An Echelon Media Company
Tuesday July 23rd, 2024

Central bank swaps symptomatic of Sri Lanka’s IMF return tickets and default: Bellwether

AGE OF INFLATION: Swaps help Sri Lanka’s macro economists to suppress rates after running out of reserves, bring the country nearer to default and expand imports and the current account deficit.

By Bellwether

ECONOMYNEXT – Sri Lanka’s central bank has been playing with swaps for some time and the agency’s 778 billion rupee forex loss in 2022 was directly related to swaps and other borrowings, which allows it to maintain an artificial policy rate.

Central bank swaps along with other doctrines like portfolio balance channels, are the foundation of modern age-of-inflation forex crises, default, outmigration and sudden soaring poverty.

As part of steps to prevent the next sovereign default by macro-economic policy, outlawing forex swaps will be a key measure that legislators can take.

The Nick Leeson style losses came not only from swaps but also IMF borrowings taken during an earlier flexible inflation targeting crisis and borrowings from India through the Asian Clearing Union, which have since been converted to a term facility.

A central bank is supposed to have foreign reserves, but with the invention of the policy rate, modern central banks engage in ‘macroeconomic policy’ or try to boost growth through money printing to suppress the policy rate and run out of reserves.

At least before swaps, macroeconomists were forced to allow market rates to go up to stop the currency from depreciating further after a central bank ran out of reserves.

But after the invention of the swaps by the Federal Reserve when it started aggressive macroeconomic policy in the 1960s, a modern central bank can continue to print money by sterilizing non-existent reserves and promote investment and imports essentially re-financing private sector activity.

The People’s Bank of China, bless its Communist heart, at least stopped the macroeconomists in Sri Lanka from busting the proceeds of its swap after gross foreign reserves fell below three months of imports.

Otherwise, the central bank would have used the swap, printed more money to suppress rates, private imports would have gone up some more and instability would have continued and people would have suffered more, like they did due to the misguided ACU loans India gave.

The entire doctrine of ‘reserve adequacy metric’ of the IMF’s statistics is completely flawed as central bank reserves cannot be used to make private sector imports, which is enabled by liquidity injections made to sterilize outflows.

Any use of central bank reserves must result in a rise in market rates and a fall in rupee reserves in banks (a real outflow of funds) to maintain external stability.

Where and when did this perfidy start?

The Federal Reserve was the culprit behind the swaps which allowed macro-economists to suppress rates on borrowed money.

The Fed during the Bretton Woods had a lot of gold reserves, but it did not have a lot of foreign exchange, unlike other central banks which did not have much gold.

When the fed printed money for ‘macroeconomic policy’ (boost employment/lean against the wind) and continued artificially low interest rates, it had to get foreign exchange from somewhere to redeem the dollars that boomeranged on itself if it did not want to lose gold. The Fed then went shopping in Europe, from Swiss National Bank, the Bank of International Settlement, France and Germany.

The initial ad hoc swaps started with Swiss National Bank in 1960.

Charles Coombs, head of the foreign exchange desk at the New York Fed was the perpetrator who built swap facilities with counterparty central banks on a standing basis and eventually helped in the collapse of the Bretton Woods.

Swaps also helped worsen currency crises in Sri Lanka (and also in other countries) by giving yet another tool to policy-rate-obsessed macro economists to delay rate corrections and end up with a 778 billion rupee loss in 2022.

When the Fed printed money in excess of its gold holdings it was obliged to exchange them for gold (as were free banks in the old days through the clearing system) under the Bretton Woods agreement. To prevent the dollar boomeranging on itself, the Fed hit upon the idea of the swaps.

The fx taken from the swaps could be used to buy back the excess dollars from Germany or France or Belgium or whatever bank that did not print money.

Governor Brunet of Banque de France cottoned onto the trick and reportedly Bank of England the “thought that the American idea of organizing swap facilities around Europe for large sums indefinite in time was, wrong in principle” because it allowed the United States to avoid going to the IMF to resolve “deep seated difficulties” with the dollar.

The ‘deep seated’ difficulty was of course the bureaucratic policy rate which had done so much harm to Sri Lanka in the recent past.

France had greater monetary knowledge unlike the Anglophone macro-economists with the French Franc recently being fixed by Jacque Reuff, who had argued with Keynes as far back as the 1920s on current account deficits, and failed to convince him.

France was right since the dollar and the Bretton Woods eventually collapsed against gold like the rupee collapsed against the dollar in 2022.

Swaps were wrong in principle in 1960s and they are wrong in principle now.

Assuming Risk.

One of the reasons that European banks agreed to swaps was that it acted as a forex hedge. When the Fed got Deutsche Marks and exchanged them for excess US dollars instead of giving gold, the Deutsche Bank was left with exactly the same volume of dollars as before.

However, this was under the swap and any dollar devaluation (against gold) will not affect the more prudent French, Swiss or German counterparty central bank.

The Fed eventually browbeat Deutsche Bank into accepting part of the forex loss.

In 2022 when the rupee collapsed steeply Sri Lanka’s central bank made a 720 billion rupee loss on its forex operations and it was deeply in debt.

Fast forward to 2024.

What did the IMF say in support of the swaps?

This is what an IMF official told reporters in Colombo in response to a question about the central bank’s predilection for swaps.

“Rebuilding reserves is a very important component of the IMF supported programs.“One, is what we call organic purchases by the central bank in the foreign exchange market. The other one is rebuilding reserves for engaging with swaps. This can either be swaps with domestic banks, but also swaps with other central banks. The latter is a very important part of both global and regional financial safety nets.”

RELATED IMF sees no problem in Sri Lanka central bank building reserves with fx swaps

To be fair to the lady, Fed swaps of recent origin, including during the collapse of the housing bubble it fired, were aimed at giving dollars to other central banks as markets froze and everyone held on to cash of all kinds.

But what the Sri Lanka’s central bank did and is doing by engaging im buy/sell swaps are the 1960s style transactions, assuming enormous forex risks which eventually end up as losses like in 2022 when the currency eventually collapse from the impact of reverse repo injections or standing facilities.

Swaps with domestic banks simply allows them to convert dollar deposits (or foreign credit lines), lend them as rupee loans and the central bank will end up holding the baby when the ‘flexible exchange rate’ rears its ugly head.

What can be done?

From the foregoing it can be seen that swaps are deadly in multiple ways.

One: Central bank swaps allow macroeconomists in Sri Lanka to cut rates through open market operations and liquidity facilities and keep them down, making the eventual crisis worse.

Two: It creates a forex risk and losses to the central bank and the people since it is a state agency

Three: It creates a moral hazard for private banks as it allows them to dump the forex risk on the central bank and lend in rupees to customers or the government.

Four: In the language that modern inflationist macro-economists understand – or should understand – swaps are a threat to the credibility of its monetary policy.

As banks are sitting on large dollar balances at the moment, the temptation for Sri Lanka’s central bank must be irresistible to either swap them or borrow them and show dollars as ‘reserves’ to all and sundry and the IMF. And that has happened to some degree already.

Sri Lanka’s politicians can move and amendment to the central bank’s new inflationist and output targeting monetary law to ban forex swaps, as part of measures to prevent a second default.

Or legislators can draw up an outside law like the classicals did with the Bank Charter Act of the UK, and impose restrictions on the central bank through a second law notwithstanding its inflationist output targeting IMF-backed monetary law.

That will make it less easy for macro-economists to drive the country into a default in the future.

Support for swaps shows why countries with bad central banks keep returning to the IMF as bad habits are encouraged.

Once a country has defaulted, defaults tend to follow swiftly unless the central bank is restrained through tight laws on its ability to mis-target rates.

Through swaps, a central bank can mis-target rates without buying Treasury bills. In fact the central bank can print money and destabilize the country without contravening the ceiling on domestic assets in the IMF program, just like the Fed did in the 1960s as it went about busting the Bretton Woods.

Argentina’s central bank also ended up with negative foreign assets due to its dollar borrowings. It also issued dollar securities.

Same Story – All geographies, all centuries

For several years this columnist had warned that swaps would result in enormous losses for the central bank when the currency collapsed.

Though examples abound, the IMF dependent central banks continue to use swaps and get into trouble again and again.

The Central bank of the Philippines had to be recapitalized.

The Bank of Thailand got dollars from speculators and hit an own goal. .

So did the Bank of England in the ERM crisis. Fed minutes show it drew on swaplines in the run up to the late 60s Sterling crisis as well.

More recently Lebanon’s central bank borrowed dollars (took deposits) and eventually collapsed itself.

Argentina’s BCRA also does the same.

All this happens due to the policy rate. The swaps simply allow artificially low rates to be continued until the swap proceeds are lost.

Sri Lanka also has a history of this type of forex risk going back to a note issue bank before the current central bank.

The Eastern and Oriental Bank, one of two note issue (Chartered) banks that issued rupees in Ceylon closed its silver door in 1884 just like the Fed closed its ‘gold window’ and floated in 1971.

The Oriental Bank rupee collapsed 50 percent overnight but the Madras Bank’s rupee held according to surviving accounts of what happened in 1884.

The problem with the Oriental Bank was the same as Sri Lanka’s central bank.

Modern Saltwater/Cambridge central banks, borrow dollars, sell them in the forex market, and then prints large volumes of money to sterilize the intervention by repurchasing Treasury bills from banks to maintain its policy rate, worsening the credit cycle, leading to an eventual collapse of the currency.

The Eastern and Oriental Bank borrowed in Sterling and loaned in Silver. The rupee was Silver backed or silver denominated.

In fact, researchers who went into 19th century ledgers of the Bank of England found that Oriental Bank was a top borrower at its sterling discount window.

That is why this column advised that removing counterparty limits for borrowing through the standing facility or reverse repo auctions was a mistake.

The imposition of the counterparty limit was a key prudential move by the current management of the central bank.

The Oriental Bank closed its doors not only due to a parity problem between Silver and Gold.

It is unfortunate that in almost 150 years we have learned absolutely nothing.

Plus ça change, plus c’est la même chose

The Eastern and Oriental Bank did not just collapse due to exchange risk, but also because of its clients, the plantation companies were hit by falling prices (as a commodity bubble deflated) and could not repay loans.

The central bank which used Sri Lanka Government paper as collateral to print money into the banking system also ended up with a ‘bad loan’.

The restructure of Sri Lanka government debt had left it with hefty losses.

It must be noted that except when foreign debt is repaid with a reserve appropriation, or some deficit is being monetized through provisional advances (which was supposed to conform to the bills only policy), most of the money printed by a central bank targeting the potential output gap or policy rate has nothing to do with the government.

Government securities already in the balance sheets of commercial banks (from previous deficits) are taken to the central bank to conduct overnight term or outright reverse repo injections.

Before the Fed, central banks did not discount government paper but discounted actual trade bills (banker’s acceptances) from various fairly good companies.

The BoE researchers found that in the past, when some of the bill brokers or banks went down, the Bank of England did not actually have much losses, as the paper it took was from strong companies.

Violating bills only Policy

Either way the large mark-to-market losses of Sri Lanka’s central bank is from violating another classical central banking principle, the bills only policy.

This prudential practice was also violated in Sri Lanka in the general deterioration of policy after the end of the war, eventually ending in sovereign default.

Violating the bills only policy which was seen during the Yahapalana regime which was ousted amid currency collapses and low growth from stabilization program, allows inflationists to mis-target rates deeply into the yield curve, create forex shortages and bust the rupee.

In defence of the central bank it must be said that it took a hit on its balance sheet in 2023, so as to protect the government securities market and the move has helped bring down rates faster.

There are banking practices that must be observed in running banks.

There are even more stringent prudent rules to be observed when running a note-issue bank or a bank that can create its own reserve money or circulating medium as the classical greats used to say.

IMF has weak knowledge of operational frameworks of note-issue banks, in keeping with general saltwater doctrine, that is why its patients keep going back with increasingly worse symptoms and diseases.

The doctrine of the ‘portfolio-balance channel’ is laughable at best.

If the central bank is mis-used to target potential output, or if the domestic 5-7 inflation anchor rears its ugly head, a second default is not too far away.

A peaceful country, which overcame a civil war, was driven to a default with flexible inflation targeting/potential output targeting, the latest spurious monetary doctrine of the Saltwater/Cambridge inflationists.

Sovereign defaults hit the world like a Coronavirus pandemic after the IMF’s Second Amendment to its articles in 1978 led to severe monetary instability as the restraint from external anchoring was taken away from reserve collecting central banks.

Nothing of the ideology has changed, as can be seen with IMF endorsement of central bank swaps. That is why IMF-dependent central banks keep going back to the agency, again and again and the country sovereign-defaults within 10 years of getting market access.

If legislators and the public want to end a second sovereign default, outlawing swaps should be a key rule in a law that should be brought to restrain the central bank or revise the current law into a true central bank constitution and not a law that gives it discretion to create 5 percent inflation and run exchange rate policy on top.

Leave a Comment

Your email address will not be published. Required fields are marked *

Leave a Comment

Leave a Comment

Cancel reply

Your email address will not be published. Required fields are marked *

Sri Lanka to introduce digital program for foreign workers facing problems

ECONOMYNEXT – Sri Lanka will introduce a digital program via smart phones for migrant workers to report any concerns while employed abroad, Minister of Labor and Foreign Employment Manusha Nanayakkara said.

“We will have a digital program that is accessible from their smart mobile phones where domestic workers can notify us if they have not got their salary or if they have fallen into some trouble,” Nanayakkara said in parliament on Tuesday.

Sri Lanka has sent 301,000 domestic workers and 360,000 skilled workers abroad, Nanayakkara said.

Several workers, especially domestic workers, face abuse at the hands of foreign employers.

Nanayakkara said that the government only receives 0.001 percent of complaints with regard to abuse.

“We can only act on complaints received from people who go through legal channels. We are educating those who go through the Foreign Employment Bureau on how to escalate complaints.” (Colombo/Jul23/2024)

Continue Reading

Sri Lanka cabinet approves apology from Muslims for COVID-19 cremation ahead of election

ECONOMYNEXT – Sri Lanka’s Cabinet of Ministers approved a proposal to tender apology for the grievance caused for ethnic minority Muslims due to the cremation of bodies during the Covid-19 pandemic, Foreign Minister Ali Sabry said.

The move comes ahead of the upcoming presidential poll in which Muslim votes are likely to become crucial for all candidates.

The government of former President Gotabaya Rajapaksa led by current ruling party Sri Lanka Podujana Peremuna (SLPP) forced Muslims and Christians to cremate the dead bodies of those who died of Covid-19 in 2020.

The   Organisation of Islamic Cooperation (OIC) which includes Islamic states globally raised the forced cremations issue at the 46th United Nations Human Rights Council (UNHRC) in February 2021 after the SLPP government rejected repeated requests by local and global Islamic bodies.

The policy was later reversed, but the move hit diplomatic ties with Middle Eastern and OIC nations which is the highest source of employment for Sri Lankan expatriates.

Former President Gotabaya Rajapaksa later said the decision was based on expert advice. Rajapaksa who was seen as an anti-Muslim leader was heavily criticized for his decision ahead of 2020 parliamentary polls while his elder brother and then Prime Minister Mahinda Rajapaksa declined to discuss the issue with Muslim parties which asked to reverse the decision.

Hundreds of Muslims were cremated during the Covid-19 period before Rajapaksa government allowed a separate burial ground for Muslim Covid-19 victims in the Eastern town of Oddamavadi.

“A joint Cabinet Paper presented by Ministers Ali Sabry, Wijeyadasa Rajapakshe & Jeevan Thondaman apologising for the grievance caused to the Sri Lankan Muslim community due to the cremation of bodies during the Covid-19 pandemic, approved by the Cabinet,” Minister Sabry  tweeted quoting Cabinet Spokesman.

Already President Ranil Wickremesinghe and Estate Infrastructure Minister Jeevan Thondaman had tendered an apology in the parliament. The latest cabinet move is a formal and official apology.


Along with the apology, the Cabinet approved proposed law on burial or cremation of dead bodies on religious discretion.

“As stipulated in the guidelines published by the Ministry of Health on the Clinical Management of COVID19, cremation was made compulsory in removal of the dead bodies of the persons who died due to the COVID-19 virus. The decision created displeasure among the various religious groups and human right activists especially Muslim religious persons,” a government document on the cabinet decision showed.

“The studies made in this respect have been confirmed that the faeces and the urine are the primary source of transmission the virus but not with the safe burial. Therefore, in order to prevent arisen of such condition in future, attention has been drawn to introduce a law, a certain person or relations to be selected the burial or cremation of the dead person at their discretion.”

“Further, it has been seemed that introduction of new laws is appropriate to donate the dead bodies to the Medical Faculty, if necessary.”

“Accordingly, Cabinet of Ministers has approved the joint proposal presented by the Minister of Justice, Prison affairs and Constitution Reforms, Minister of Foreign affairs to instruct legal Draftsman in order to prepare a draft for the introduction of new law.”

Rajapaksa’s arrogant policy led the OIC and Middle East nations to reject Sri Lanka’s repeated requests for credit lines and loans to buy oil before the country collapsed following an unprecedented economic crisis in 2022.

Minister Sabry faced harsh criticism from human rights defenders and from members of the Muslim community for what they claimed was his silence in the face of the inhumane, unscientific decision by the Rajapaksa government.

The Rajapaksa government’s stubborn insistence on cremating Muslim and Christian victims of the Covid-19 virus was against the communities’ religious beliefs and drew widespread condemnation and concern of Muslim countries and leaders.

Rajapaksa, after the economic crisis hit the country, was forced to flee in the face of massive protests against him in July 2022. (Colombo/July 23/2024)

Continue Reading

Fireworks erupt in parliament over Sri Lanka’s VFS Global controversy

ECONOMYNEXT – Sri Lanka’s parliament erupted in heated debate after government legislators raised a privilege issue against Committee on Public Finance Chair Harsha de Silva, who last week tabled report on a controversial visa deal with the IVS-GBSVFS Global, consortium.

Justice Minister Wijedasa Rajapaksa questioned the propriety of raising a privilege issue against a Committee chairman, who was acting under powers derived from the Constitution, saying it amounted to challenging the Speaker himself.

Related Sri Lanka visa deal with IVS-VFS be cancelled or revised, forensic audited: COPF Chief

Sri Lanka’s Department of Immigration had awarded a visa issuing monopoly to IVS-GBS-VFS Global without tender which was charging 25 dollars per visa compared to an earlier 1 dollar by Mobitel, and it should be terminated or revised, de Silva said presenting a report earlier this month.

Privilege Over VFS Report

State Minister Shehan Semasinghe said de Silva had presented a defective and false report misleading parliament saying among other things that the report was unanimously approved by the COPF membership.

As a result, privileges of 16 members had been broken, and misleading a parliamentary committee was a punishable offence and de Silva should be referred to the privileges committee.

De Silva said he severally and individually rejected the charges and all views of the members were attached to the final report and he would stand down as COPF chair until the matter was decided.

“This was not done secretly. There were three weeks for members to respond,” de Silva said.

“There was a debate about the tourism arrival numbers, which was included. If I am to be imprisoned, do it. I am not afraid. Give me an opportunity and I will show how each word is true.

Semasinghe said there was no desire on the part of government members to remove de Silva from the COPF.

Government member Nimal Lanza said that he was under the impression that tourist arrivals had fallen due to the VFS deal but there was an increase this year. There was no desire to imprison de Silva, he said.

Verbal Exchange

Public Security Minister Tiran Alles said five years of data was given, and there was an increase in tourism arrivals. And after April there were 53,000 tourists under new categories, which brought revenues of 1.4 billion rupees.

The report was also attached as an addendum, de Silva said.

Minister Alles questioned why the Deputy Speaker was allowing a debate over the VFS deal which would now attract media headlines.

“If you are allowed, all our members must be allowed to speak,” he said.

Opposition leader Sajith Premadasa said if competitive tenders were called, there would not have been a charge of 25 dollars per visa as Mobitel was charging only one dollar.

Premadasa said he was responding due to charges made against de Silva and claims that he had committed a punishable offence. The opposition leader questioned how his microphone was muted.

Justice Minister Wijedasa Rajapaksa said while it was fair to allow de Silva to respond to the initial charge, a long debate should not have been allowed on the matter and also the contents of the report.

“The second bad precedent is this. It is not important whether it is Harsha de Silva or not. There are many committees. Can the Chairman of a Committee be called over a privileges issue?

“Under the Constitution there are powers to make standing orders. It is implemented through the 1953 Privileges Act. The Chairmen have certain powers. The Chairman has acted under the limits of his powers.

Parliament Undermined

Minister Rajapakshe said while there may be errors in a report, the Parliament’s powers were diminished if privilege questions were raised against Chairmen of a committee who carried out there duties.

“There may be errors in the report. We have seen that. But I am raising a question on the constitution.

“In this way, in whatever Committee, if he did his official duties, if he is made an accused in another committee of the same parliament and there is an investigation, it is the parliament’s power that is degraded.

“So it is the confidence people have in the parliament that is reduced. There is a legal question here. The Chair should consider whether it is possible to raise a question like this

“Ultimately the final responsibility of all these Committees rests with the Speaker. It is the Speaker’s powers that are delegated to the Chairman of a Committee.

“So, this challenge is made against the Speaker. How is the Speaker doing this?

“If the next day, the COPE, or COPA issues a report, someone asks to put him in the punishment log (dandu kanda) or to do whatever and calls him to the privileges committee.

“What are you going to ask at the Privileges committee? What punishment are you going to give? (Colombo/July23/2024)

Continue Reading