The Price Signal-SRI LANKA HEADING FOR UNCERTAIN TERRITORY WITH RATE OBSESSION
In 2018, the central bank triggered two runs on the currency with a combination of a buffer strategy (where maturing bonds were repaid with central bank re-fi-nanced overdrafts), overnight and term reverse repo injections and rupee/dollar swaps of a type used by hedge funds to generate domestic currency to hit currency pegs. If the central bank generated currency crises through open market operations in 2018 when budgets were tight and there was a fuel price formula, what are the odds on it keeping the exchange rate steady when budgets deteriorate?
There have been claims made that in 2005 Sri Lanka had similar economic troubles, but the country managed to overcome them despite a war. But many countries which had no war had been brought down by money printing central banks and soft pegs, of the type Sri Lanka has now, when private credit picks up and budget deficits widen. Countries like Argentina, Ecuador, Mexico and Turkey had been repeatedly brought down by similar central banks.
2020 is not 2005 for several reasons. The 2002 to 2004 United National Party [UNP] administration fixed many of the problems with the economy that came with the peg collapse in 1999/2000. The currency was, actually, appreciating in 2004, bad loans were coming down and inflation was near zero when the ministries were taken over by Chandrika Kumaratunga in the last quarter of 2003, triggering a run on the rupee. Most of the ‘circular debt’ in Petroleum and Ceylon Electricity Board and the banks was cleared. Tight fiscal policies and moderate state expenditure, wage restraints and a hiring freeze, allowed the private sector to expand. Several agencies were privatised, which brought an immediate transformation of the economy. The administration followed clear classical economic policies and the central bank under A S Jayewardene stood for sound money.
But the last UNP administration loosely followed socialist policies based on price controls, taxing private citizens and companies to give high salaries to state workers, and achieve ‘revenue based fiscal consolidation’ under an International Monetary Fund program with a highly unstable peg. CPC was heavily mis-managed despite a price formula, by restricting its ability to buy foreign exchange and forcing it to borrow dollars, despite having cash surpluses, based on Mercantilist false doctrine. This strategy—pioneered by Mercantilists many years ago—will continue to harm the country. The central bank also followed un-interrupted Mercantilist monetary policy, targeting the real effective exchange rate (an external anchor) along with other domestic anchors, while the IMF stayed silent and/or added fuel to the fire with different types of ‘overvaluation’ calculations.
The central bank based on public pronouncements also targeted core inflation and under an IMF program, a high headline inflation of eight percent (domestic anchors), which gave enough rope to the monetary authority to generate balance of payments troubles. The IMF also taught the central bank to target an output gap, essentially a variation of so-called full employment policies that led to the collapse of the US dollar, and the Bretton Woods system itself.
Similar full employment policies also led to the Sterling Crises and made the UK a shadow of its former self. It also made the Bank of England a client of the IMF. Collapsing exchange rates pushed up nominal interest rates to high levels in both the US and the UK and triggered stagflation. As predicted, the UNP administration paid the price for REER targeting and currency depreciation and the monetary indiscipline of the central bank in the electorate.
After generating structurally high interest rates with monetary instability and dual anchor conflicts, Sri Lanka’s central bank also slapped price controls on lending and deposits of banks, invoking a blunt instrument it had not used before.
“The Monetary Law also seeks to give the Central Bank of Ceylon, powers of control over the direction as well as over the quantity of bank finance in Ceylon,” an analyst wrote in 1951 August issue of The Banker Magazine in London as Sri Lanka’s monetary printing central bank was established.
“Although this is intended primarily as an anti-inflation regulation it is obvious that it can be used to slow down or prevent the increase of any particular type of credit which the Monetary Board regards as undesirable,” The Banker Magazine warned.
The central bank could slap portfolio ceilings, prescribe minimum capital and minimum cash margins as cover for any letters of credit they open. “One other control granted to the central bank, that of limiting the interest paid by commercial banks on deposits or changes on loans, is apparently intended to be used only sparingly,” The Banker noted.
“It will be obvious from this summary that the new Monetary Board is going to be given almost unlimited power of control over the banking system of Ceylon, a power which, if misused, could do irreparable harm to the island’s economy.”
IN ANOTHER SEVERE DETERIORATION OF POLICY UNDER GOVERNOR INDRAJIT COOMARASWAMY, THE CENTRAL BANK HAD BROKEN THE RULE ON ONLY BUYING TREASURY BILLS AND HAS STARTED BUYING BONDS.
In Sri Lanka and elsewhere deposit rates do not fall quickly after a ‘flexible exchange rate’ collapse, partly due to competition and also because bad loans squeeze inflows to banks. By trying to resist market rates, the central bank had denied resources to banks to lend in the recovery period. A strengthening exchange rate, after an initial fall in consumption, would have led to a V-shaped recovery.
In another severe deterioration of policy under Governor Indrajit Coomaraswamy, the central bank had broken the rule on only buying Treasury bills and has started buying bonds. By breaking the restraints, Governor Coomaraswamy had opened the doors for the central bank to manipulate rates far down into the yield curve.
As a basic principle, a central bank should sell long term sterilisation securities and build up reserves when private credit is weak and rates are low, not buy them. Later, at the top of the credit cycle if necessary, short term securities can be sold when they come up for maturity. Either way, to keep the peg and preserves reserves, all sterilisation securities have to be rolled over, preferably to the same buyer.
IMF ADDS TO INSTABILITY
In addition to powers contained in the monetary law, which allow the central bank to control rates and generate instability, the IMF program now in force intensified the problems.
One was the lack of a ceiling on domestic assets of the central bank, which would have put the central bank’s domestic operations in a straight jacket immediately and provided stability to the currency, the country, the people and energy prices.
The disorderly market condition rule, to defend the rupee (delaying interventions to stop the fall of the rupee from excess liquidity until the currency fell sharply), further undermined the credibility of the rupee and generated panic. In Pakistan, specific ceilings were set on domestic assets of the central bank. The State Bank of Pakistan [SPB] was banned from sterilising interventions with new money, unlike Sri Lanka’s program, which left everything open-ended with an upper-level inflation target big enough to sink Sri Lanka.
“Going forward, the SBP might intervene to prevent a possible overshooting or disorderly market conditions (DMCs), while at the same time not suppressing an underlying trend and in a manner consistent with rebuilding reserves,” the IMF program in Pakistan read. “These sales will not be sterilised, such that the stance of monetary policy will be correspondingly tightened if intervention is needed.”
Though Pakistan’s programs (and Argentina’s), which through the sterilisation block, tries to prevent the central bank from targeting a call money/overnight rate with liquidity injections, nevertheless has a ‘disorderly’ undertaking that triggers panic in forex markets. The DMC is downwardly skewed. While selling dollars is delayed, which can trigger panic in forex markets, there is no corresponding DMC before buying dollars, giving rise to convertibility undertakings which are skewed towards depreciation.
NO EXCESS DEMAND FROM DEFICITS
There is a belief in Sri Lanka articulated by policymakers that budget deficits generate excess demand.
They don’t. Deficits transfer money from savers and bond holders into government spending. Excess demand comes if the central bank prints money by purchasing bonds or through open market operations to accommodate the deficit. Deficits—if no money is printed—simply crowds out private investment or consumption. Currencies fall because deficits are accommodated by the central bank. The cut in taxes, if implemented in December, could lead to Rs30 or 40 billion revenue loss a month. This is a considerable shock. But if it is accommodated by foreign borrowings, or through domestic borrowings at a higher interest rate, it may be possible to maintain stability.
However, December is a month where money is printed to accommodate festival demand. In January provisional advances are given, and salary hikes of state workers take effect. If rates are controlled through liquidity injections, and the DMC is deployed, the grounds will be set for instability and capital flight. In 1994, A S Jayewardene as central bank Governor, who was an LSE graduate, inherited an awful budget from the UNP election promises. The budget deficit was 10.5% of GDP in 1994 and 10.1% of GDP in 1995. He was able to weather the shock with high call money rates.
Now deficits are much lower though there are doubts about the size of the GDP itself. It must be borne in mind that Argentina frequently collapses because of the BCRA, its central bank, not the budget. It was very clearly evident in the latest crisis. Before the latest currency collapse, the central government deficit was a little over five percent, and the overall public sector deficit was over six percent. What happens is when a deficit deteriorates by one percent the central bank resists rate hike with injections, and all hell breaks loose. Argentina’s foreign debt was only 37% in 2017. Then foreign debt ballooned to nearly 52% of GDP as the BCRA printed money, and the peso collapsed. John Exter, in fact, is said to have used one of the provisions in Sri Lanka’s central bank, which is credited with being invented by Raúl Prebisch, who helped design the BCRA and started the beginning of the end of Argentina.
THE CONFLUENCE OF FACTORS
Sri Lanka is now seeing the confluence of three deadly monetary regressions, with the restraints set by A S Jayewardene also being casually broken by Governor Coomaraswamy.
The first is the ‘flexible exchange rate’ involving call money rate targeting with excess liquidity which removes the protection the rupee gets from the policy corridor. The onesided ‘DMC’ convertibility undertaking with the foreign reserve target is the second. The third is the newly given license to repress of the long term bond yield curve with central bank bond purchases. To this monetary witches’ brew has now been added a spiking fiscal deficit with the possibility of a boost in consumption and private credit. Usually ‘stimulus’ packages are temporary and will expire when private credit and consumption picks up. Capital spending projects stop when the projects end. Tax cuts expire. But we know of no such limits.