ECONOMYNEXT – Sri Lanka’s exchange rate arrangement involving ad hoc interventions, which has so far remained stable and provided a strong foundation for economic activities to resume amid broadly deflationary monetary policy, has been classified as ‘other managed’ by the International Monetary Fund.
Especially after 1978 as the IMF’s Second Amendment to its Articles deprived members of a credible anchor for money, countries ended up with various exchange rates arrangements, which collapse due to conflicting money and exchange policies, triggering high inflation, social unrest and political upheavals.
De Facto
“The de jure exchange rate arrangement is classified as free floating, while the de facto exchange rate arrangement is classified as other managed,” the IMF said in its last economic report.
The de jure arrangement is usually the one that is conveyed to the Fund by the authorities of a country. The de facto regime is what IMF staff observes it to be usually after watching how a currency behaves for six month or more.
A free-floating central bank does not intervene in the market and build foreign reserves, or lose them or sterilize in either direction.
Sri Lanka now has a reserve target under an IMF program so the rupee cannot free float. The central bank must intervene in the forex markets in some kind of pegging operation to buy dollars, with new (printed) rupees.
The point or points at which interventions are made by an IMF-prone central bank in a country with monetary instability or a soft-peg, is a source of puzzlement to outsiders who suffer high inflation and currency depreciation as they try to discover a consistent rule.
Intervention Policy
“What is the policy framework that used to make interventions,” Dhananath Fernando, Chief Executive of Advocata Institute, a Colombo-based think tank, asked a central bank forum earlier this year.
“Today we are buying, tomorrow we are buying, what time are we buying.. Can you explain to use the policy framework use to decide this?”
“The central bank does not pre-determine an exchange rate and intervene in anyway,” Governor Nandalal Weerasinghe explained.
“At one time banks were told to keep it at 203. Now there is nothing like that.
“It is called a flexible exchange rate because we have allowed it (to move) based on supply and demand. Also we know the reserves have been lost.
“There is a need to rebuild the country’s reserves to some stable level.
“We have agreed with the IMF to build the reserves steadily each year.
“As a policy what we do is, in the market there is a supply and demand. On some days there is a supply but no demand. On those day if we allow the market only to determine the rate, there can be large fluctuations.
“If it changes are lot in a single day there can be some uncertainty and it is difficult for market participants to determine the value. So we will buy the excess, giving rupees.”
Buying dollars for non-circulating medium
Fernando also asked where the central bank gets money to pay for the US dollars.
“Like all central banks there is no limit to the rupee we can issue,” Governor Weerasinghe said.
“We can issue rupees against Treasury bills or foreign exchange.
“On the other side, we conduct open market operations, targeting the interest rates on the longer term.”
The central bank however does not ‘own’ the foreign exchange it bought against the new notes given to the public, which expands the monetary base, pushing rates down.
The original note owners (exporters or family members of expatriate workers) will spend the notes for real goods, some of which are imports.
Since the reserve money grows at a slow rate according to the needs of a cassh demand, almost all the rupees created will eventually turn into imports, deprecating the currency, unless dollars are later sold in exchange as they come up for redemption in forex markets.
To prevent the rupees from being demanded again, the central bank has to extinguish them (mop them up) by giving a central bank held asset which is not of the circulating medium, either to the original or subsequent owners of the notes or to banks which hold deposits from their savings.
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Building Reserves
This mopping up or ‘sterilization’ of inflows, require interest rates to be kept a little higher than needed to keep the exchange rate unchanged and the external balance of payments in perfect balance.
The sell down of domestic assets of the central bank to banks to re-absorb the rupees created in dollar purchases leads to a reduction of potential domestic investment of a similar amount.
The transaction creates a ‘surplus’ in the balance of payments by the same amount, effectively triggering final transfer of wealth from banks to the central bank and a imbalance in the exchange markets that push the exchange rate up, in a virtuous cycle.
If a reserve collecting central bank targets the interest rates by open market operations to reduce policy rates, injecting money to banks, there will be an excess of domestic investments financed with money created through Treasury bill purchases.
This leads to pressure on the exchange rate, and a loss of reserves if domestic traded good prices are not inflated through depreciation, leading to social unrest.
As long as the policy rate is suppressed through open market operations, reserves would be lost, and social unrest kept at bay.
Modern IMF-prone central banks will inject money either to target the policy rate (to generate inflation like in Sri Lanka) or to target some specific reserve money level like as in Bangladesh.
The effect of targeting a policy rate through OMO injections after interventions also resists a contraction in reserve money and is a de facto targeting of reserves money. It leads to build up of foreign reserves as long as reserve money is under-supplied.
Consistent
Countries that successfully targets inflation do not intervene in the forex markets and do not collect reserves, allowing outflows to be limited to inflows do not go to the IMF for balance of payments needs as currency crises do not take place.
The exchange rate is then determined by monetary policy, typically strengthening against commodities or other currencies in a different cycle, as monetary policy is ‘tightened’ as attempts are made to reduce domestic credit and bring inflation down.
Countries that successfully target an exchange rate (and not interest rates), also successfully allow outflows to be determined by inflows, with foreign reserve growth limited to the net expansion of reserve money and small and temporary purchases and sales of foreign exchange in a consistent manner.
They also do not have to go the IMF as forex shortages and currency crises are not created.
Dollarized countries also limit outflows to inflows in the same manner.
The intermediate regimes or soft-pegs can collapse at any moment when exchange rate stability and the balance of payments are subordinated to domestic targets (anchor) either involving inflation or the reserves money or even broad money.
The intermediate regimes have big fluctuations in foreign and domestic assets in the balance sheet of the note-issuing banks and trigger crises when the policy rate is suppressed.
The IMF now classifies exchange rate regimes in to four broad categories, apparently by observing the behaviour of the exchange rate and not necessarily the balance sheet of the central bank linked to the note issue.
One main category called ‘hard pegs’ is made up of true currency boards with legal restrictions against mis-targeting rates, and dollarized regimes, which it called ‘no separate legal tender’.
Soft-pegs
Soft pegs the IMF has divided into separate categories, called a conventional peg, which seemed to include currency board like arrangements where the interest rate is not targeted in practice (the operational framework) and the exchange rate has been credibly fixed for decades.
Examples include Dubai and Denmark. Monetary laws in such countries usually have holes that allows money to be printed, unlike true currency board, according to economists in the classical tradition.
The IMF has classified other crisis prone regimes as ‘pegged exchange rate within horizontal bands, stabilized arrangements, crawling peg and crawl-like arrangements’, all of which seem to have overt anchor conflicts, according to analysts.
The last category is ‘Residual’ involving ‘Other managed arrangement’.
Sri Lanka has now been included in this category.
In the 2022 IMF Annual Report on Annual report on exchange arrangements and exchange restrictions, Sri Lanka was listed among countries with a ‘crawl-like arrangement’ in a change from ‘floating’
“The residual category (other managed arrangement) usually increases during heightened uncertainty in the economic environment,” according to the report.
Whatever the label, under the current category, of ‘other managed arrangement’, the central bank has provided Sri Lanka a strong foundation for stability and growth and also undershot its 5 percent inflation target under which serial currency crises were seen in the last decade. (Colombo/Aug11/2024)