ECONOMYNEXT – The International Monetary Fund has warned Sri Lanka that foreign reserve collections have started to slow and renewed a warning on money printing, amid other warnings on liberal reverse repo injections.
“Reserve accumulation has slowed in recent months,” IMF senior mission chief Peter Breuer told reporters after the conclusion of a mission to the island.
“Against continued uncertainty, it also remains important to rebuild external buffers through strong reserves accumulation.
“Building on the Central Bank of Sri Lanka’s success in controlling inflation, refraining from monetary financing will help keep inflation in check.”
Sri Lanka started to print money (on a gross basis) injecting artificial rupee reserves into banks to tempt them to overtrade (buy Treasury bills or give private credit with central bank re-finance and not real deposits) from May 2023, critics say.
Some of the money went to purchase oversold Treasury bills from the central bank’s stocks, reducing the injections on a net basis, though altering rupee reserve balances of individual banks and primary dealers.
From June, a few weeks after reverse repo injections resumed, purchases of foreign exchange from commercial banks were slightly negative while the exchange rate volatility worsened and appreciation stopped, denting confidence.
The central bank later cut the reserve ratio also dumping more liquidity into the banking system, which were for the most part also mopped up through sales of central bank held security sales.
Analysts had warned that Sri Lanka’s central bank tends to cut rates in the second year of an International Monetary Fund program on the basis of a monetary policy consultation clause, and if the rate cuts are enforced with reverse repo injections, miss reserve targets and trigger a depreciation of the currency.
A waiver on the NIR performance criteria is then requested on the next review (Sri Lanka misses two June IMF targets: talks to continue).
In recent IMF programs, money can be freely printed to cut rates until inflation picks up again, and errors in mis-targeting rates are compensated by depreciation, which classical economists called loweringof the “value of the circulating medium”.
The falling currency and the rise in the price of energy and food prices then discredits reforms, and incumbent governments are ousted along with the IMF program.
The injections to cut rates are then blamed on the ‘budget deficit’ or ‘monetary financing’ of the deficit, because open market operations are done with securities bought back from banks, in a phenomenon classical economists called the ‘financing of merchants,’ not the government.
However due to the use of government securities for open market operations and not banker’s acceptances (accepted bills of exchange) as in classical days people are misled by interventionist inflationists that a financing of the state is taking place.
Analysts have also warned that domestic interest rates are driven by a foreign reserve target, which is essentially the financing of budget deficits of reserve currency countries, and cuts in the domestic deficit does not automatically permit interest rates to fall to very low levels quickly.
As a result the monetary policy consultation clause (inflation target) is at fundamental conflict with the fx reserve target, analysts have warned.
In this program, unlike in the failed last one, there is a ceiling on the domestic asset stock of the central bank, placing somewhat of a check on its issue department (domestic operations).
Analysts have urged the central bank to sell only a little more than maturing bills in its portfolio so as not to tempt banks and primary dealers to get addicted to standing facilities, overnight or term reverse repo injections which will trigger forex shortages, especially after private credit picks up.
Regardless of whether foreign reserves are useful or not (floating regime do not have foreign reserves and in hard pegs rates move up when a small amount of reserves are used) and may encourage reserves to be run down to artificially suppress rates in the future if there is a fixed policy rate, net reserves of Sri Lanka’s central bank are now negative, which requires reserves at least to be brought to zero, analysts say.
In a new Sri Lanka monetary law, money can also be printed to target real GDP (potential output), a practice which was not permitted under the earlier law but was done anyway to try and get a growth short cut, but instead blew the balance of payments apart and triggered output shocks.
The IMF in the first few decades of its operation did not support depreciation and was set up to avoid the currency collapses that took place in the 1930s after fixed policy rates spread and came into conflict with specie anchors, analysts say.
Western central banks started to run BOP deficits in the inter-war years but worsened especially in English-speaking countries in the 1960s where unusual monetary doctrines based on econometrics which defied laws of nature emerged, leading to the eventual collapse of the Bretton Woods soft-peg system and and Great Inflation of ‘independent’ central banks of the 1970s.
When monetary stability was maintained, BOP deficits were absent and note-isssue banks were accountable to both to a specie anchor (at zero) they were also checked by classical economists who had a clear understanding of operational frameworks and an intellectual clarity about banking and external trade.
“If …a bank were established, such as the Bank of England, with the power of issuing its notes for a circulating medium; after a large amount had been issued either by way of loan to merchants, or by advances to government, thereby adding considerably to the sum of the currency, the same effect would follow…,” explained David Ricardo in High Price of Bullion.
“The circulating medium would be lowered in value, and goods would experience a proportionate rise.
“The equilibrium between that and other nations would only be restored by the exportation of part of the coin (reserve losses in modern day parlance).”
If rupees were injected after defending the currency, to enforce a fixed policy rate or prevent a contraction in reserve money, more reserves would be lost.
It is not the defending of the currency that leads to continuous reserve losses but the injection of money after reserve sales to defend a fixed policy rate resist the contraction of reserve money, (sterilization of the sale) that blows the balance of payments apart.
Ricardo explained the problem as follows:
“…[I]f the Bank assuming, that because a given quantity of circulating medium had been necessary last year, therefore the same quantity must be necessary this, or for any other reason [to defend the average weighted call money rate for example], continued to re-issue the returned notes, the stimulus which a redundant currency first gave to the exportation of the coin would be again renewed with similar effects;
gold would be again demanded, the exchange would become unfavourable…”
The law of nature is sometimes expressed in more modern times as the ‘impossible trinity of monetary policy objectives’.
In order to collect reserves, a central bank has to run deflationary open market operations (collect rupee deposits from the domestic economy). (Colombo/Oct02/2023)