Inside an IMF deal; Sri Lanka needs monetary reform not just fiscal plaster: Bellwether
ECONOMYNEXT – With interest rates already higher which will go some way to correct monetary excesses of central bank and taxes to be raised, which will partly correct fiscal excesses, a deal with the International Monetary Fund is expected to bring stability back to Sri Lanka.
There are some expectations that Sri Lanka will go for an Extended Fund Facility or EEF, rather than a quick fix Stand-By Arrangement (SBA) as in 2009.
Most of the dire forecasts made by this column (in the hope that corrective action will be taken) including forex reserve falls, capital flight, credit and outlook downgrades, trade restrictions on vehicles have now unhappily already occurred.
The repeated policy errors which are easily predicted by columns such as these go to show that there needs to be underlying monetary reform rather than just fiscal corrections.
IMF programs here have essentially worked to correct fiscal errors and tighten monetary policy. Already bank interest rates are correcting.
These are long overdue. Had interest rates been allowed to go up according to market demand, the crisis would not have occurred.
This column warned last year that rates will have to go unnecessarily high, to correct the imbalance from the budget if rates are not allowed to up gradually as soon there was a market demand – that is when excess liquidity started to go down.
The Starting Point
An IMF program works this way. The presumption is that a runaway budget is putting pressure on the credit system which is triggering the balance of payments crisis.
This is only partly correct. A more correct assessment is to say that a BOP crisis is caused by monetary accommodation of a fiscal deficit or printing money to part-finance a deficit, or printing money to sterilize forex sales or both.
A central bank that does not accommodate a deficit and allows interest rates to go up with credit demand may slow growth, but not generate an economic crisis.
The IMF is expected to loan about a billion US dollars. This is irrelevant except as a confidence builder, since the money will be used to bridge the US budget deficit mostly through dollar Treasury purchases when foreign reserves are managed.
But with India expected to pull out 700 million dollars with the IMF program more may be needed re-build confidence. This column said earlier that India simply allowed bad policy to continue by giving swaps to the central bank. The Reserve Bank of India has now given an ultimatum and pushed Sri Lanka closer to the bosom of the IMF.
The IMF Program Core
The IMF program will try to limit the negative fallout on the budget through quarterly limits on domestic borrowings (ceilings on net domestic finance or NDF), called quantitative performance criteria which will create credit space to rebuild foreign reserves and stabilize the currency.
There will also be ceiling on reserve money (reserve money is the money created by central bank through purchases of dollars – which increases foreign reserves – or Treasury bills – which puts pressure on the currency).
There will be a targets on foreign reserves (Net International Reserve or NIR floor) which will increase foreign reserves. With a limit on reserve money, hopefully the central bank will be forced to sell down its Treasury bill stock.
In the opinion of this columnist a limits need to be put on the Treasury bill stock (progressively lowered NDA or Net Domestic Asset ceilings) to stop runaway monetizing by the central bank, with some leeway in June and December to ‘sell’ foreign reserves to the Treasury to repay debt.
The last SBA lacked explicit NDA targets, which allowed the central bank more leeway to monetize debt (print money to sterilize foreign exchange sales) in 2011 even before the program was ended and precipitate a second BOP crisis.
There may be other performance criteria, such as tax reforms.
This column would suggest that a performance criteria is needed to market price oil. If it is not started now, it should at least kick in, (if and when) crude prices go up over 15 dollars a barrel from today’s prices.
An IMF program will also contain prior action, either in written down form or not. The current tax reforms look like classic prior actions.
They will have to be legislated soon.
There will also have to be a float of the currency.
In September 2015 there was an attempt to float the currency. It failed because no effort was made to raise interest rates and reign in credit before the float.
So the so-called ‘float’ ended up as a devaluation and currency defence and reserve losses continued. A key reason was the continued printing of money to keep excess liquidity at high levels, which was loaned out and became imports.
But now liquidity levels are going down faster, partly because of exiting foreign investors. They took one hit on the float, but that failed and they are now trying to avoid further losses.
But the credit pressure is probably higher now. Because the central bank allowed banks to approve many more loans without raising rates. Those loans would now be drawn down.
An interesting bit of data that researchers who study balance of payments crises, should try to get is the total volume of approved but undisbursed loans. We can call this the credit momentum.
If interest rate corrections had occurred earlier, this problem would be less acute.
The way banks are scrambling to raise rates shows that there may be large volumes of approved but undisbursed loans.
Also some banks are borrowing through the overnight reverse repurchase window despite overall market liquidity being high due to money printing. That is also a sign.
Under these conditions a classic vicious cycle of sterilized foreign exchange sales take place.
Interventions are made in the forex market, then liquidity shortages are generated.
These are filled by Treasury bill purchases of the central bank (liquidity is usually injected to some other bank not necessarily the one that is short) which will lend it out creating more imports, which then require more intervention and so on.
A float will eliminate both problems and end the contradiction between monetary and exchange rate policy. (Detailed explanation of this policy error can read be in this column written in September 2014 which warned that Sri Lanka will lose reserves unless excess liquidity was sterilized permanently and interest rates allowed to go up).
The revised budget
The revised budget after proposed tax changes will look something like this or better after negotiations with the IMF.
Total revenue will be about 1680 billion rupees or 13.5 percent of gross domestic product, shorn of the imputed non-revenues like rent income, which were against basic principles of public finance. The November budget projected as much as 2,032 billion rupees in revenues or 16.3 percent of GDP.
Some members of the Institute of Chartered Accountants are trying to push for accrual accounting in budgeting.
This has to be resisted at all costs, because then accounts will be even more easily manipulated like audited accounts of public companies. The budget has to finally show real domestic borrowings – which is a cash flow number.
Non-tax revenues will hopefully contain some privatization revenues.
Current spending will be 1,737 billion rupees, which also about 190 billion rupees less, shorn of imputed rent expenditure, and some other spending, which if it is possible to do so, will be good.
That will leave the budget with a revenue deficit of about 50 billion rupees, compared to the unbelievable 104 billion rupee surplus projected in the budget in November. Still even this looks a bit ambitious.
Capital expenditure will be 639 billion rupees – a little ambitious considering the lack of capital projects and hopefully some room to cut the deficit. The overall deficit would be 679 billion rupees, with 378 billion rupees as domestic borrowing.
Over 300 billion will come from foreign financing. This remains a bit of a problem as Sri Lanka’s credit has been downgraded and rates are rising.
However there will be budget financing from Asian Development Bank, World Bank, Japan and also Korea if officials are to be believed. When capital gains and other taxes are legislated some money will come, since the revenue base would now be sounder to repay loans in the future.
Central Bank reforms
Even through the budget is the trigger to Sri Lanka’s problems, what allows the ruling elite to engage in such irresponsible spending is the central bank.
If the central bank was not able to print money, this budget would have been corrected soon after the elections. In fact the 2015 revised budget would not have taken place with the disastrous salary hike if not the central bank.
That is because somewhere in the early 1970s or at least in the 1980s Sri Lanka would have suffered sovereign default if not for the hidden sovereign default of currency depreciation made possible by the central bank.
It can clearly ben seen in 2015 how irresponsible the central bank was. It was even worse than during the Rajapaksa regime.
Look at how easy it was to predict what the central bank would do.
This is an update of a graph this column produced from the beginning of the crisis.
See also how the excess liquidity disappeared (brown in the BOP Cycle graphic on top) as credit picked up (see Credit Nutshell graph) and then eventually Treasury bills were bought to print money and inject new liquidity.
The rupee also fell. In September the float failed as credit was strong and rates were not raised before the float.
When the next float comes it may succeed since rates are higher now and banks are raising deposits.
The second float can be made to work at less than 10 rupees. Even if the rupee falls further than 155 or 160, it can be brought back if no interventions are made, no liquidity is injected and no dollars coming to the government are surrendered to the central bank.
But even during that second float the central bank may continue to intervene and bust the rupee even more through sterilized forex sales. This is what happened in 2011, due to so-called interventions to pay oil bills.
The float succeeded only around June, 2012 with power prices also raised.
As this column said before there is no ‘fundamental level’ for the currency. It is monetary policy that determines the price of the currency. IMF research showed that the rupee was not ‘overvalued’. Despite that, the rupee fell and remains under pressure.
Sri Lanka’s balance of payments and fiscal troubles started in 1951 with the creation of the central bank and ironically the IMF.
The architects of the IMF, people like Harry Dexter White, who was a Soviet spy, cynically created the IMF knowing this kind of thing was likely to happen.
If we have a harmless central bank that cannot impoverish us and make us a ‘third world’ country with bad policy and massive money printing and depreciation, which in turn creates the base for bad budgets.
Attempts to bring ‘inflation targeting’ to this country is doomed to failure. Inflation targeting is incompatible with basterdized pegging or ‘intervening to smooth out volatility in exchange rates’ as it is called here.
The wildly fluctuating domestic asset portfolio of the central bank (see domestic assets graph) shows that Sri Lanka is unstably pegged (soft-pegged) true and proper.
For many months the central bank kept rates low pointing to an inflation index while the balance of payments was going haywire. Inflation was falling due to low commodity prices.
Low commodity prices comes from a strong US dollar. To keep stability, rates have to go up, regardless of what flawed indices tell us. That is why UAE, Saudi and even Hong Kong raised rates. They are not stupid.
Fiscal reforms and tax hikes, are simply short term fixes. IMF programs need to contain a strong element of monetary reform.
That way fiscal profligacy can be held in check. Of course IMF will then lose a good customer. This is probably why White did not advocate monetary reforms.
After all, many of best customers of the IMF, including Sri Lanka, the Philippines and Latin American countries, built their inflating central banks with advice from the US.
If the central bank is reformed, politicians will lose their most potent tool to create poverty.
Keep this in mind. There is no great big monetary policy hocus pocus. The central bank is just a counterfeiter.
Not a common counterfeiter but a legalized mass-scale counterfeiter that prints paper fiat money by the billions to destroy entire countries and defraud the citizenry into poverty.
Feeback: [email protected]
This column is based on ‘The Price Signal by Bellwether‘ published in the April 2016 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.