Sri Lanka’s accelerating monetary meltdown began with historic low interest rates driven by Modern Monetary Theory style money printing after the tax cuts of 2019, but the storm gathered pace from 2015, when rapid foreign debt accumulation greater than the annual foreign financed deficits began.
That was also due to monetary instability.
Sri Lanka’s Liability Management Law was also a classic Weimar Republic style Young Plan financial blunder built on monetary instability and the Mercantilist fallacy of a ‘transfer problem’ based on the belief that foreign payments cannot be made with resources collected in domestic currency.
This column had already written about how the Ceylon Petroleum Corporation accumulated dollar debt when money was printed to target call money rates and later also an output gap triggered forex shortages and the state enterprise was forced to borrow accumulating billions of dollars in debt.
Much the same happened to the central government.
THE WEIMAR DAWES AND YOUNG RESTRUCTURING PLANS
No pegged exchange rate country (or even a floating one) can hope to repay foreign debt if it is printing money on a net basis amid a mild economic recovery.
A grandfather of this policy debacle is the Weimar Republic. As the Prussian/nationalist aggressor, post World War I Germany had to pay reparations to Allies who defeated them. But the economy descended into hyperinflation in 1923 as money was printed and Germany defaulted.
In 1924, a committee under Charles G Dawes and also Owen Young re-organized the Reichsbank which was correctly identified as the cause of the inflation. A new repayment plan was made. To help Germany with the debt, the US arranged a Wall Street loan with JP Morgan, like the Liability Management Law, in the Keynesian/Mercantilist belief that money raised in domestic currency cannot be used to repay foreign loans and ‘dollars’ were needed.
There were however several problems with the Dawes plan, not least something similar to what happened to Mangala Samaraweera’s petroleum price formula, where money was parked in the banking system, awaiting dollars. When money earned from Samaraweera’s formula was parked in a state bank it was loaned to others to bring imports and buy dollars.
If not for the output gap targeting and REER targeting exercise Samaraweera would have gone down in history as the Tun Daim Zainuddin of Sri Lanka.
Dawes won a Nobel Peace Prize. Predictably, the country ran into trouble again.
Britain’s John Maynard Keynes, who seemed to have a weak understanding of the link between trade deficits and credit, claimed that Germany must have a trade surplus (or current account surplus in modern parlance) to repay foreign debt.
Several classical economists in vain tried to explain to him that it was inflationary policy (liquidity injections) that made it difficult to collect foreign exchange and as long as domestic money was raised (the budgetary problem was solved) either through taxes or loans; it was possible to generate dollars (transfer problem) to make foreign payments.
Keynes did not get it. He insisted that there was a ‘transfer problem’. Mercantilists insisted that government ‘political’ repayments were somehow special. Classical economists insisted it was not so, showing examples of other countries including France.
Because Keynes was influential the US in particular and Allies in general bought it. Then a similar plan to the Dawes Plan was devised under Owen Young, in 1929.
The Allies were from the very beginning of the negotiations handicapped by their adherence to the spurious monetary doctrines of present day etatist economics,” explained Ludwig von Mises later. “They were convinced that the payments represented a danger to the maintenance of monetary stability in Germany and that Germany could not pay unless its balance of trade was “favorable.”
“They were concerned by a spurious “transfer” problem. They were disposed to accept the German thesis that “political” payments have effects radically different from payments originating from commercial transactions.”
The Young Plan also had another JP Morgan syndicated loan.
Heavily US driven agencies like the IMF and World Bank or any institution which has staff from Cambridge or other Keynes influenced university will believe all this.
AUTOMATIC TRANSFER
Sri Lanka’s Liability Management Law which came alongside an International Monetary Fund program was a classic Young Plan with a ‘JP Morgan’ style International Sovereign Bond to raise dollars to repay maturing debt.
Even now many people write and say that reparations made Germany cause hyperinflation, based on Keynesian ideas. They have romantic notions about central banks or have no idea at all.
“The truth is that the maintenance of monetary stability and of a sound currency system has nothing whatever to do with the balance of payments or of trade,” Mises explained.
“There is only one thing that endangers monetary stability—inflation. If a country neither issues additional quantities of paper money nor expands credit, it will not have any monetary troubles.
“An excess of exports is not a prerequisite for the payment of reparations. The causation, rather, is the other way around.
“The fact that a nation makes such payments has the tendency to create such an excess of exports. There is no such thing as a “transfer” problem.
“If the German Government collects the amount needed for the payments (in Reichsmarks) by taxing its citizens, every German taxpayer must correspondingly reduce his consumption either of German or of imported products.
“In the second case the amount of foreign exchange which otherwise would have been used for the purchase of these imported goods becomes available.
“Thus collecting at home the amount of Reichsmarks required for the payment automatically provides the quantity of foreign exchange needed for the transfer.”
PETROLEUM WEIMAR
This is the reason economists and analysts want fuel to be market priced. Then the enhanced payments to the CPC would reduce non-oil consumption and savings and therefore imports and generate the dollars required to pay the import bills.
But if the central bank printed money, there would be a forex shortage. When the central bank printed money in 2018, CPC was made to borrow, like the JP Morgan loan. In the end CPC ended up with massive losses. However in 2017 and 2019, when the central bank was selling down its Treasury bill stocks, there was plenty of dollars not only to pay the current bills but reduce the past borrowings as well.
In 2018 it made a historic 80 billion loss despite market pricing, due to the forex loss. The same thing happened to the central government. However the numbers are not seen in the budget. They are seen in the national debt.
The experience with Germany shows that Keynes made a bigger impression on Americans than Europeans since those who opposed him included French, Swedish as well as Austrian economists like Mises.
Shortly after during the Depression created by the Fed, Alvin Hansen and others adopted Keynesianism wholesale. The US Treasury was badly infected. The New Dealers were deadly Keynesians. The Marshall Plan (Economic Cooperation Administration), the precursor to US AID, also perhaps gave the idea for the World Bank.
Someone brought up in Keynesian thinking cannot understand how fixed exchange central banks which run deflationary policy in East Asia collect vast reserves (Asian Savings Glut) and GCC peg which run deflationary policy also collect vast foreign reserves (Petro dollars).
THE DEATH SPIRAL
Sri Lanka’s death spiral started in late 2014, when liquidity was injected (inflationary policy) to keep rates down and accelerated after the 100 day program of fiscal profligacy, did not lead to a rate hike as credit expanded because ‘inflation was low’. It is however not possible to run an inflation targeting framework with a peg. So the currency collapsed under a ‘flexible exchange rate’ in 2015 and 2016 with excess liquidity being injected.
In 2017 there was stabilization or a deflationary policy. In 2018 money printing began again to target the call money rate and an output gap with discretionary flexible inflation targeting. The flexible exchange rate collapsed again.
Current State Minister for Capital Markets Nivard Cabraal goes around saying that when the Mahinda Rajapaksa administration left in 2015 International Sovereign Bonds were 5.0 billion dollars and when they came back in 2019 it was 14.0 billion. Most people dismiss this as politicking.
However, that is not so. This was a classic Young Plan in action. The death spiral happened in several ways.
REER TARGETING , FLEXIBLE EXCHANGERATE , CAPITAL FLIGHT
In the case of market debt, the REER targeting (destroying the rupee to destroy real wages of the working class in monetary protectionism and give freebies to the exporters at the expense of social upheaval), led to flight of capital. Depreciation leads to the expropriation of foreign capital unless they are dollarized.
“The Keynesian school passionately advocates instability of foreign exchange rates,” explained Mises. “The days are gone in which most persons in authority considered stability of foreign exchange rates to be an advantage.
“Devaluation of a country’s currency has now become a regular means of restricting imports and expropriating foreign capital. It is one of the methods of economic nationalism. Few people now wish stable foreign exchange rates for their own countries.
“Their own country, as they see it, is fighting the trade barriers of other nations and the progressive devaluation of other nations’ currency systems. Why should they venture to demolish their own trade walls?”
Foreign capital however will not stay and be expropriated by the REERtarget inconsistent ‘flexible’ exchange rate. They fled. They had to be replaced by dollar denominated debt, which gave protection against any REER targeting expropriation.
In 2013 when the rupee was at 131 to the US dollar 3.6 billion dollars equivalent was in rupee securities. At the time the total market debt including ISBs and foreign held SLDBs was 7.1 billion US dollars. By 2019, and two currency crises later, the rupee debt was down to 573 million dollars and the total market debt was 15.6 billion US dollars.
In 2020 with flexible exchange rate and MMT rupee debt almost disappeared and dollar debt also began to disappear after downgrades following the December 2019 tax cut and the March 2020 ‘flexible exchange rate episode.
The people of the country however faced this debilitating expropriation. The debilitating depreciation will make it that much more difficult to generate resources to repay debt. Rapid depreciation, though the monetary expropriation of domestic savings will make it even more difficult to generate real resources to repay debt. But this is just one side of the problem.
THE ALM YOUNG PLAN FALLACY
After the 100 day program and revenue based fiscal consolidation of the IMF where cost cutting was pooh poohed, state spending ratcheted up to around 20 percent of GDP from 17 percent. GDP itself was revised up.
However, revising GDP may have made deficits appear smaller, but in actual fact they got bigger. The worst deficits were in 2015 and 2016, under Finance Minister Ravi Karunanayake.
Mangala Samaraweera fixed them but was betrayed by REER targeting and output gap targeting in 2018 despite the deficit being brought down. But that is not all.
In the money printing years of 2015, 2016 and 2018, Sri Lanka accumulated foreign debt rapidly due to the liquidity injections. The entire ALM law was based on a ‘transfer problem’ fallacy. It was not necessary to get dollar debt to repay dollar loans.
If deflationary policy was run it was possible to generate a large volume of dollars. Even if a neutral policy was run, any rupees collected by borrowings would have been able to be used to save dollars and repay debt. Sri Lanka had borrowed from the World Bank, Japan and ADB for many years. But not all debt had been paid back with fresh debt.
The accumulation of new debt is lower than the total foreign financing of the budget deficit in years with monetary stability.
DEATH SPIRAL
This is where the death spiral comes. In 2014 the foreign financing of the budget deficit was 1.6 billion US dollars but the total foreign debt went up by only 1.1 billion US dollars. In 2015, money was printed and the foreign financing of the budget was 1.74 billion US dollars. Foreign debt however grew by only 845 million dollars.
This is because a part of the foreign debt was repaid in that year with a run-down of foreign reserves. Therefore to find out the actual increase in debt, it has to be adjusted by net international reserves. The debt is adjusted by NIR because the central bank also started borrowing, through IMF loans and so on.
After the adjustment it can be seen that foreign debt grew by only 105 million US dollars in 2013 when net international reserves were deducted though the foreign financed deficit was 958 million US dollars.
In 2014, a year with monetary stability until the third quarter the dollar deficit was 1.6 billion, but after NIR debt fell by 256 million dollars on a net basis. In 2015, a money printing year, the dollar deficit was 1.7 billion but the debt after NIR grew by 2.3 billion US dollars. In 2016 which was partly a money printing year, the dollar deficit was 2.6 billion US dollars and debt after NIR went up 2.9 billion US dollars.
In 2017 the deficit was 2.8 billion but debt went up only 1.8 billion. In 2018 the deficit was brought down by Minister Samaraweera to 1.9 billion but output gap targeting money printing pushed up debt by 2.7 billion dollars.
In 2019 the dollar deficit ratcheted up to 3.0 billion dollars as the deficit expanded after the output targeting gap policy corrections slowed the economy. However total debt grew by only 1.2 billion due the accumulation of reserves by the selling down of Treasury bills (reversing money printing).
In the period central government debt went up from 23.7 billion US dollars to 34.1 billion US dollars. After deducting NIR, net debt went up to 28.3 billion US dollars from 17.2 billion in 2014. In 2020, the central bank said a lot of foreign debt has been paid. In fact foreign financing of the deficit was 448 million dollars negative or a net pay back.
However it was achieved with a massive run down of reserves due to the money printing. Debt after net reserves actually went up by 603 million dollars to 28.9 billion dollars from 28.3 billion US dollars.
TAKING DOMESTIC DEPOSITS AND INVESTING ABROAD
Overall debt with SOEs, banks and the private sector seems to have come down with more dollar deposits being raised domestically.
IN SUMMARY
The simplest way to understand the foreign reserves and foreign repayments and the fallacy of the Transfer Problem and ALM Law is to think about Sri Lanka’s history.
Sri Lanka has been taking World Bank, Asian Development Bank and Japanese loans for decades. However not all these loans (and interest) were paid back with fresh loans.
The growth in dollar debt was not linear with the part of the deficit that was financed with foreign debt. It was less, due to squeezing the current account to repay debt. There is no ‘transfer problem’.
When there is monetary instability the opposite happens. This is the Keynesian ‘transfer problem’ in action.
This is why the Weimar Republic collapsed and could not pay any debt. Whereas the Austrian economics/Ordoliberal driven Federal Republic which was bombed to the core and was three quarters of the country (with East Germany a separate country), not only paid WWII reparations, but also paid for US occupation and ultimately repaid all WWI reparations that the Weimar could not.
It can also be understood in the opposite way. This is the reason why East Asian nations with monetary stability (now Bangladesh central bank also) acquire billions in forex reserves (negative debt) while other oil producing countries’ meltdown is due to liquidity injections. The East Asian ‘savings glut’ and the GCC area ‘fixed’ exchange rate ‘petro dollar’ forex reserves shows that there is no ‘transfer problem’.
The same with Nordic sovereign wealth funds, Singapore GIC, and also MAS itself. When there is no currency depreciation (inflationary destruction of domestic wealth), it is very easy to repay loans, and also invest abroad.
GRAVE SITUATION
The situation with Sri Lanka’s central bank is grave.
The 800 million dollar IMF SDR allocation will briefly improve the situation. But SDRs are also debt or a swap. As soon as SDR holdings are sold for dollars, interest will have to be paid on the allocation. The net reserves also contain items like swaps, partly because that was a trick used to shore up reserves but it is also a borrowing.
Net foreign assets on the other hand show the correct situation. It does not count SDRs or swaps.
Even as this is published, the central bank must be making quasi fiscal losses and may eventually require recapitalization. Sri Lanka is therefore on the path of central banks in Latin America, Philippines and Korea that were set up by the Fed.
Without net reserves, if the central bank intervenes it will eat into reserve liabilities and become even more insolvent. Already interventions had been reduced. The central bank can go bankrupt along with the government and default on the International Monetary Fund loan.
DOLLARIZATION
When central banks lose the ability to intervene it can float. But usually soft-peggers do not know how to float and will intervene at crucial points. This will make the currency fall faster. Eventually it could lead to market dollarization as people lose confidence in the currency. Already there is significant deposit dollarization, with dollar accounts. The black market rates also show that people are chasing after US dollars.
In 2018 there was a chance for official dollarization. But de facto dollarization happens when people start selling and pricing in US dollars. The reason dollarization did not happen earlier is because there are legal tender laws prohibiting the domestic use of foreign currency.
Economic collapse from a plunging currency is the result. If these laws are removed allowing any currency to be used, Sri Lanka’s economic and monetary instability will end.