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IMF warns Sri Lanka on slowing reserve collections, money printing

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.

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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.

READ MORE Sri Lanka interest rates are dictated by the IMF reserve target, not inflation

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)

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Sri Lanka beats key IMF program targets for March 2024 amid rupee stability

ECONOMYNEXT – Sri Lanka has exceeded key quantitative targets set in an International Monetary Fund program for March 2024, based on preliminary data the Washington based agency said in a report.

The March data are not performance criteria on which reviews are conducted but are indicative targets which shows the progress of the program and are a stepping stone for a September review based on June data.

An indicative target for the primary balance (roughly overall deficit minus interest costs), was assessed at 316 billion rupees more than four times the 70 billion rupee target set in the program.

Primary balance can be a big surplus if the interest bill is high and capital expenditure is cut and is a type of crisis management tool after a central bank triggers a currency crisis by cutting rates with inflationary liquidity tools.

However, Sri Lanka’s Treasury has also kept a lid on most current spending. A state salary hike is however due after the currency collapse made life difficult for everyone.

Meanwhile more taxes have been collected from the people to finance the island’s bloated state.

A 750 billion rupees central government tax revenue floor has been exceeded to reach 837 billion rupees.

Central bank credit to government (outstanding stock) has been reduced to 2,691 billion rupees in March compared to a target of 2,800 billion rupees. In December the CB credit was calculated 2,742 billion rupees.

Net international reserves of the central bank were brought up to a negative 1,268 million US dollars exceeding the target of a negative 2,035 by almost 700 million dollars.

In order to collect foreign reserves, which is a type of appropriation of domestic savings of the people by the central bank (taking in deposits) and exporting it to the US and other countries to finance their deficits or by other agency debt in reserve currencies.

In order to collect such ‘deposits’ the central bank has to prevent them from being invested domestically.

It is achieved with deflationary policy through sell-downs of down its Treasuries holding to domestic banks or others, at a market rate, collecting interest from the government or repayments of re-finance credits, subject to any nominal changes in reserve money at a given exchange rate.

In 2024 the central bank allowed the exchange rate to appreciate, which can also reduce prices of traded goods boost real and nominal savings and make it easier to collect foreign reserves.

When domestic credit is weak it is easier to collect reserves. Reduced domestic credit and collection of reserves, including by private banks which then cannot be invested domestically, can push the external current account into surplus.

The central bank also met a 5 percent 12-month inflation target, with an achievement of 4.3 percent.

Sri Lanka’s economy grew 5.3 percent despite reserve collections, amid the stability provided by the central bank.

There were no central bank purchases of Treasuries from the primary market.

However the central bank injected overnight and term money to banks (not on a net basis) showing how easy it is for a rate-obsessed monetary authority to get around the requirement and create external instability again as soon as private credit recovered.

The central bank also allowed excess liquidity from dollar purchase to remain unsterilized for an extended period under its ad hoc pegging arrangement, getting a short term falls in rates, but triggering pressure on the rupee as a result in May and June.

It is not possible to collect reserves with a free floating exchange rate. (Colombo/June15/2024)

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Sri Lanka GDP grows 5.3-pct in first quarter of 2024 amid monetary stability

ECONOMYNEXT – Sri Lanka’s gross domestic product grew 5.3 percent in the first quarter of 2024 data from the state statistics office showed as the central bank continued to refrain from generating monetary instability.

Instead of printing money to cut rates under ‘flexible inflation targeting’ and printing money to boost growth by taking into account ‘potential output’ as permitted by its new monetary law, the central bank ran deflationary policy and also allowed the rupee to appreciate.

“The Sri Lanka economy experienced a more favorable economic condition[s] in the first quarter 2024, when compared to the first quarter in the year 2023,” the Department of Census and Statistics said.

“The high inflation had prevailed in the first quarter of year 2023, gradually reduced to a lower level by the first quarter of 2024 and this low inflation incentivized the economy by providing inputs at [a] much lower price.

The agriculture sector grew 1.1 percent in the first quarter of 2024, after also growing 1.6 percent last year.

Industry grew 11.8 percent in the first quarter, against a 24.3 percent last year.

The economy grew amid falling prices, the statistics office said in sharp contrast to the Anglophone macroeconomic claim that inflation is needed to boost growth, on which Sri Lanka has 5-7 inflation target has apparently been set.

Related Sri Lanka central bank pushing for high inflation target to boost growth

“Among ‘Industrial activities’, coinciding with the decline in input prices, the ‘Construction industry’ grew by 14.2 percent, parallel to this, the ‘Mining and quarrying’ industry too expanded by 18.3 percent during this quarter,” the Statistics Department said.

Sr Lanka’s services sector grew 2.6 percent, against a decline of 4.6 percent recorded last year.

The International Monetary Fund has also urged the central bank to give priority to stability.

Sri Lanka dropped the stability mandate in the earlier monetary law which was violated after the end of a civil war to push the country into serial currency crises especially after the International Monetary Fund gave technical assistance to calculate potential output.

Related Sri Lanka has a corrupted inflation targeting, output gap targeting not in line with monetary law: Wijewardena

Sri Lanka survived a 30-year civil war by giving priority to a stability mandate despite shortcomings in its operational framework but defaulted in peacetime amid activist monetary policy which denied monetary stability to the people. (Colombo/June12/2024)

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Sri Lanka’s NPP notes five-point crisis for economic growth sans details

Former JVP MP Sunil Handunneththi

ECONOMYNEXT — The leftist National People’s Power (NPP) has identified five crises that need resolving for Sri Lanka’s economy to progress, much of which emphasise a production economy targeting export growth though sparse on the detail on resource allocation.

NPP spokesman and former parliamentarian Sunil Handunneththi speaking at an event in Mulaitivu on Thursday June 13 said Sri Lanka is grappling with firstly, a collapse of the production economy, second, a budget deficit, third, a balance of payment crisis which has, fourthly, created a debt crisis, and finally, a resultant gap between haves and have-nots.

“We must first understand the crisis. We reocgnise five main crises that have the same impact irrespective of differences between the north and south.

“The first is the collapse of the production economy. We can see this historically. Agriculture that used to be some 30 percent of gross domestic product (GDP) has now fallen to 8 percent. Essential food is imported. We cannot produce the rice needed for the small population here. Things that can be made here are also imported.

“Second is the income crisis. For the people, their expenses are twice their income. The budget deficit is two or three-fold every day. Banks cannot give loans to businesses and industries because the government takes funds to address the budget deficit. The government takes most of the people’s savings for this,” he said.

The balance of payment crisis Sri Lanka is facing the third crisis, according to Handunneththi, which has triggered a debt crisis, in turn leading to a crisis of income disparity among the people.

“Third is the balance of payments crisis. Imports are two or three fold export income. The government has to take 11 to 12 billion US dollars in loans from foreign countries. When GDP is 80 billion US dollars, debt has gone over 100.”

“All this creates a massive gap between haves and have-nots. Without finding solutions to these crisis, there is no point distributing goods,” he said.

Handunnethi’s remarks appear to be departure from the NPP’s anti-corruption rhetoric which had centred its economic development policy agenda primarily on fighting corruption.

‘Fighting corruption’ and ‘recovering stolen assets’ have been popular slogans since the Aragalaya protests in Sri Lanka and the NPP has made it its central theme in its bid for power. The leftist outfit had also adopted a position that’s cautiously critical of the International Monetary Fund (IMF) and the reforms the international lender has prescribed for Sri Lanka in exchange for a 2.9 billion-dollar bailout.

However, NPP leadership had recently acknowledged the need to continue the IMF programme since the agreement has already been signed.

The Marxist-Leninist Janatha Vimukthi Peramuna, which controls the NPP, though it was never in government barring a brief stint in an Sri Lanka Freedom Party (SLFP)-led coalition in the early 2000s, has been instrumental in driving popular support against privatisation.

Three key policy pillars articulated by the JVP from 2001-2004 and embraced by mainstream politician Mahinda Rajapaksa’s administration in 2005 onward have been highlighted by experts.

From 2005, Sri Lanka halted privatisation, started recruiting tens of thousands of unemployed graduates into the public service every year with lifetime pensions, expanding an already bloated public sector and denying any benefit of a peace dividend to the country.

Sri Lanka also abandoned a price formula for fuel that had helped keep the rupee stable and inflation low from 2001 to 2003 even as global commodity prices went up from the ‘mother of all liquidity bubbles’ fired by the Federal Reserve from 2001.

From 2001 to 2003, state workers fell from 1.164 million to 1.043 million. By 2020, the public sector cadre has grown to 1.58 million with another batch of 53,000 unemployed graduates being paid tax money. (Colombo/Jun14/2024)

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