ECONOMYNEXT – The People’s Bank of China mopped up excess liquidity in money markets to prop up its now unstable ‘flexible exchange rate’ while fending off false accusations by US Mercantilists that it was ‘manipulating’ the currency to get a trade advantage.
Global financial media jumped on the US bandwagon claiming that China was undervaluing the currency to compensate for US import taxes, while the People’s Bank of China mopped up excess liquidity to prop up the Renminbi.
In Hong Kong alone the People’s Bank of China announced the sale of 30 billion Yuan worth securities to mop up excess liquidity (sterilize) in offshore markets.
Sri Lanka’s rupee has also slightly weakened amid unsterilized excess liquidity.
Mopping up excess Yuan
The PBOC can also mop up excess liquidity by selling dollars against Yuan at an intervention rate.
On Tuesday the PBOC said it was setting the rate at 6.96 against the US dollar (a weak side convertibility undertaking) after allowing the rate to fall to 6.987 to the US dollar a day earlier, setting off a hysterical reaction from US Mercantilists and mainstream international media.
The PBOC indignantly denied it was ‘manipulating’ the Yuan to get any trade advantage.
Under a floating rate the Yuan (or rupee) has to weaken if the US dollar strengthens. Any resistance immediately turns the arrangement into a peg.
China operated a tight peg from 1993 to 2005, which had high credibility – an arrangement labeled ‘exchange rate fixity’ by economist Steve Hanke.
But it was forced into an unstable ‘flexible exchange rate’ in 2005 mainly under US pressure, reducing credibility, generating frequent panics and instability and generally pushing up nominal interest rates.
The PBOC continues to generate liquidity from dollar purchases showing that it still operates a peg. It also announces a daily rate setting a two way convertibility undertaking.
Flexible Exchange Rate
Sri Lanka has a mish-mash of shifting convertibility undertakings for its highly unstable ‘flexible exchange rate’, which has left analysts dizzy.
Sri Lanka does not announce a daily rate but the central bank has a foreign reserve target and is committed to stopping ‘disorderly adjustment’ through a weak-side convertibility undertaking, analysts have pointed out.
Sri Lanka also has a real effective exchange rate target mainly involving a strong side convertibility undertaking to weaken rupee and give wage subsidies to exporters.
But it may become a weak-side undertaking if the REER sharply overshoots 100 though there is no floating policy rate to enforce a weak-side convertibility undertaking.
Sri Lanka’s rupee also weakened in recent days as the central bank failed to permanently mop up a part of about 200 million US dollars worth of excess rupee liquidity since July 17 with its Treasury bill stock was last materially sold down.
Progressives steady mopping up of forex inflows (consistent policy), squeezes outflows keeping a peg strong.
Analysts have said that the rupee was not under pressure as private credit has been weak or negative up to May 2019 and consumption has taken a hit.
Ceiling Policy Rate
But state spending has picked up with salary hikes and subsidies amid weak revenues, showing that the central bank has to be careful.
"In August 2018 the central bank triggered a run on the rupee by allowing unsterilized excess liquidity from dollar purchases to build up in money markets," EN’s economics columnist Bellwether says.
"More liquidity was generated by a rupee/dollar swap."
"In China excess liquidity usually builds up from dollar purchases as the PBOC is prohibited from buying Treasury bills to finance government spending or SOEs.
"Both Sri Lanka and China are vulnerable to excess liquidity because they have a ceiling policy rate.
Hong Kong can allow high volumes of excess liquidity as there is no ceiling policy rate to threaten the HK dollar. The Hong Kong Monetary Authority makes unsterilized dollar sales."
But the Hong Kong Monetary Authority also mops up through currency board paper. This is partly because actual HK dollar notes (Certificates of Indebtedness) are issued by note issuing banks against currency board paper (Exchange Fund Bills).
By issueing longer term sterilzation paper a monetary authoritiy can avoids large fluctuations in short term rates and is able to keep forex reserves for longer periods. EN’s economic columnist has called on the Centarl Bank to resume selling it own paper shortly before monetary instability began in 2018. (Sri Lanka’s Central Bank should sell own securities in new credit cycle: Bellwether)
The PBOC this week offered 20 billion 3-month paper and 10 billion 1-year paper.
Currencies collapse not because pegged central bank’s sell dollars, but because after selling dollars domestic money is printed to enforce a ceiling policy rate (sterilized forex sales).
"According to Mercantilist and Keynesian thinking currencies move because of so-called ‘price effects’," says Bellwether.
"They do not understand ‘income effects’ or savings propensities in the way that classical economists did.
"This obsession with price effects makes neo-Mercantilists think that there is something mysterious or bad about currency boards though the entire gold standard which was the basis of the European industrial revolution was based on basically the same principle."
"The current reaction against the Yuan is also based on the same mis-conception."
Currencies also collapse due to excess liquidity from deficit financing with printed money with the direct purchase of Treasury bills with printed money (central bank credit).
Sri Lanka’s is planning to change the country’s monetary law to prohibit outright financing of the deficit, though President Maithripala Sirisena has apparently wants wholesale money printing to continue.
Analysts have said Sri Lanka should keep excess liquidity from dollar purchases at between 20 to 30 billion rupee when operating a peg with strong side convertibility (dollar purchases) and mop up liquidity before switching to a floating regime. But as credit picks up it may need to be narrowed.
Analysts have also warned the central bank to keep the policy corridor wide, and not cut the ceiling rate so that the exchange rate corrects quickly and there is no prolonged monetary instability to undermine economic activity.
Sri Lanka’s ‘flexible exchange rate’ has been the biggest threat to economic stability in recent years, and is likely to remain so in the near term, analysts say.
Analysts and economists have called on Sri Lanka to follow a consistent policy, either float with a narrow inflation target, operate currency board, or operate a tighter-than-currency-board like China between 1993-2005 or GCC nations.
"Stability is not everything, but without stability, everything is nothing," Germany’s Economy Minister Karl Schiller once said.
Consistent policy (either floating or fixed) results in low nominal interest rates as well as low inflation, analysts say have said. (Colombo/Aug07/2019)