IMF urges Sri Lanka to lift cap on foreign bond investors, ease exporter controls

ECONOMYNEXT – The International Monetary Fund has urged Sri Lanka to lift a cap on foreign investment in rupee bonds, and remove exchange controls on exporters slapped to maintain an unstable soft-pegged exchange rate regime.

Sri Lanka slashed the limit on foreign investor rupee denominated bond holdings to 5 percent of total outstanding from 10 percent, after generating several balance of payments crises, while operating a non-credible peg with the US dollar.

"In the absence of a capital inflow surge, staff advised to loosen the measure back and take advantage of portfolio inflows to build reserves and deepen the domestic bond market, in line with the Fund’s Institutional View on capital flows," an IMF staff report said.

"The authorities expressed concerns about capital flow volatility and agreed to review the foreign investment threshold as reserves reach more comfortable levels."

In 2018, Sri Lanka cut rates and generated a ‘super abundance of paper money’ from March 2018, just as the US tightened and domestic credit also picked up, putting foreign bond holders to flight.

Sri Lanka operates a peg with the US dollar with multiple convertibility undertakings to build forex reserves under an IMF backed programs but does not have complementary monetary policy to keep the peg on the strong side of the CUs.

Contradictory Policy

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The IMF current program is also flawed in not have falling ceilings on net domestic assets which would have helped keep the peg on the strong side of the convertibility undertakings and helped stop liquidity injections, analysts have said.

Instead the central bank prints money to cut rates when inflation falls (in a de facto inflation targeting attempt), just as domestic credit picks up from the end of an earlier balance of payments crisis, triggering capital flight, and cascading credit across the banking system.

The central bank then intervenes in forex markets selling dollars, and prints large volumes of money to keep rates down or maintain reserve money (sterilize outflows), triggering more balance of payments pressure.

In order to keep printing money and avoid raising rates (or floating the currency) the central bank then slaps restriction on exporters or importers.

In 2018, Sri Lanka started printing money from around March, cut rates and printed money in April generating excess liquidity, a phenomenon labelled ‘super abundance of paper money’ by classical economists, just as the US tightened and domestic credit also picked up, putting foreign bond holders to flight.

A second liquidity shock was generated from around August.

The IMF had said the controls amounted to a type of exchange controls that are discouraged by the agency, which are called Capital Flow Measures.

"We will assess removing existing capital flow management measures (CFMs)," Sri Lanka’s pledged in policy agreed with the IMF.

"In 2016, we introduced a repatriation requirement of export proceeds with the aim of encouraging exporters to keep FX (foreign exchange) within the domestic financial system and reduce the imbalance of the FX market in the face of substantial balance of payment pressures.

"In January 2019, we lowered the threshold for foreign investments in rupee-denominated government securities to 5 percent of the total outstanding stock, from 10 percent before, to reduce capital flow volatility.

"We understand that these measures constitute CFMs under the IMF’s Institutional View on capital flows.

Exporter Controls

Sri Lanka also slapped controls on exporter remittance after an earlier episode of printing money.

"We plan to loosen the repatriation requirement by extending the period to repatriate the export proceeds from 120 to 180 days, with funds in the business foreign currency accounts maintained by exporters of goods freely remittable, and we will assess removing it with the timing linked to progress with the macroeconomic adjustments."

In 2018 the rupee collapsed from 153 to 182, overshooting an exchange rate target or convertibility based on a real effective exchange rate index.

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Sri Lanka’s capital account and balance of payments troubles primarily stem from a soft pegged exchange rate regime, where the central bank prints money to push rates down artificially and targets the exchange rate at the same time, which is impossible without exchange and trade controls.

Economists call it the ‘impossible trinity of monetary policy objectives’.

After defending the peg, the central bank prints more money, triggering cascading and unsustainable credit across the banking system.

Unstable Peg

There have been calls to reform the peg, which have been resisted. Under proposed new law where the central bank will again try to target inflation with a peg, direct purchases of Treasury bills by the central bank will be outlawed.

There was no pressure from the finance ministry to print money in 2018, otherwise known as ‘fiscal dominance’ of monetary policy. Instead the central bank pushed the Treasury to imposed trade controls on gold and cars to be able to operate a soft-peg in monetary dominance of fiscal policy.

The soft-peg drives Sri Lanka to IMF bailouts frequently and has been the key economic challenge to people’s well-being and stability since it was created in 1950. Before 1950 Sri Lanka had a currency board, with floating interest rates.

The Britain Woods and the European Exchange Rate Mechanism, which were also soft-pegs, have similarly collapsed.

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In 1971 when the Bretton Woods collapsed, Sri Lanka effectively closed the entire economy.

Thought a liquidity shock was generated from around August 2018, after October 23 political instability was triggered by President Maithripala Sirisena and ex-President Mahinda Rajapaksa who appeared to be violating the constitution leading to a further erosion of international confidence in the peg.

When Sri Lanka’s unstable peg comes under pressure, analysts have advocated that excess liquidity be quickly mopped up and the rupee floated, as prolonged liquidity shorts lead to output shocks.

However the central bank was in a difficult position after October 23 and the outcome of a clean float would have been uncertain, analysts say, since there does not seem to reliable evidence elsewhere of a floating exchange rate operating in a country without a constitution. (Colombo/May21/2019).