In Sri Lanka and other countries with bad central banks like in Latin America, inflation and currency shortages are perpetuated by a series of false narratives repeated ad nauseam until the public accepts them as true.
By these actions, inflationists escape accountability for money printing or the deployment of inflationary policy to trigger monetary instability by cleverly transferring the blame to the victims, which include not only the general public but also politicians who lose office.
To escape Sri Lanka’s 73 years of monetary instability which started with the setting up of the central bank and frequent trips to the IMF, it is important to examine the truth or otherwise of these claims.
These red herrings were not developed in Sri Lanka, but Western inflationists as macro-economic policy advocated by US post-Keynesian in particular threatened the Bretton Woods soft-peg system and the last vestiges of the gold standard.
The mislabelling of monetary instability as macro-economic instability was also one of the ways the victims of central banks were misled as well.
But the most enduring and oft-repeated false excuse given by these inflationists in what were effectively ‘independent’ central banks of the West was that the budget deficit was the cause of forex shortages and inflation.
The Deficit Lie/Fiscal Dominance
The false narrative around deficits goes like this: politicians expand the budget deficit and the central bank is subject to de facto fiscal dominance (by the large deficit by itself) and also operational dominance by Treasury officials blocking rate hikes.
There are two problems with this claim. One is that there is no data to support this claim, especially in Sri Lanka, especially after the end of the civil war. The other is that Treasury Secretaries in Sri Lanka have almost always been ex-central bankers, therefore, it is a problem of economists and not politicians or the general public anyway.
A close examination of recent currency crises shows these trends. Some of these factors are also present in older crises before the civil war started in many countries including Latin America that experienced peacetime currency collapses and defaults.
One: the deficit expands in the stabilization year when currency crises are eliminated and the BOP returns to surplus. This deficit is not subject to ‘fiscal dominance’ either de facto or de jure. Two: In the year the currency crisis is triggered, the deficit to GDP sometimes falls and even nominally the increase is small.
Three: The money printed in the year that the central bank triggers crises is disproportionately higher than any nominal increase in the deficit, compared to the previous year when there was monetary instability.
The Recent Crises
In the 2008 crisis, which happened in the middle of an intensified war and the Great Financial Crisis, some of these factors were present, but it was also driven by capital flight within a stable exchange rate, but monetary policy was tight.
In the 2001 crisis, which also took place in the middle of a war some of the characteristics can be seen. This column makes some allowances for war since, even in classical days, private central banks like the Bank of England got into trouble in wartime. But there can be no excuse for peacetime monetary instability.
But the trend in stabilization years holds even in war years. In 2001 for example, when monetary stability was restored and reserves were rebuilt with a BOP surplus of 219.8 million US dollars, the deficit went up steeply from 9.5 to 10.4% of GDP.
The nominal deficit went up from Rs119.4 billion to Rs146.7 billion, yet money printing was reversed by Rs5.7 billion.
In 2009, a stabilization year, the budget deficit went up from Rs309.6 billion to Rs476.4 billion, yet the BOP was in surplus with higher interest rates. In peacetime currency crises came in rapid succession as money was printed to keep rates down as the economy recovered.
The Crisis Year
In the 2011/12 currency crises, the central bank triggered a BOP deficit of Rs1,059.4 billion without a war as the economy strongly recovered and private credit recovered. The deficit in the crisis year of 2011 went up only by Rs5.2 billion from Rs445 billion to Rs450 billion.
This deficit could have been easily managed if interest rates were allowed to move up a little. But the central bank printed Rs184.6 billion that year. In 2015, however, there was a substantial increase in the deficit due to Yahapalana salary and subsidy hikes, where an excuse can be made that there was de facto fiscal dominance.
However, the central bank started injecting money from the third quarter of 2014 before that government even came to office to suppress rates. As the deficit went up by Rs238.3 billion the central bank printed Rs80.4 billion, according to the rise in credit to the government, which however did not tell the whole story.
In 2016, when the deficit was reduced by Rs189.2 billion to Rs640.3 billion, the central bank printed Rs183.0 billion. However, in 2017, the stabilization year, the deficit went back up to Rs733 billion or Rs93.2 billion and the central bank reduced its credit to the government by Rs188 billion. In terms of GDP also the deficit fell marginally.
In 2018, in another currency crisis year, the budget deficit went up by only Rs27.3 billion but the central bank printed Rs247.7 billion as massive amounts of money were injected to target the call money rate and then sterilize interventions when foreigners fled.
In 2018 as well as in other crisis years, the budget deficit could have been easily bridged by a 100 basis point rate hike. Instead of which rates were cut in that year, just like in earlier crisis years. As a share of GDP, the deficit fell from 5.5% to 5.3% of GDP.
In 2019, the stabilization year, the budget deficit went up to 6.8% of GDP and the BOP came back into surplus. In rupee terms, the deficit went up to Rs1,016 billion from Rs760 billion, but Rs109.6 billion in central bank credit was reduced. It can be very clearly seen that budget deficits were not a big problem.
Data-Driven Monetary Policy
Then what is the problem? The problem is data-driven monetary policy or the belief that rates can be cut with printed money to get easy growth when inflation falls. In 2015 when the deficit went up, the central bank had no business cutting rates. The central bank was already printing money from the third quarter of 2014 and running forex shortages.
Yet it cut rates in April 2015 suicidally and injected money to target the call money rate claiming inflation was low. And it was justified in doing so under data-driven monetary policy, where econometrics triumphed over laws of nature.
In 2018 it cut rates while the deficit was down. The excuse at the time was that fiscal policy was tight, therefore monetary policy must be loose to boost growth. That was the time it was quite evident that Sri Lanka had no future.
To suggest that Mangala Samaraweera or Eran Wickremeratne was putting pressure on the central bank to print money does not hold water. Whatever the fiscal authorities did was not relevant, the central bank would cut rates and trigger currency crises as soon as private credit recovered. In currency crises, 12-month inflation tends to fall around the same time as private credit recovers.
Why Does it Matter?
There is a further complication for a reserve-collecting central bank. To collect reserves a country must finance the deficit of a third party country.
If Sri Lanka buys US securities, then the American deficit is financed. Raising taxes and reducing the deficit domestically is not enough, domestic investment must be curtailed sufficiently to build reserves (finance a reserve currency country deficit).
So why does all this matter? This is the reason IMF programmes fail in the second year. It is important because Sri Lanka is now about to make the same mistake again. This is what happens in peaceful Latin American countries and it is what happens in Sri Lanka.
Politicians in particular must take note. Ranil Wickremesinghe and his ministers must not put pressure on the central bank to cut rates.
Already the writing is on the wall. The IMF itself has warned that the pace of reserve collection has slowed. And no wonder. The central bank started injecting money on a gross basis in May. From June the external sector started showing signs of instability. But the IMF warning about reserve collections is disingenuous.
The IMF is at Fault
It is the IMF that promotes econometrics (data-driven monetary policy and the monetary consultation clause) that go against laws of nature well described by classical economists to avoid balance of payments troubles.
The IMF suggests there is monetary financing. There is minimal monetary financing of the deficit, except after 2020. There is monetary financing of banks consistently, which is way higher than the deficit.
This mistake did not happen in classical days. Financing of banks (or discount houses) was through bills of exchange. Hence classical economists, some of whom got themselves elected to parliament to bring laws against central banks, made the distinction between financing of ‘merchants’ and the ‘government or the King.’
Unlike the IMF or present-day economists of third-world central banks that go to the lender for bailouts frequently, classical economists had a deep knowledge of note-issue banking operations.
As the data shows above, in the crisis year, the reason large volumes of money, much higher than the increase in the deficit are printed is because the central bank is financing the private sector. In Argentina for example crises are driven by the failure to roll over BCRA’s sterilization securities.
In Sri Lanka, it is the re-financing of banks by either outright, term or overnight purchase of securities from banks, through inflationary open market operations claiming inflation is low. That is why IMF programmes are destined to fail and second or third defaults happen in many cases.
An examination of the data table shows that all post-war currency crises had taken place by targeting a 4-6% inflation range. What that number shows is that targeting 4-6% failed to stop currency crises, which eventually led to growth shocks and spikes in debts as the monetary brakes were hit.
The post-2020 “macro-economic policy” deployed had tax cuts on top of money printing. During that crisis also inflation was relatively low as large volumes of money were printed including for deficit financing.
Sri Lanka’s problem – and that of other African and Latin American countries – is that monetary regimes are fundamentally flawed. There is a propensity to deploy macroeconomic policy despite the existence of a reserve-collecting central bank in the legal and operational frameworks themselves. No amount of reforms in other sectors, including in budgets which are required and are very positive, can help a country, if monetary stability is denied.