The obsession and delay over reopening car imports shows a defeat of economics and the iron grip of naked mercantilism that led this country to exchange and trade controls and eventual external default since setting up the central bank over 74 years ago.
From time to time, Sri Lankan mercantilists have obsessed over various goods, falsely believing they caused forex problems rather than domestic central bank operations. For many years, it was oil. Oil took the blame for forex shortages. It also took the blame for inflation.
The 2015 currency crises happened due to money printing, mostly via open market operations, while oil prices collapsed, seemingly curing that petroleum obsession to some extent. Gold is another obsession in a country with a bad central bank operating framework.
Exchange control is another tool through which the people are oppressed in such countries. The Bretton Woods and the IMF set up Article IV, permitting capital controls after the policy rate was invented, showing the regression in understanding economics since the 1920s. In the next decade, the Fed, Cambridge University and Harvard destroyed the learnings of a century. It was as if the classical greats did not exist.
Are car imports different to any other imports?
Car imports are no different from any other credit-financed import. In any case, imports cannot cause monetary trouble. Monetary troubles and the loss of central bank reserves (an asset in its balance sheet) are causes of the direct or open market operations that increase reserve money (a liability in its balance sheet exchangeable to dollar reserves). Since direct market operations are now opposed by the public, macro-economists shifted to open market operations to cause forex shortages, as seen in the 2015 and 2018 crises. The 2020/2022 crisis was caused by direct market, open market operations (OMO) and liquidity releases from SRR cuts. OMO has largely been deflationary since September 2022, but concerns have been raised that the inflationary operations are just starting.
What happens when someone decides to buy a car?
A decision to purchase a car, especially a sudden opening, impacts the banking system in two ways. Potential owners will withdraw a deposit and get a loan to finance the balance. Both actions will lead to a drain of rupee reserves from the system. Banks and finance companies will curtail other credit to give these loans.
What type of other credit will they reduce?
One thing that may happen is that they will reduce their Treasury bill holdings. Finance companies for example have invested in Treasury instruments, directly and through repos as car imports and other private credit slowed.
They will now cut the repos and refrain from re-investing in Treasury bills beyond their liquidity requirements. Depending on how the budget deficit is managed, this will lead to upward pressure on Treasury bills.
Banks could also reduce other types of credit private and give car loans with new deposits or loan repayments they get. This leads to the sequencing or prioritizing of car loans over other products.
Are car credits different from other credits?
Car credits are slightly different from say a credit to build a hotel or factory. A credit to build a hotel will generate imports of building materials like steel or cement (or clinker and gypsum) but things like sand or labour will be domestic.
In a second round, fuel is used to transport rocks or sand and then the suppliers will use the money on food, or save in banks which in turn will be used in imports. So there must be several rounds of credit for all the loans to hit the forex market.
However, cars are imported. So almost all the money except the margin and taxes will immediately hit the forex market. Since taxes are around 200%, only a third of the money will hit the forex market.
Some of the worst credit loans go to the CPC and CEB to finance losses. That is almost 100% spent on imported fuel and hardly any taxes. When that happens the exchange rate comes under quick pressure, if the policy rate is maintained with open market operations.
For example, in 2004, when the fuel pricing formula was abandoned, macro-economists offset taxes from CPC and printed money to finance the budget. As a result, the currency collapsed in 2004. In 2012 it was done with the policy rate cut and so was 2018. This column called the cut the unkindest cut of all.
What if banks use the excess liquidity that exists in the banking system
These are customer money or their profits, which banks deposited in the central bank, from which the monetary authority bought dollars when interest rates were market-driven. There are about Rs200 billion deposited in this way in the central bank.
Some of the money has been printed recently without reserve backing. The central bank has injected around Rs80 billion into the system through term and overnight operations.
If these monies are withdrawn and given to customers, instead of using new deposits and loan repayments to fund car loans, there will be excess demand for dollars and it can pressure the currency. If the currency is allowed to fall, all traded goods including food for the hungry and coal for electricity will go up. If the exchange rate is defended, against the liquidity, foreign reserves will be lost.
Can foreign reserves be used for private imports?
No. At least they should not be. If they are then, there is trouble. IMF’s reserve adequacy matrix is a false concept. If a small amount of reserves is used, and liquidity in the banking system drops, interest rates go up and total credit is reduced. The further loss of foreign reserves stops.
However, since there is a policy rate, the central banks will inject more money to target the average weighted call money rate. This is done to depress interest rates against market credit demand. To the extent that more money is injected to suppress rates, more reserves will be lost.
Let’s assume that one commercial bank will use Rs30 billion of the excess liquidity they have deposited in the central bank to give some investment credit for imported capital goods. That will lead to a demand for around $100 million in the first month.
If there isn’t enough savings generated in that month from dollars coming in, the central bank will have to lose $100 million from its foreign reserves to stop the rupee from falling. If the same demand persists in the second month, another $100 million will be lost.
Let’s assume that since foreign banks have lots of liquidity that they will not use for car loans, they will hold on to the dollars.
In that case, the central bank will have to print money through open market operations to keep rates down and when the new money is used as credit, there will be more pressure on the rupee and more pressure on reserves.
What if foreign banks buy more Treasury bills now that the external debt restructuring is complete, and domestic risks are reduced?
If foreign banks buy more Treasury bills from the excess liquidity, pressure on government securities will reduce. Once the suppliers to government or state workers who got the money, start spending, the money will hit the forex markets in the imports consumed or subsequent rounds of cascading credit.
What factors will determine interest rates in the first quarter of 2025?
Sri Lanka’s central bank – or most central banks under IMF programmes using monetary policy consultation clauses or flexible inflation targeting – tend to cut rates just as private credit recovers, around 18 to 20 months after the initial float and rate hikes restored monetary stability.
This action tends to plunge the country into a new currency crisis in peacetime. This was shown in 2012, 2015 and 2018. In 2020 it was compounded by tax cuts, which required rates to rise to keep the BOP in balance, and the exchange rate stable.
In the first quarter of 2025, electricity prices may be cut. That will reduce loan repayments from CEB to banks. There is usually a drought in February and March that drives up coal and fuel use. That may also put pressure on interest rates.
On the positive side, car imports will bring more tax revenues for the budget, but there may be higher spending on state worker salaries and welfare.
All this is difficult for bureaucrats of the money monopoly to estimate as the policy rate but will be reflected accurately through the market credit demand.
If there is a wide policy corridor or no ceiling rate, or the ceiling rate is pushed up until credit slows like in Singapore, external stability and the exchange rate will be maintained. But if the central bank does not obsessively target the average weighted call money rate with open market operations nothing will happen.
If this is so, why don’t central banks allow rates to go up?
Currency crises happen because central banks believe the monetary policy board knows the correct interest rates more than the market.
It is part of what the IMF calls ‘monetary policy modernization’. If the central bank has a wide enough policy corridor as liquidity drops due to currency defence, rates go up, new credit is limited to deposits and loan repayments, and the balance of payments and reserves are protected.
But if they target inflation and say inflation is low therefore there is ‘space’ to cut rates, the balance of payments will go haywire. This is why flexible inflation-targeting countries like Ghana, Zambia and Sri Lanka which receive IMF technical assistance default or go from one bailout to the other.
After the monetary policy consultation clause (MPC) was introduced in 2014, and flexible inflation targeting-with-a-peg or reserve target generally, the risk of programme failure has intensified in Sri Lanka with reserve targets being missed halfway into programmes.
In Sri Lanka, this was seen in 2012 and 2018. The 2020 crisis happened outside an IMF programme. This time however there is a ceiling on the domestic assets of the central bank, in the IMF programme.
An examination of history shows that central bankers and bankers in the city knew this in the UK at least until August 1914 when the pound floated after war was declared.
After the policy rate was invented by the Fed in the 1920s, the knowledge was gradually lost. In the 1930s, as currencies collapsed due to the policy rate and open market operations, capital flows were blamed, and the IMF was set up permitting capital controls and only a commitment to Article IV. What was common knowledge till 2014 was no longer known.
In countries that had capital controls inflationists/macroeconomists started to blame currency trouble on current account deficits. They never blame themselves.
In Sri Lanka, a silly concept has emerged recently where it is claimed that money printing is financing the government and not re-financing private investments.
Why does this happen and why is knowledge that stopped inflation, economic crises and social unrest lost?
It happens because what we call economics now is not a positivist science based on reason. It is a kind of doctrine which swings from reason (classical economics) to unreason (mercantilism) from time to time.
Because macro-economists lack knowledge of history they do not know that all these arguments are old hat and had been thoroughly debated and refuted many decades ago, such as during the bullionists debates in the UK and Austrian economics in German-speaking countries.
Unlike in the past when central banks were private, state central banks, with a money monopoly are completely unaccountable. They can also make their laws, despite causing social unrest through inflation.
They also have the power to control citizens instead of correcting their open market operations or other easy money tools. Silly concepts like ‘exchange rates are market determined’ have been spread by the IMF and Anglophone inflationists.
Anglophone universities like Cambridge, Oxford, Harvard and MIT have done a great deal to revive the debunked mercantilism of the 17th century which led to the collapse of the Bretton Woods and Great Inflation.
University textbooks written by economists like Paul Samuelson and books and the doctrine spread by John Maynard Keynes are also part of the problem. The latest debacle relates to the positive inflation ideology of Ben Bernanke, who tried to reverse productivity-driven price falls and fired the housing bubble which then led to quantitative easing. QE did not cause much problem when the banking system was in shambles, but 10 years later it caused the worst inflation since the Great Inflation and set off a fresh wave of defaults in pegged countries like ours.
QE seems to have eliminated the fear of excess liquidity which the classical greats called superabundance of paper money. The central bank has allowed excess liquidity to build up to Rs200 billion like during the 2020 crisis.
State-owned central banks, set up or nationalized in the last century, are also problems. The tyranny of exchange controls and import controls, wherever imposed on innocent citizens, indicate a deep flaw in the operating framework of the central bank concerned.
In floating exchange rate central bank regimes, asset price bubbles and inflation, the most recent of which the media called the ‘cost of living crisis’, in Europe and the US, is the consequence.
Yet they send out a great many public communications at taxpayer expense to defend miss-targeted policy rates and the consequences of their errors and the media reproduces them faithfully and people believe them. Gordon Tullock in his book Capitalism and Freedom: Problems and Prospects, related something Milton Friedman has said.
“On several occasions in my hearing (I don’t know whether it is in his writing or not but I have heard him say this several times) Milton Friedman has pointed out that one of the basic reasons for the good press the Federal Reserve Board has had for many years has been that the Federal Reserve Board is the source of 98% of all writing on the Federal Reserve Board. Most government agencies have this characteristic.”
There is a history of over 70 years of exchange control and import controls, as well as 17 IMF programmes, to get over. But it is not impossible. Singapore after the Japanese left, Germany did it after World War II, Japan in 1948, Saudi Arabia in the late 1950s, and Taiwan in the 1960s as did France. The UK did it in 1978 (but got into trouble with the ERM), Hong Kong in 1981 (it had a solid system until 1971), New Zealand and Australia and the UK again in the 1990s.
Switzerland never got into trouble and Sweden largely escaped also. So it can be done and the ideology of exchange and trade controlling central banks can be changed.
The opinions expressed in this article are solely those of Bellwether