IMF says ready to help Sri Lanka with capping Central Bank deficit financing
ECONOMYNEXT – The International Monetary Fund is ready to help cap central bank credit to government (deficit financing with printed money) as the monetary authority plans to keep price increases low with inflation targeting, an official said.
An IMF staff report said changes to Sri Lanka’s monetary law, in the run up to inflation targeting, will address issues identified in a safeguards assessment including the presence of a Treasury representative in the monetary board, and "inadequate limits of credit to government".
"I understand the central bank will be analysing this issue and if needed we are always ready to share our experience with other countries," IMF Mission chief Jaewoo Lee told reporters, when asked how a cap on central bank credit could be structured.
A central bank that targets an exchange rate peg generates, a balance of payments crisis and inflation much higher than the anchor currency when it prints money to finance and encourage budget deficits.
The first reforms were made in the mid-1990s by then Central Bank Governor A S Jayewardene, who was influenced by his teachers at London School of Economics and F A Hayek, according to an interview with economist W A Wijewardene, who also helped implement tight policies when he was Deputy Governor. Though the 1990s changes failed to end BOP crises it laid the framework for more market determined interest rates and brought more transparency to domestic operations and the central bank’s balance sheet.
After more than a 50 years of BOP crises, high inflation and IMF bailouts the central bank came under intense public pressure from around 2005 to reform as members of the public began to doubt oft-repeated false narratives that Sri Lanka’s inflation was due to high growth, cost-push factors, diesel, spiralling wages, or other convenient non-monetary scapegoat.
In 2003 and early 2004, Jayewardene had brought inflation to almost zero with prudent policy and the government operating a price formula even as the US Fed was firing a commodity and credit bubble with loose policy.
Harsha de Silva, economist at LirneAsia, a regional think tank, and now Deputy Minister of Economic Policy played a key role in explaining the monetary nature of inflation, to the public and calling for reforms and taking the central bank head on.
Steve Hanke, an economist from John Hopkins University through a concise explanation aimed at laymen showed that Sri Lanka’s high inflation came from the central bank’s targeting of two anchors (the exchange rate and price index through interest rates), simultaneously, where monetary and exchange rate policies are at cross purposes.
He also backed calls for the re-establishment of a currency board in Sri Lanka.
In Sri Lanka under its flawed monetary law, the central bank is obliged to provide deficit financing of up to 10 percent of estimated revenue at the beginning of the year through a so-called ‘provisional advance’, under 1950 law that created the agency.
The law effectively abolished a currency board that has made the country a regional financial centre and reportedly made it possible to have highest per capita income in Asia after Japan when it gained self-determination from British rule, in addition to being a net importer of labour.
The creation of the central bank removed a so-called ‘hard budget constraint’ that stopped rulers from borrowing to deficit spend and the destroying that debt through currency depreciation, leading to unprecedented fiscal profligacy.
Under a currency board, fiscal profligacy puts a country on a path of default as indirect default by currency depreciation is no longer possible, forcing probity on rulers.
With heavy commercial dollar borrowing by the Rajapaksa regime, a semi-hard budget constraint has come back to some extent, with possible default of commercial debt looming.
Rulers are now scrambling to avoid sovereign default claiming that there is a ‘debt trap’ with rating agencies breathing down their necks.
Sri Lanka is now going for a modified inflation targeting regime which it calls, flexible inflation targeting, involving the targeting of inflation, keeping a loose peg and at least in the run up to it, targeting a real effective exchange rate index as well, raising concerns among some analysts.
A further de-simplification is planned with forex auctions, raising fears of a continuation of a dual anchor monetary system. Analysts have also expressed fears that REER targeting may indicate the targeting of triple anchors, with a 1980s style deliberate depreciation-inflation cycle added on (Sri Lanka may be heading for a triple anchor ‘inflation targeting’ oxymoron: Bellwether).
Central Bank Independence
Sri Lanka’s monetary law being revamped and central bank credit limits are being discussed in the context of modified inflation targeting.
"It is important to ensure the autonomy and the autonomy and independence of the central bank and its decisions to follow monetary policy," Lee said.
"If the central bank is obligated to provide some amount out financing to the central government it ends up limiting the scope of autonomy in conducting monetary policy."
"The need to free the CB from this obligation is another necessary condition for an inflation targeting frame work."
"So it will be viewed from that objective. And at what level and what pace needs to be worked out."
However it is not clear whether the problem is fiscal dominance of monetary policy (lack of independence allowing the finance minister to put pressure) though the last Finance Minister did make public comments on interest rates and an earlier Treasury Secretary had reportedly stopped policy rate hikes through an unofficial veto, forcing the central bank to have two policy rates.
Mother of all liquidity injections
Sri Lanka’s central bank also intervenes in Treasury auctions directly, sometimes rejecting all bids, outside its transparent open market operations to engage in ‘quantity easing’ style exercises to precipitate balance of payments crises.
These moves were made without any apparent prompting from the Treasury. In both the 2011 and 2015 BOP crises, the central bank cut rates to speed up the credit momentum and fuel to the fire just as the domestic credit cycle turned and state borrowings also surged.
The Central Bank’s domestic operations department also injects unlimited volumes of liquidity to sterilize interventions once the credibility of the dollar peg had been sufficiently undermined with unsustainable credit for capital flight to begin and exporters to start holding back dollars, just like South American central banks.
In the 2015/2016 BOP crisis, the domestic operations department not only sterilized outflows, but kept the pressure on the credit system with high levels of overnight excess liquidity (sterilization of more than 100 percent), until March 2016, when liquidity was kept short with sterilization of 100 percent or below.
The domestic operations department released almost 360 billion rupees of liquidity tied up in term repos until about July 2016, and the then bought up around 270 billion rupees of Treasury bills.
At the height of the BOP crisis the twin operations represented around 630 billion rupees of liquidity injections in total over a period of less than 24 months helping lose over 4 billion US dollars in the forex reserves to capital flight and central bank credit driven imports in the process.
The 270 billion rupees of Treasury bills have now been sold down, mopping up liquidity from dollar purchases, and 1.7 billion US dollars of reserves have been collected after credit growth has slowed with higher interest rates.
EN’s economic columnist Bellwether has suggested that the central bank now start selling its own securities and future open market operations be limited to CB securities only, which will place a ceiling on the level of money that the domestic operations department can inject when credit starts to pick up.
However countries like Argentina which put a sterilization cap of 30 percent of forex reserves have failed to prevent BOP crises or a peso collapse, despite having floating interest rates.
Singapore has addressed the problem successfully by placing a floor of at least 100 percent forex reserves of reserve money and not having a rigid policy rate. (Colombo/Jan17/2018)