ECONOMYNEXT – A minister in Sri Lanka has taken a radically opposite approach from Turkish President Recep Erdogan and President Donald Trump by urging a central bank not to give weapons to undermine a national currency by printing money at low rates.

Sri Lanka’s central bank had intervened heavily to protect its unstable peg with the US dollar in September, after allowing excess liquidity to build up in the weeks before, including with some swaps of the style that are used by speculators to attack pegged exchange rates.

When a central bank intervenes in forex markets, unlike the Treasury or any other entity, a liquidity shortage is created as rupees disappear in to the monetary authority, which tends to tighten the credit system and contract base money (unsterilized intervention) automatically protecting the peg.

Printing Press

But because the soft-pegged central bank has a policy rate or interest rate target, it will then print large volumes of money (to sterilize or fill the intervention) in a bid to keep rates down, giving more ammunition for speculators to hit the currency and take away forex reserves.

Money is printed through overnight auctions of cash, term auctions, outright purchases of securities, non-transparently purchasing Treasury bills at auctions, at rates unknown to the public or through forex swaps.

When rates are raised, the volume of new money needed to be injected falls ((sterilization is reduced), as banks also restrict credit or raises new deposits both of which tends to reduce imports and consumption.

"In fact I have always argued for CBSL (central bank of Sri Lanka) to let rates rise in such situations and not sterilize interventions," Harsha de Silva, State Minister of National Policies and Economic Affairs, wrote in a facebook.com post, responding to question by a follower, which referred to a story on EconomyNext.

 When interest rates are closer to market, the sterilization is progressively less than 100 percent, as credit systems adjust faster.

Over the longer term when central banks follow consistent policy (either pure float or fixed peg) nominal interest rates plunge and economies take off.

China is the most obvious case in recent decades.

Those that don’t end up with both high interest rates and currency collapses, a situation which EN’s economy analyst Bellwether calls ‘rawulath ne kendath ne."

Quick rises in market rates are followed by a fast return to normal.

Last week the central bank bought Treasury bills for up to three months, at a little over the overnight 8.50 percent ceiling policy rate giving subsidized printed money to speculate against the rupee, when banks were raising money from depositors at around 11 percent.

However after weeks of excess liquidity which sent the rupee sliding, the central bank kept overnight markets short for more than a week, which also helped, while the rate at which new money was printed overnight was raised up to 8.19 percent after keeping it down to 7.95 percent up to the third week of September. Most of the liquidity shortage is sterilized short term by term repo injections, which also helps.

The higher bank deposit rates mean that the credit system is tightening and pressure on the rupee is reducing, despite central bank attempts to stop the correction by printing more money.

Though money is still printed below that rate, overnight market rates are also now close to the 8.50 policy ceiling. Prolonged liquidity shortages, however can have a shock on output, unless a float re-stablishes credibility of the peg quickly after the system has tightened.

Confusion

But last Monday the central bank said bought dollars, just as exporters began to sell, signaling that it was happy at the exchange rate of around 170 to the US dollar.

Central Bank Governor Indrajit Coomaraswamy expressed satisfaction that a Real Effective Exchange Rate Index, which had risen to 104 was now back near 100 after the latest collapse further, confusing exporters who were beginning to sell at a little over 169 thinking the rupee had overshot.

If the central bank was so happy with the rupee at 170 to the US dollar or weaker, it is not clear why the Treasury was pushed to slam trade controls, leaving the administration’s entire trade agenda in tatters and advocates of free trade with egg on their faces.

Analysts had warned that the central bank and its contradictory monetary and exchagne rate policy was a threat to free trade (Sri Lanka central bank has to be restrained for free trade to succeed: Bellwether).

Economic analysts have said that Sri Lanka’s 8.50 percent policy rate which is three times that of the US is enough to keep a peg, if the central bank does not switch from pegs to floating regimes suddenly, maintains consistent policy and does not print money in unorthodox ways at the drop of a hat to expand base money.

Last Friday 5.4 billion rupees of overnight money was auctioned at 8.25 percent where the maximum, minimum and weighted average yield were the same raising questions whether it was a coincidence or a result of deliberate action.

Soros Swaps

De Silva, an economist, was also a former Head of Treasury of a Colombo-based bank, and is familiar with money, bond and forex markets.

But now as a State Minister in the ministry that was overseeing the monetary authority, he appeared to be struggling to protect credibility of agency, while pushing it to adopt prudent, consistent policy.

"And yes, I agree with the EconomyNext piece that CBSL providing cash advances to Treasury against dollars is not helping the situation," de Silva wrote.

"While crediting the CBSL with managing the current situation well this is one area I am not in agreement with them."

The central bank had been a counterparty (with the Treasury) to the type of forex swaps that offshore speculators had used to break East Asia central bank pegs in their latest attempt to print new money and bring rates down just as the economy was recovering.

It is not clear who advised the Treasury and central bank to enter into Soros-style swaps, but such deadly practices have to be nipped in the bud, long term watchers of the central bank say.

The forex swaps had since been reversed. The Bank of Thailand had entered into longer term swaps. The forward legs were eventually paid off during an IMF program. Central bank forex swaps have been halted under the current IMF deal with Sri Lanka and it is not clear why there were revived.

Sri Lanka’s central bank, which is under an IMF program also paid off a 379 million dollar swap originally entered in 2013 in September, which led to severe liquidity shortages and forex reserve losses last month.

In 2017, many such deals had been unwound, when the peg was on the ‘strong side’ with steady permanent mopping up of inflows by selling down securities held by the central bank.

While selling securities out of the balance sheet of the central bank (or unwinding swaps without causing large shocks which require sterilization) helps squeeze outflows, buying securities into its balance sheet, or initiating swaps, injecting new money (loanable rupee reserves) into the banking system makes dollar outflows exceed inflows.

George Soros, the-man-who failed-to-break the Hong Kong currency board, lost money when swap rates jumped in the territory during the East Asian crisis, whose monetary authority does not sterilize interventions and interest rates float. The peg did not break, unlike in Thailand.

The Hong Kong’s hard peg at 7.8 to the US dollar had not moved since 1983, when it was created. Sri Lanka had become a lagging nation since a hard peg was abolished in 1950 to create a money printing, soft-pegged central bank.

Analysts say China’s speculative pressure and volatility including in economic output had increased after the firm peg was broken in 2005 under US pressure.

"…[U]nder pressure from the United States and on the advice of the International Monetary Fund (IMF), China dumped its embrace of exchange-rate fixity and adopted a flexible exchange-rate arrangement," economist Steve Hanke wrote in a column on two months ago in Forbes.com (President Xi’s Nightmare)

"We anticipated that instability would accompany the introduction of exchange-rate flexibility. Never mind, the U.S. and IMF ruled the day."

"Their thinking was that, if flexibility was introduced, China would be forced to adopt an ever-appreciating renminbi policy.

"Well, contrary to what Washington wished for, the renminbi has been up, down, and sideways in the era of flexibility."

‘Exchange rate flexibility’ is an amorphous term where no consistent policy can be found backing it.

Central Bank Independence

De Silva was critic of the central bank before 2015. His criticism helped it do tighter policy, and also helped create wide public understanding about the danger of buying Treasury bills and creating new money to manipulate rates.

The current administration had promised central bank independence, but there is no accountability.

While ordinary people are have their salaries and savings destroyed and foreign investors run amid when currrencies collapse in one direction, central bankers get inflation protected salaries and pensions.

Turkey’s Erdogan threatened the Turkish central bank which had also erred in generating double digit inflation, when it was hiking rates to protect a plunging lira. In September the central bank raised rates from 17.75 percent to 24 percent despite criticism from the President Erdogam.

"Here you go, have your independence. We will see the results of the independence," he was quoted as saying later.

President Donald Trump had also criticized the Fed for raising rates.

De Silva has also been pushing central bank independence, though a REER peg, involves importing the monetary policy of the worst central banks in the region and generating instability like the current situation, is directly undermining his own plans to build a financial centre in the island.

Politicians like de Silva however are accountable and will get their reward at the elections from an angry public who are struggling to feed their families as sugar, milk, tea, fuel, gas, go up in price.

But some of the best performing pegged central banks in the region were run by politicians with monetary knowledge, including in Singapore (Finance Minister Goh Keng Swee), and China (Vice Premier Zhu Rongji), who were in favour of sound money and used monetary policy for domestic stability and not for Mercantilist subsidies for industrialists at the expense of the working class.

After China fixed the peg in 1993, nominal interest rates collapsed.

Ironically, China came under fire from US Mercantilists for ‘undervaluing’ it currency when it stopped depreciating from 1993, though the US Treasury has never officially named it as having done so.

Policy Errors

Analysts had identified failed term repo auctions in the first quarter of 2018 in Sri Lanka – which may have happened due to the unwillingness of the central bank to pay market rates – as a contributory factor to the weakening of the peg in the first run as well as outright injections in April.

An unsterilized liquidity spike in August including Soros-style swaps led to the current run and the undermining of the administration’s entire free trade agenda.

Critics say laws should be brought to limit the unorthodox avenues the central bank has to inject money including outlawing Soros swaps because it may become as big a source of instability to the country as is the direct non-transparent purchases of Treasury bills, where weekly auctions and the entire credit system is undermined by expanding base money.

Laws should also be brought to prohibit the central bank from purchasing bills at outright auctions below the Sri Lanka Interbank Offered Rate for the particular tenor, so that exiting bond holders and other market participants do not get subsidized printed money to hit the currency and un-necessarily prolong speculative runs.

Reserve Bank of India has just announced 360 billion rupees of bond purchases to sterilize interventions made as the Indian rupee tanked, showing that it is also not free floating and is subject to contradictory policy.

Bond yields fell after announcement and the rupee fell further. India’s policy errors however may provide temporary relief via imported food prices in Sri Lanka.

In Sri Lanka since the March/April policy debacle, bond holders have also exited steadily. In any case, it is now clear that under a REER peg, the rupee is a one way bet and not a ‘flexible exchange rate’, analysts say. (Colombo/Oct08/2018)