ECONOMYNEXT – While Sri Lanka’s monetary meltdown accelerated with historic low interest rates driven by money printing after the tax cuts of 2019, the storm gathered pace from 2015, when rapid foreign debt accumulation greater than the annual foreign financed deficits began.
That was due to monetary instability coming from a non-rule based monetary regime of ‘flexible exchange rate’ and ‘flexible inflation targeting’ with built in contradictions of epic proportions which created forex shortages and forced maturing debt to be repaid with more foreign borrowings.
Even in 2020, when authorities claimed that foreign debt had fallen, and foreign financing of the budget was negative, the net foreign debt had risen by over 600 million dollars when the fall in net international reserves are taken in account.
A country that has monetary stability (no forex shortages) and does not inflate the domestic reserve money supply above a consistent anchor can transfer wealth from the domestic economy to repay foreign loans through the credit system.
However a country which inflates reserve money, cannot transfer wealth to repay foreign debt through the credit system as it runs into ‘foreign exchange shortages’.
Any country which follows a similar set of cascading policy errors, ends up at the same place.
While Latin America nations with bad central banks are the most widely known after World War II, the original blunder, backed by the US policy confusion, was made in Germany after World War I, during the period of what is called the Weimar Republic.
This is the key reason the ‘Yahapalana’ administration failed to solve the foreign debt problem and worsened it in peacetime despite raising taxes to high levels, expanding the state under ‘revenue based fiscal consolidation’, bringing down the deficit and creating the much mis-understood ‘primary surplus’.
Why did foreign debt rocket, despite a ‘primary surplus’?
If fiscal problems were solved, why did foreign debt ratchet up so fast?
Why did foreign dollar denominated debt rocket in particular? Why did foreign investors flee from rupee debt?
While fiscal problems are usually there from time to time, foreign debt default in a pegged exchange rate regime is at its core a problem with monetary instability.
To know why it happens, there has to be a clear understanding of what inflationary and deflationary policy is in a pegged exchange rate regime.
As long as deflationary policy is run (central bank withdraws liquidity), it is very easy to repay foreign debt (or build massive foreign reserves), however if the opposite inflationary policy is run for several years in a row (the central bank injects liquidity), foreign debt default is almost certain as ad hoc ‘stop-go’ policies also slows growth.
The contradictory and unstable monetary regime, triggered rapid stop-go policies, confidence shocks, which led to subdued growth.
This was topped off by the Liability Management Law (borrowing abroad instead of transferring wealth from the domestic economy through savings) which is also an automatic and inevitable consequence of the mindset of any country with chronic monetary instability and is founded on Keynesian thinking.
If anyone tries to fix Sri Lanka’s economic problems without understanding this phenomenon, it will keep recurring, as it happens in Latin America despite repeated IMF programs.
The core mis-understanding behind these cascading policy errors that leads to foreign debt default is an economic fallacy spread by most Anglo-Saxon Keynesian universities (other than a few like LSE) that foreign debt cannot be repaid with domestic resources or a domestic transfer of wealth.
While people can understand that it can be done with real goods (give a building in return for debt or a port for that matter), it is almost impossible to imagine how it can be done through a credit system when paper money of different note-issue banks are involved in what is generally called ‘foreign exchange.
The Weimar ‘Dawes’ and ‘Young’ repayment plans
Before getting into Sri Lanka’s numbers to see how foreign debt suddenly ballooned, it is useful to understand how this thinking emerged and what happened in Weimar Germany in the 1920s.
As the Prussian/nationalist aggressor, post World War I Germany had to pay reparations to Allies who defeated them. But the economy descended into hyperinflation in 1923 as money was printed and Germany defaulted.
In 1924, a committee under Charles G Dawes and also Owen Young re-organized the Reichsbank which was correctly identified as the cause of the inflation. A new repayment plan was made.
To help Germany with the debt, the US arranged a Wall Street loan with JP Morgan, like the Liability Management Law, in the Keynesian/Mercantilist belief that money raised in domestic currency cannot be used to repay foreign loans and ‘dollars’ were needed.
There were however several problems with the Dawes plan, not least something similar to what happened to Mangala Samaraweera’s petroleum price formula, where money was parked in the banking system, awaiting dollars under a ‘transfer clause’.
When money earned from Samaraweera’s formula was parked in a state bank it was loaned to others to bring imports and buy dollars.
If not for the output gap targeting and REER targeting exercise, Samaraweera would have gone down in history as the Tun Daim Zainuddin of Sri Lanka who fixed the fiscal problem.
However he had no Bank Negara to provide monetary stability, instead money was printed for output gap targeting.
Dawes won a Nobel Peace Prize.
But, the country ran into trouble again like Sri Lanka’s IMF programs.
Britain’s John Maynard Keynes, who seemed to have a weak understanding of the link between trade deficits and credit, claimed that Germany must have a trade surplus (or current account surplus in modern parlance) to repay foreign debt.
This kind of obsession with the ‘current account deficit’ is also found in Sri Lanka.
Several classical economists in vain tried to explain to Keynes that it was inflationary policy (liquidity injections) that made it difficult to collect foreign exchange and as long as domestic money was raised (the ‘budgetary problem’ was solved) either through taxes or loans without printing money; it was possible to generate dollars (‘transfer’ problem) to make foreign payments.
Keynes did not get it. He insisted that there was a ‘transfer problem’. Mercantilists backed by Germany who did not want to pay reparations insisted that government ‘political’ repayments were somehow special and different from commercial payments.
Classical economists insisted it was not so, showing examples of other countries including France.
Because Keynes was influential, the Allies in general bought it. When the first one failed, a similar plan to the Dawes Plan was devised under Owen Young, in 1929.
“The Allies were from the very beginning of the negotiations handicapped by their adherence to the spurious monetary doctrines of present day etatist economics,” explained classical economist Ludwig von Mises later. “They were convinced that the payments represented a danger to the maintenance of monetary stability in Germany and that Germany could not pay unless its balance of trade was “favorable.”
“They were concerned by a spurious “transfer” problem. They were disposed to accept the German thesis that “political” payments have effects radically different from payments originating from commercial transactions.”
The Young Plan also had another JP Morgan syndicated loan like Sri Lanka’s ISBs.
Heavily US driven agencies like the IMF and World Bank or any institution which has staff from Cambridge, Harvard (where Alvin Hansen taught) or other Keynes-influenced university will easily believe all this.
Sri Lanka’s Liability Management Law which came alongside an International Monetary Fund program was a classic Young Plan with ‘JP Morgan’ style International Sovereign Bonds to raise dollars to repay maturing debt.
Even now many people write and say that reparations made Germany caused hyperinflation, based on Keynesian ideas. They have romantic notions about central banks or have no idea at all.
“The truth is that the maintenance of monetary stability and of a sound currency system has nothing whatever to do with the balance of payments or of trade,” Mises explained.
“There is only one thing that endangers monetary stability—inflation. If a country neither issues
additional quantities of paper money nor expands credit, it will not have any monetary troubles.
“An excess of exports is not a prerequisite for the payment of reparations. The causation, rather,
is the other way around.
“The fact that a nation makes such payments has the tendency to create such an excess of exports. There is no such thing as a “transfer” problem.
“If the German Government collects the amount needed for the payments (in Reichsmarks) by taxing its citizens, every German taxpayer must correspondingly reduce his consumption either of German or of imported products.
“In the second case the amount of foreign exchange which otherwise would have been used for the purchase of these imported goods becomes available.
“Thus collecting at home the amount of Reichsmarks required for the payment automatically provides the quantity of foreign exchange needed for the transfer.”
Petroleum Weimar ‘Young Plan’
This is the reason why economists and analysts want fuel to be market priced. Then the enhanced payments to the CPC by its customers, would reduce non-oil consumption and savings and therefore non-oil imports and credit.
This offsetting series of events would generate the dollars required to pay the import bills.
But if the central bank printed money (ran inflationary policy), there would be a forex shortage regardless of whatever the CPC did with fuel pricing because the entire credit system rus with central bank money.
When the central bank printed money in 2018, CPC was made to borrow, like the JP Morgan loan to Weimar Republic. In the end CPC ended up with massive losses when the currency fell.
That is one of the cascading policy errors in Sri Lanka.
However in 2017 and 2019, when the central bank was selling down its Treasury bill stocks (when the central bank was running deflationary policy), there was plenty of dollars not only to pay the current bills but reduce CPCs past borrowings as well.
The experience with Germany shows that the Keynes made a bigger impression on Americans than Europeans since those who opposed him included French, Swedish as well as Austrians like Mises.
Shortly after, during the Depression created by the Fed, Alvin Hansen and others adopted Keynesianism wholesale.
Someone brought up in Keynesian thinking cannot understand how fixed exchange central banks which run deflationary policy in East Asia (or Bangladesh) collect vast reserves (Asian Savings Glut) giving loans to foreign governments, while Latin America with higher per capita income and revenue to GDP ratios default.
GCC pegs which run deflationary policy also collect vast foreign reserves (Petro dollars).
In short foreign borrowing need not be repaid with more foreign debt, if there is monetary stability.
In fact in all recens years with monetary stability, the net growth in foreign debt in Sri Lanka, is lower than the foreign financed debt component of the budget deficit.
In all years with inflationary policy, debt after foreign reserves went up faster than the dollar financed debt.
Sri Lanka’s death spiral started in late 2014, when liquidity was injected (inflationary policy) to keep rates down.
It accelerated after the 100 day program of fiscal profligacy, which did not lead to a rate hike as credit expanded but rates were instead cut because ‘inflation was low’, despite having a peg.
It is however not possible to run an inflation targeting framework with a peg. So the currency collapsed under ‘flexible exchange rate’ in 2015 and 2016 with excess liquidity being injected.
In 2017, there was stabilization or a deflationary policy. In 2018 money printing began again to target the call money rate and an output gap with discretionary flexible inflation targeting. The flexible exchange rate collapsed again.
Current State Minister for Capital Markets Nivard Cabraal goes around saying that when the Mahinda Rajapaksa administration left in 2015 International Sovereign Bonds were 5.0 billion dollars and when they came back in 2019 it was 15.0 billion.
Most people dismiss this as politicking. However, that is not so.
This was a classic Young Plan in action. The death spiral happened in several ways.
REER Targeting, Flexible Exchange Rate, Capital Flight
In the case of market debt, the REER targeting (destroying the rupee to destroy real wages of the working class in monetary protectionism and give freebies to the exporters at the expense of social upheaval), led to flight of capital from rupee debt markets.
Remember depreciation leads to the expropriation of foreign capital unless they are dollarized. As a result any investor will try to protect themselves against monetary expropriation.
“The Keynesian school passionately advocates instability of foreign exchange rates,” explained Mises as Keynesian depreciation became popular among some countries during the interwar years.
“The days are gone in which most persons in authority considered stability of foreign exchange rates to be an advantage.
“Devaluation of a country’s currency has now become a regular means of restricting imports and expropriating foreign capital. It is one of the methods of economic nationalism. Few people now wish stable foreign exchange rates for their own countries.
“Their own country, as they see it, is fighting the trade barriers of other nations and the progressive devaluation of other nations’ currency systems. Why should they venture to demolish their own trade walls?”
Foreign capital however will not stay and be expropriated by the REER-targeting and inconsistent ‘flexible’ exchange rate.
Therefore they fled. They had to be replaced by dollar denominated debt, which gave protection against any REER targeting expropriation.
In 2013 when the rupee was at 131 to the US dollar 3.6 billion dollars equivalent was in rupee securities. At the time the total market debt including ISBs and foreign held SLDBs was 7.1 billion US dollars.
By 2019, two currency crises later the rupee debt was down to 573 million dollars and the total market debt was 15.6 billion US dollars.
The people of the country however faced this debilitating expropriation. The debilitating depreciation will make it that much more difficult to generate resources to repay debt.
Rapid depreciation, the monetary expropriation of domestic savings will make it even more difficult to generate real resources to repay debt.
The rise steep increase in dollar denominated, International Sovereign bonds, the rapid flight of rupee debt after ‘flexible exchange rate’ and REER targeting can be seen in the table.
In 2020 debt holders also began to flee after downgrades following the December 2019 tax cut and the March ‘flexible exchange rate episode when the rupee fell to 200 to the US dollar.
Total foreign owned commercial debt went up from 8.4 billion US dollars in 2014 to 14.1 billion dollars in 2020 after rising to 15.6 billion US dollars in 2019. In 2019 however foreign reserves also grew.
But this is just one side of the problem.
The ALM Young Plan Fallacy
While the current administration cut value added taxes in a crazy policy move, delivering the coup de grace to state finances the Yahapalana administration had also severely undermined state finances with the 100 day program.
Then under ‘revenue based fiscal consolidation’ of the IMF cost cutting was pooh poohed, and state spending ratcheted up to around 20 percent of GDP from 17 percent in 2014, increasing the burden of the state on productive sectors.
GDP itself was revised up.
Revising GDP up may have made deficits appear smaller, but in actual fact they got bigger. The worst deficits were in 2015 and 2016, under Finance Minister Ravi Karunanayake.
Mangala Samaraweera fixed them but was betrayed by REER targeting and output gap targeting in 2018 despite the deficit being brought down.
This is where the death spiral from monetary instability comes in.
In Sri Lanka, about half the budget deficit – give or take – is foreign financed.
From 2014 to 2019 the dollar financing ranged from about a billion to three billion dollars each year as the following table shows.
Under revenue based fiscal consolidation, as the state was expanded with higher salary payments, budgets expanded, and so did foreign financing of the budget. The interest bill was also financed abroad in years with monetary instability.
This is the basic dollar financed deficit.
Based on ALM thinking one would imagine that foreign debt grows by the foreign financed deficit.
But that is not so.
In 2014 the foreign financing of the budget deficit was 1.6 billion US dollars but the total foreign debt went up by only 1.1 billion US dollars.
In 2015, money was printed and the foreign financing of the budget was 1.74 billion US dollars. Foreign debt however grew by only 845 million dollars.
Total foreign debt grew at a slower pace because a part of the foreign debt was repaid in that year with a run-down of foreign reserves.
Therefore to find out the actual increase in net debt, foreign reserves have to be deducted from the gross debt.
But gross reserves also have central bank borrowings such as swaps or IMF loans. So did the Treasury through the ALM law much later.
Therefore to get the actual net increase in debt, gross debt has to be adjusted by net international reserves rather than gross international reserves.
When adjusted for the fall in reserves, net foreign debt grew by a massive 2.3 billion US dollars in 2015, not 845.9 million.
After the adjustment it can be seen that net foreign debt grew by only 105 million US dollars in 2013 when net international reserves were deducted from gross debt, though the foreign financed deficit was 958 million US dollars.
In 2014, a year with monetary stability until the third quarter the dollar deficit was 1.6 billion, but after NIR debt fell by 256 million dollars on a net basis. In 2015, a money printing year the dollar deficit was 1.7 billion but the debt after NIR grew by 2.3 billion US dollars.
In 2016 which was partly a money printing year, the dollar deficit was 2.6 billion US dollars and debt after NIR went up 2.9 billion US dollars.
In 2017 the deficit was 2.8 billion but debt went up only 1.8 billion. In 2018 the deficit was brought down by Minister Samaraweera to 1.9 billion but output gap targeting money printing pushed up debt by 2.7 billion dollars.
In 2019 the dollar deficit ratcheted up to 3.0 billion dollars as the deficit expanded after the output targeting gap policy corrections slowed the economy. However total debt grew by only 1.2 billion due the accumulation of reserves by the selling down of Treasury bills (reversing money printing).
In the period central government debt went up from 23.7 billion US dollars to 34.1 billion US dollars. After deducting NIR, net debt went up to 28.3 billion US dollars from 17.2 billion in 2014.
In 2020, the central bank said a lot of foreign debt has been paid. In fact foreign financing of the deficit was 448 million dollars negative or a net pay back.
However it was achieved with a massive run down of reserves due to the money printing.
Debt after net reserves actually went up by 603 million dollars to 28.9 billion dollars from 28.3 billion US dollars.
Overall debt with SOEs, banks and the private sector seems to have come down with more dollar deposits being raised domestically for banks to use.
The simplest way to understand the foreign reserves and foreign repayments and the fallacy of the Transfer Problem and ALM Law is to think about Sri Lanka’s history.
Sri Lanka has been taking World Bank, Asian Development Bank and Japanese loans for decades.
However not all these loans (and interest) were paid back with fresh dollar loans, like the ALM law.
The growth in dollar debt was not linear and in step with the part of the deficit that was financed with foreign debt.
It was less, due to squeezing the current account to repay debt.
When there is monetary instability the opposite happens. This is the Keynesian ‘transfer problem’ in action.
This is why the Weimar Republic collapsed and could not pay any debt.
On the other hand the Austrian economics/Ordoliberal driven Federal Republic which was bombed to the core and was three quarters of the country with East Germany separate country, not only paid WWII reparations, but also paid for US occupation.
Ultimately the Federal Republic repaid all WWI reparations that the Weimar Republic could not.
It can also be understood in the opposite way.
This is the reason why East Asian nations with monetary stability (now Bangladesh central bank also) acquire billions in forex reserves (negative debt) while other oil producing countries like Iran or Nigeria meltdown.
The East Asian ‘savings glut’ and the GCC area ‘fixed’ exchange rate ‘petro dollar’ forex reserves shows that there is no ‘transfer problem’.
The same with Nordic sovereign wealth funds, Singapore GIC, and also MAS itself. When there is no currency depreciation or a flexible exchange rate (inflationary destruction of domestic wealth), it is very easy to repay loans, and also invest abroad.
The situation with Sri Lanka’s central bank is grave.
The 800 million dollar IMF SDR allocation will briefly improve the situation. But SDRs are also debt or a swap. As soon as SDR holdings are sold for dollars, interest will have to be paid on the allocation. The net reserves also contain items like swaps, partly because that was a trick used to shore up reserves but it is also a borrowing.
Net foreign assets on the other hand show the correct situation. It does not count SDRs or swaps.
Even as this is published, the central bank must be making quasi fiscal losses and may eventually require recapitalization.
Without net reserves, if the central bank intervenes it will eat into reserve assets and could become even more insolvent.
If bond auctions fail and liquidity injections continue to be made, the central bank can also default on the IMF loan and the swaps.
The first order of priority is to get bond auctions working. Then the CB’s Treasury bill stock has to be sold down. This is not about policy rates.
Before any policy rate hike, bond auctions and the sell-downs should begin. If necessary, policy rates can be raised later.
A tax hike will keep the rates lower than they need be. So will a debt restructuring and a debt sustainability sign off from the IMF which will unlock World Bank and ADB budgetary finance. It may be barely possible to do without an IMF program, but the corrective rate would be higher.
More Young plans one might say, but if monetary stability is maintained for over two years growth will take off without stimulus like East Asia and Germany. Privatization would help enormously to grow and also manage debt.
On the other hand, if interventions are made and bond auctions are not allowed to happen, the central bank itself can default on the IMF loan and it can default on the swaps.
When central banks lose the ability to intervene it can float. But usually soft-peggers do not know how to float and will intervene at crucial points. This will make the currency fall faster.
Eventually it could lead to market dollarization as people lose confidence in the currency.
Already there is significant deposit dollarization, with dollar accounts. The black market rates also show that people are chasing after US dollars.
But de facto dollarization happens when people start selling and pricing in US dollars and imagining their lives in dollars. The reason dollarization did not happen earlier is because there are legal tender laws prohibiting the domestic use of foreign currency and people had some confidence in the rupee.
If these laws are removed allowing any currency to be used, Sri Lanka’s economic and monetary instability will end.
In 2018 there was a chance for official dollarization by converting forex reserves and exchanging the note issue to rupee notes.
But parallel dollarization can still be done to cushion people and companies from any default shock. Several high performing stable economies have such arrangements.