Onions, potatoes to cushion Sri Lanka depreciation shock

ECONOMYNEXT – Onions, potatoes and rice which are now grown in the country will cushion the people against currency collapse, Central Bank Governor Indrajit Coomaraswamy said, as the rupee’s unstable soft-peg with the US dollar saw its second run in 2018 despite weak credit growth.

Sri Lanka was no longer the country it was when it got independence in 1948, as it is producing more rice domestically and in a good rainfall year, no rice is imported, he said.

"Things like potatoes and onions we are producing more which can compete with imports," Coomaraswamy told reporters.

"So the whole scenario has changed in terms of the impact of the exchange rate on the cost of living. It still does, please do not get me wrong. It does have an impact.

"Though currency deprecation may lead to bus fare hikes, train fare hikes and some imported items going up in price, the impact is relatively low because we have had fairly decent Yala (minor cultivation season) and Maha (major cultivation seaon) harvests."

"And also things like onions and potatoes which we import, domestic production is competitive so there is a limit beyond which import prices can go up."

Import Substitution

Sri Lanka started to grow onions and potatoes –effectively, non-tradable import substitution products supported by protection—in the 1980s when the country saw the worst monetary instability and currency depreciation in its post-independent history, triggering waves of strikes that eventually gave the ‘open economy’ a bad name.

Sri Lanka’s balance of payments troubles began shortly after a money-printing central bank was created in 1950 with a soft-peg where the exchange rate and interest was simulataneously targeted, abolishing a hard peg with a floating interest rate, unlike countries like Singapore, which kept floating interest rates.

In the 1970s, SriLanka closed its entire economy as the Bretton Woods soft-peg system, which was based on similarly contradictory policy, collapsed, as gold prices shot up in a commodity bubble and oil-shock fired by the Federal Reserve with the Vietnam War in progress.

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In the US, President Nixon slapped import restrictions for a few months after the dollar stopped gold convertibility in 1971 eliminating the conflict of the soft-peg with gold, until the start of the short-lived Smithsonian agreement. The second deal also collapsed in 1973 leading to floating fiat-money exchange rates seen today.

At the time people in Sri Lanka were urged to grow and eat manioc (cassava), sweet potatoes, taro (kiri ala) and other native yams like hingurala, to save ‘foreign exchange’ as the central bank bought government securities with printed money to maintain a fixed pattern of interest rates.

Great Inflation

There were no Treasury securities auctions with a secondary market in the 1970s but sugar and rice were rationed and red onions were grown in the North of the country. Black markets were rife amid price controls.

At the time, reserve currency central banks were also struggling to come to grips with operating floating exchange rates without an effective peg to anchor their operations. Until 1971, the Bretton Woods system was anchored to gold.

Consumer prices ran riot, in the so-called ‘Great Inflation’ period, growth fell, leading to stagflation. The monetary instability ended when Paul Volcker was appointed Fed Governor who tightened policy with double digit interest rates.

The Sterling was stabilized with quantity targeting. Exchange controls were eliminated.

But floating exchange rate regimes (except in Germany and Japan which had the strongest exchange rates and became export power houses) struggled without a credible anchor until inflation targeting was formalized by the Reserve Bank of New Zealand in the early 1990s.

Inflationary Pressures

In Sri Lanka credit growth is muted and until the first quarter of 2018, the central bank was actively sterilizing foreign exchange purchases and contracting domestic credit.

Sri Lanka is just recovering from a full blown balance of payments crisis the central bank generated in 2015 and 2016, by releasing over 300 billion rupees of liquidity tied up in term repos and buying up another 250 billion rupees of Treasury bills to keep interest rates down.

"Fortunately the currency depreciation has come when inflationary pressures are muted within the economy," Coomaraswamy said.

Under Coomaraswamy, a potentially bigger property bubble had been averted, analysts say.

But despite credit still being weak, the central bank had managed to generate two runs on the rupee so far this year.

The second run came despite market pricing oil and a narrower budget deficit on the part of the Finance Ministry, giving the lie to the long term claim that budget deficits de-rail monetary policy.

Coomaraswamy said all kinds of reasons were being forward for currency falls in the media, but the culprit was the lack of exports, and imports were much larger than exports.

Imports were double that of exports, because it came from an ‘overvalued exchange rate’ which needed to depreciate, he said.

"Now it has come to a competitive rate," Coomaraswamy said.

"But I understand that it can have an impact on the cost of living and clearly inflation is a highly regressive tax on the poor, because rich people have (non-financial) assets which increase in value during inflation.

"Having a competitive exchange rate is critical to support our domestic producers."

Trumpism

Sri Lanka slapped overtly Mercantilist import controls over the weekend dealing a severe blow to the free trade agenda of the government as well as its credibility overall.

Ex-President President Mahinda Rajapaksa also agreed Sri Lanka’s currency problems were due to the trade deficit rather than monetary stability.

Sri Lanka’s central bank generated two balance of payments crises during his time but the rupee was allowed to bounce back in 2009, leading to a quick recovery.

"President (Donald) Trump has strengthened the US economy through a policy of giving incentives to indigenous businesses and imposing tariffs on imports to encourage local production," Rajapaksa crowed in a statement.

"My government also had a policy of producing whatever we could locally and reducing imports particularly of foodstuffs such as dairy products, maize, soya, sugar, onion, potato, fruits, vegetables, poultry and certain industrial products.

"This government in contrast believes in limitless liberalization andfree trade without a clear strategy to increase exports and reduce imports."

The import controls strengthened that hand of infant industry and import substitution ideologues and economic nationalists.

Activists who favour giving more powers to coercive politicians and bureaucrats taking away from the ordinary people and community are also having a field day blaming trade and other freedoms of ordinary people rather than contradictory state interventions in money and forex markets.

"Why did they not restrict imports and implement mechanisms to slow capital flight," asked Ahilan Kadirgamar, an activist, writing Sri Lanka’s Daily Mirror newspaper.

"Discussing reductions to imports was taboo and mentioning import substitution was forbidden.

"While politicians are finally talking about restricting imports, some of their ideologues have gone silent, and others seem to accept the crisis and consequent suffering of people as inevitable, in their bid to push the economy further down the path of liberalisation".

But analysts who knew about the central bank’s dangerous juggling of dual anchors had already warned that trade freedoms were incompatible with simultaneous state interventions in money and forex markets.

That the central bank’s targeting of multiple anchors will lead to this situation was warned by analysts familiar with its past record. (Sri Lanka’s Central Bank has to be restrained for free trade to succeed).

Under Governor Coomaraswamy the central bank is also targeting a real effective exchange rate, which analysts have warned is a slippery slope involving a never ending race to the bottom to out do the policy errors of the worst central bank in the REER basket.

Unsound Money

When a currency falls (against a relatively stronger reserve currency central bank like Fed), the prices of all traded goods inflate—whether an import like sugar or an export like tea. The more export competitive a product is, the faster it will go up to reach the world market (dollar prices).

Potatoes or onion prices may not go up immediately because they already get import protection due to being uncompetitive and partly due to bad quality, and behave like non-traded goods and are not exported.

However for ‘domestic producers’ to get the full benefit of currency depreciation, prices eventually have to move up to world market levels as the expense of all wage earners or domestic currency salaries.

Since currency depreciation eliminates the need to boost productivity, costs eventually catch up and famers call for protections when the full effects of depreciation spreads to the broader economy.

Currency depreciation destroys salaries and lifetime savings (which is why foreign investors run), and depending on how steep the fall is can kill domestic demand.

It can halt an economic recovery in its tracks as people and businesses try to protect their financial savings from being expropriated (speculating in bureaucratic parlance) instead of focusing on productive work. This can trigger business failures and even lead to stagflation.

Depreciation will also destroy investible capital, forcing savings to be sought for investment from abroad leading to chronic external current account deficits as well as chronically high nominal interest rates even if capital accounts are open, critics of unsound money say.

Currency depreciation is a subsidy paid to exporters and inefficient domestic producers by an entire society, and sometimes the ruling party as well, who will face the music in the polls as citizens react to the effects of unsound money.

China saw the Tiananmen Square protests after several years of continuous depreciation and inflation, and Korea faced the Great Workers Struggle after explicit attempts to lower the Real Effective Exchange Rate by keeping wages of the export sector down and with continuous currency depreciation, analysts say.

Meanwhile Governor Coomaraswamy claimed Sri Lanka inherited an economy from colonial rulers where most of the rice was imported because they focused on tea rubber and coconut, which led to a pre-occupation with exchange rate stability.

"One of reasons we think that when the exchange rate depreciates the whole world comes to an end, ..it harks back to a much earlier age," he said.

"After independence we had to import almost all of our rice. And in 1952, Sri Lanka had to sign a barter agreement with China, the rubber-rice pact with China to get rice from them."

Monetary Instability

When Sri Lanka (then Ceylon) was hard pegged from 1885 to 1950, with the Indian rupee, Sri Lanka’s economy was ahead of many Asian nations.

During that period, the rupee fluctuated against the pound only when silver and gold prices changed, because the Sterling had a gold anchor. The rupee had a silver anchor until the Reserve Bank of India was created and the anchor was later switched to gold.

But increasingly, draconian exchange controls were slapped from 1952 onwards, after the hard peg was abolished in favour of the soft-peg operated by the central bank.

In the early 1950s Sri Lanka’s rice subsidy costs shot up, as the US Fed fired an inflation bubble in the middle of the Korean War and an economic recovery, threatening the US dollar’s own peg with gold.

Primarily, liquidity came from an undertaking to buy Liberty Bonds, issued for war financing at a 3/8 percent fixed rate, and pressure from the Treasury to roll-over bills at a fixed rate.

Governor Marriner Eccles’ comments published in minutes said that the Fed was making it possible to "convert government securities into money to expand the money supply," by holding down rates and it had to stop.

"We are almost solely responsible for this inflation," Eccles had said in the February, 1951 open market committee discussions.

It is not deficit financing that is responsible because there has been surplus in the Treasury right along; the whole question of having rationing and price controls is due to the fact that we have this monetary inflation, and this committee is the only agency inexistence that can curb and stop the growth of money."

"We can not pass this responsibility; we should tell the Treasury, the President, and the Congress these facts, and do something about it."

It is not known whether Sri Lanka’s rate setting Monetary Board ever had a discussion of this type or members had admitted that they were "almost solely responsible" for price controls and rationing that took place in this country, or for mis-managing a soft-peg with dual anchors, which leads to exchange controls, because minutes are not published.

Only ex-Central Bank Deputy Governor W A Wijewardene has pointed out that central banks caused both currency depreciation and inflation.

Neither has the public or media aggressively called for accountability of central bankers in the belief that actions from which the people suffered were done with the best intentions amid overall lack of knowledge even among reserve currency central banks at one time.

But policy errors of soft-pegs, the relative success of true floating exchange rates and the clear success of hard pegs linked to better managed free floating central banks is now there for anyone who cares to observe them. (Colombo/Oct03/2018)

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