ECONOMYNEXT – Sri Lanka’s International Monetary Fund program has a series of long overdue essential reforms but its budget support loans show a troubling confusion about foreign reserves, central bank operations, their impact on domestic credit and the balance of payments.
The fallout of converting IMF loans to new rupees as well as conflicting core performance criteria in the program can derail the external sector and discredit reforms as the economy recovers.
All IMF loans even if they are disbursed to the central bank’s balance sheet directly are budget support loans in the sense that they create space in the domestic credit system for the government to borrow by reducing the need to collect reserves and lowering market interest rates.
The big advantage of direct disbursements of IMF money into the central bank is that it does not disturb rupee reserves of individual banks and reserve money (no reserve pass-through).
To understand why, one has to look closely at the operations of a monopoly note issue (or central) bank within the domestic credit system. Once this is understood, balance of payments troubles and IMF programs become a thing of the past.
That is why IMF programs were constructed in this fashion originally. IMF giving budget support loans to Greece is different from Sri Lanka which has a pegged exchange rate with forex shortages.
What are foreign reserves?
Any foreign reserves collected are savings made in the domestic economy by reducing domestic investments and consumption.
Reducing consumption alone is not enough if the money is loaned back by the credit system for domestic investment which will in turn generate imports.
Building foreign reserves, as a practical matter, is exactly the same as repaying debt and has a similar effect on the domestic credit system.
Building monetary foreign reserves involves the central bank purchasing debt of a foreign country like the US with dollars bought outright from the domestic credit system, or borrowed through swaps for new rupees
Swaps tend to ‘short’ the rupee and is a deadly practice, which has brought down pegged central banks in the past.
In any country, the current inflows (exports and remittances) do not change much in a year or two.
What changes in a very short time to fix balance of payments troubles under an IMF program (or dollarization after hyperinflation) is the central bank’s liquidity or domestic operations.
That is why a central bank can trigger a massive currency crisis within a single year and also end it in a similar period by backpaddling on its domestic operations.
In Sri Lanka, there are two types of official foreign reserves. The central bank has monetary foreign reserves bought by creating rupees (the reserve money supply) and the Treasury also has some dollars coming from foreign loans or asset sales.
These fiscal dollars are like a sovereign wealth fund which have no link to reserve money and can be used as required without de-stabilizing the external sector.
Sterilization and currency crises
Currency crises happen when a central bank engages in inflationary policy by injecting money to suppress interest rates, usually through open market operations, overnight injections, term repo injections or outright purchases of bills f and by rejecting bids for maturing securities from past deficits at auctions.
The newly injected money then triggers credit without deposits from banks and a surge in credit and imports. The central bank then intervenes in forex markets and continues to inject money to keep the policy rate down by offsetting the intervention with new money, an action known as sterilizing outflows.
Large volumes of Treasury securities bought to sterilize the interventions and maintain the artificial policy rate and domestic interest rate structure are then blamed on ‘budget deficits’ by interventionist policy makers.
To stop forex shortages and maintain the exchange rate the central bank has to stop the injections and give up its independence to print money (policy rate) and allow interest rates to go up.
As long as money is injected into the banking system (rupee reserves are injected) the central bank will continue to lose foreign reserves by a like amount at a given exchange rate.
East Asian countries build large volumes of foreign reserves by doing the exact opposite. The monetary authorities in these countries sell central bank securities or new central bank securities into the banking system and suck up domestic money and prevent banks from giving excess credit.
In GCC countries the monetary authority sells certificates of deposits to withdraw domestic money, which in turn creates an excess of dollars in the balance of payments.
The sale of central bank sterilization securities (MAS Bills/Bank Negara Bills bills or Shariah compliant CDs in the UAE) into the banking system reduces domestic credit by taking away domestic currency reserves in banks and keeps the exchange rate under upward pressure.
In order to suck domestic money out of the system, and trigger an excess of dollars in the balance of payments, the interest rates have to be slightly higher than the anchor currency (the US) and domestic credit has to be curtailed.
This action in practice has not hurt the countries with consistent pegs because the domestic money which does not depreciate has the same purchasing power as the anchor currency (the dollar, Euro) and there is enough real capital for domestic investment.
In East Asia reserves are built slowly and steadily. But to build a large volume of reserves in a short space of time, large volumes of domestic rupee reserves have to be withdrawn.
A front-loaded IMF tranche drawdown in to the central bank is budget support
Regardless, at the inception of the program, a reserve injection into the central bank creates space in the domestic credit system and allows interest rates to fall faster by reducing the need to collect reserves.
An initial reserve build-up with IMF loans allows the government to borrow more funds domestically by dipping into the space created by the tranche injection. Foreign reserves to be built slowly over time.
There is not much difference between an IMF money given to the central bank’s balance sheet without disturbing domestic rupee reserves of banks (a transaction that has no reserve passthrough) which gives space to borrow more domestically to a direct injection to the Treasury.
The old IMF veterans who designed these programs knew this.
The first IMF programs in the 1960s were one year stand-by programmers, where the IMF forced rates up, hiked taxes to further reduce domestic credit, lifted administered prices to stop losses in state enterprises and went away after the exchange rate stabilized.
Of course, a few years later the central bank suppressed rates – for rural refinance, or other refinance programs, or bought maturing bills at auctions to suppress rates as the economy picked up, or suppressed rates while energy utilities borrowed for subsidies and triggered a new currency crisis, social unrest and elections defeats.
In Sri Lanka, provisional advances to the government and transfers of central bank profits also trigger currency pressure when there is a strong domestic credit recovery.
It is easy to lose the credibility of the exchange rate but not easy to restore confidence in the currency and stop capital flight.
After everyone panics, very high rates are needed to kill domestic credit and restore credibility in the peg and get everyone to trust the exchange rate again.
IMF budget support loans like hedge fund swaps
IMF budget support loans which are converted to new rupees by surrendering dollars to the central banks has a further complication.
A part of the first 331 million IMF US dollar tranche had been used to repay an Indian loan of 121 million dollars. That does not create any disturbance in the domestic credit system or reserve money.
However, if IMF money is sold to the central bank to generate rupees, reserve money expands.
As the Treasury pays domestic expenses the money will eventually hit the exchange rate as import demand builds up as cascading credit flows through domestic banks.
The money, if temporarily kept in state bank accounts, can hit the forex market if used for private credit – say a loan given to refurbish a hotel – even before the Treasury uses it.
Any money created from dollar purchases will pressure the currency unless the central bank is prepared to sell the dollars when the rupees come up for redemption on the forex market.
If the dollars are not sold at the time, the rupee will fall. Under IMF programs, dollar sales are severely curtailed and the central bank cannot operate a consistent peg.
This was seen soon after the surrender rule (a surrender rule pushes a currency down by creating liquidity) was lifted and the rupee appreciated.
When banks were in oversold positions and were trying to buy back a few dollars – in thin volumes – the central bank did not sell enough back, the rupee became unstable again, despite underlying credit conditions favoring a strong rupee.
Because the IMF discourages the central bank from selling reserves to mop up the rupees created from dollar purchase when they come up for redemption in forex markets, any budget support loans converted to new rupees through a surrender to the central bank will have the same effect as swaps used by hedge funds to hit East Asian pegs in the 1997 crisis.
Such money will ‘short’ the rupee. Such actions also have the same effect as the Hambantota port sales dollars which was swapped for rupees in August 2018.
To avoid the new money pressuring the currency the central bank will have to sell down its Treasury bill stock and mop up the money and pre-empt domestic credit.
This action will be the same as the IMF directly giving the reserves to the central bank and the government borrowed domestically.
At the moment there is a liquidity shortage in banks to absorb the money.
When the liquidity shortage is gone and domestic credit picks up, it will be a different story.
After the debt re-structuring is done, foreign and other banks will begin to buy Treasuries with the money in the SDF window. Pressure will also come to the rupee if the money is not absorbed through a sell down of central bank held Treasuries.
Under flexible inflation targeting, the central bank is not obligated to sell down its domestic assets in line with net international reserve targets.
The only obligation is to maintain a very high inflation target. Trying to stabilize countries with high inflation targets is a dangerous practice.
Governor Nandalal Weerasinghe operated a guidance peg very effectively with zero foreign reserves by raising rates and reducing credit demand and giving dollars back to the market as permitted by credit conditions.
Then banks also stopped giving loans and started to deposit liquidity in the Standard Deposit Facility of the central bank, effectively creating a liquidity trap or private sector sterilization.
In this situation – where market rates were 30 percent – the policy rate was no longer effective and the transmission mechanism was dead.
Governor Weerasinghe was right to operate an external anchor, using a not-fully-credible peg, but a peg with fully complementary monetary policy.
As a result, inflation started to collapse ahead of IMF projections as if the country was dollarized.
In Sri Lanka, goods exports, remittances and tourism are the major source of dollar inflows. When these moneys are spent by their recipients, imports take place.
Whatever is saved by the recipients and loaned to the real economy will also trigger imports. Whatever is loaned or deposited in the central bank will not. It is those monies that will lead to a build-up of foreign reserves.
Countries run into balance of payments troubles because of a weak understanding of central bank operations and the policy rate within anglophone policy circles.
Conflicting Performance Criteria
The IMF program’s Net International Reserve Target and the monetary policy consultation clause are in fundamental conflict. The budget support loans had created a further potential conflict, given the ‘flexible’ exchange rate.
The ‘flexible exchange rate’ and balance of payment troubles in general are a result of anglophone mis-understandings of the external sector and monopoly central banks, dating back to the 1920s and 1930s which drove anglophone policy thinking in the immediate aftermath of World War II.
Washington based policy circles have been particularly at fault.
What is happening to Surinam and Zambia now, what happened to Pakistan within its IMF program, should be a warning to domestic policy makers.
If central bank securities are not sold down in line with foreign reserve targets, the rupee will collapse again as the economy recovers later this year or next year.
The depreciating currency will unravel inflation and impose a regressive tax on the poor by pushing up food prices.
The falling currency will destroy the finances of energy utilities, make budgets impossible to manage, trigger trade restrictions and exchange controls, raise public discontent, which will discredit the reform program and reformist politicians.
The whole vicious cycle then starts once again. Usually, IMF programs fail in the second year as rates are suppressed with liquidity injections on the claim that inflation is low under data driven monetary policy.
Depreciating flexible exchange rates are not floating rates. Clean floating rates, like hard pegs, are extremely strong ‘hard currencies’ which provide stability and eliminate the need for exchange controls.
That monetary foreign reserves can be spent on imports is a myth.
Here is a brief explanation from the Singapore government on how the monetary authority collects reserves and also operates the GIC (a sovereign wealth fund) from domestic borrowings turned into foreign through the MAS. Singapore can do all this because the MAS does not have a fixed policy rate.
If any IMF official or any economic bureaucrat in a country with a depreciating currency can read and understand what the Singapore Ministry of Finance is saying, balance of payments troubles, forex shortages, worries about external current account deficits and sovereign defaults will be history.
That is why neither the IMF nor policy makers in third world nations with chronic balance of payments troubles can write as central bank law to stop external instability or end foreign exchange controls.
It must be mentioned that the last American economist in official policy circles who could write a central bank law to eliminate balance of payments troubles was a Princeton economist called Edwin Walter Kemmerer.
He died in 1945 and his advice – for the most part – was not taken in building the Bretton Woods, leading to its collapse in 1971-72.
To avoid monetary instability from budget support loans, the central bank will have to do the following;
a) Use IMF funds only for external repayments that fall due.
b) Avoid surrendering the dollars to create money and fund domestic spending
c) If any such rupees are not sterilized immediately, during the same week, be prepared to sell dollars to maintain confidence in the currency
d) Any IMF moneys can be sold in the market, which will put upward pressure on the currency and avoid any changes to reserve money
e) Sell down central bank held treasuries consistently through gentle deflationary open market operations to always maintain a small liquidity shortage in money markets and keep the exchange under appreciating pressure
f) If the IMF reserve target are too high, be prepared to keep rates high enough to curtail domestic credit in like amount
g) Any procrastination under ‘data driven flexible inflation targeting’ with lead to exchange rate pressure and a subsequent default
i) Avoid transferring any central bank profits as rupees. Central bank profits should be transferred as foreign reserves in the first instance with the knowledge that reserves would be lost by the act. Tips on how to do it can be found from Singapore.
A pegged central bank simply takes dollars in as ‘deposits’ and then lends it to the US and other countries to build reserves.
To stop the depositors using the money – the persons to whom the rupees were given by the central bank from asking for the dollars back through spending – the pass books have to be taken away.
That is what happens when a central-bank-held Treasury bill or sterilization securities are sold to banks or other customers and the liquidity is mopped up.
Without a peg there are no foreign reserves.
It is very easy to maintain monetary stability, low inflation and exchange rate stability as long as open market operations are not inflationary.
All the central bank has to do is avoid inflationary open market operations.
In countries like Sri Lanka, as in East Asia where people have high savings rates, it is absurdly easy to fix exchange rates and also repay foreign debt or collect reserves.