.
How the anti-austerity brigade and general statism corrupted the IMF itself (not that it needs much corrupting the roots of the IMF lay in US New Dealers who were among the worst Keynesians and policy shockers in history) showed in the ‘revenue based fiscal consolidation.’
The need is to cut the deficit not to push revenue to some arbitrary, divine, auspicious or voodoo number. The great political value of currency depreciation is usually that voters are unaware that it is due to money printing of the central bank.
In the 19th century they knew that, since central banks were private and they were held accountable, including by parliaments, and there were no Keynesians and confused academics with university degrees to brainwash them otherwise.
In 19th century England when the bullionists and anti-bullionists were debating the restoration of convertibility (putting the sterling back on the Gold standard, David Ricardo or Henry Thornton did not make the laughable puerile infantile arguments that present day academic economists do.
They did not say that weakening of the Sterling was due to ‘demand and supply’ or that the ‘strength of the economy’ determined the value of the currency. In fact classical economists like Ricardo proved to parliament that it was not imports of corn or other goods that led to the depreciation of the pound and high price of gold but the actions of the Bank of England. They in fact defeated Mercantilism.
But now neo-Mercantilists will say inflation, currency depreciation and BOP deficits are due to oil, due to imports, due to the trade deficit, due to current account deficit. The latest Mercantilist excuse is that the rupee is falling due to tourism. In fact any excuse will do for monetary instability other than monetary policy itself.