Sri Lanka busts US$1.2bn on soft-peg in late 2018, exceeds IMF receipts

ECONOMYNEXT – Sri Lanka’s busted 1,229 million US dollars over the past four months, to operate a highly unstable soft-pegged monetary regime, exceeding the total receipts from the International Monetary Fund under program started after a 2015 collapse of the soft-peg.

By June 2018, the IMF had disbursed 715.23 million Special Drawing Rights (a denominator currency used by the IMF), which it said was equal to 1,014 million US dollars.

The full program is 1.1 billion SDR or about 1.5bn US dollars at the time the program was approved.

Defending and Printing

In December the central bank spent 122 million US dollars defending a soft-peg, a monetary arrangement where money is printed after intervention (sterilized) to stop the money supply from adjusting (mis-targeting real money demand) to the balance of payments.

In December the central bank had also bought 2.71 million dollars to prevent the rupee from appreciating, amid pressure on the peg, the data shows.

In November the central bank spent 519.23 million US dollars defending a peg, amid a political crisis and uncertainty triggered by President Maithripala Sirisena.

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In that month, about 90 billion rupees of money was released to finally sterilize interventions by cutting the reserve ratio.

Unlike in previous balance of payments crises where Treasury bills were bought outright to print money and finally sterilize interventions, the central bank has injected more money on term and overnight basis, putting more pressure on banks to slow credit.

In October the central bank had spent 303.55 million US dollars defending the soft-peg and also bought 7 million dollars to prevent its appreciation.

Mish-mash of convertibility undertakings

Severe pressure began on the currency in September after an August incident of mis-targeting real money demand where excess liquidity in money markets were pushed up to 55 billion rupees by the central bank, including through a type of currency swap that speculators usually use to attack soft-pegs.

In September the central bank spent 297.5 million dollars to defend the peg (and also spent 3 million dollars to stop its appreciation) when a (weak side) convertibility undertaking in the form of an exchange guarantee in forward markets matured.

Sri Lanka operates a pegged exchange rate system with multiple convertibility undertakings (a real effective exchange rate index, forward exchange cover or currency swaps, and an undertaking to prevent a disorderly adjustment of the exchange rate).

But there is no monetary policy to bac the exchange rate peg in the form of a floating interest rate.

The dollar purchases in December, October and September in the midst of currency trouble also shows that a convertibility undertaking is in operation on the strong side of the peg, where the rule is unclear to outside observers.

But the IMF through a forex reserve collection target in its deal had de facto imposed a strong-side convertibility undertaking on the soft peg but with no complementary restrictions on domestic assets acquisitions to make it work.

The mish-mash of convertibility undertakings are labeled a ‘flexible exchange rate’.

Monetary Politics

Sri Lanka runs into frequent balance of payments crisis primarily by mis-targeting real money demand by sterilizing forex sales with printed money to maintain the soft-pegged exchange rate regime, which results in a loss of credibility of the peg followed by exporter hold backs and capital flight.

To regain credibility of the soft-peg rates have to rise, the exchange rate has to fall or trade or exchange controls have to be imposed.

"Sterilized intervention enables the central bank to leave unchanged its issue of local currency even when losses of foreign reserves signal lower demand for local currency," economist Kurt Schuler, an expert on pegs once explained to the US congress (Why Currency Crises Happen).

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"However, if the central bank persists in refusing to reduce its issue of local currency, it will eventually lose all its foreign reserves.

"It must choose among abandoning the exchange rate, restricting convertibility by imposing exchange controls, or giving up independence in monetary policy by allowing the money supply to shrink.

"Politically, devaluation is usually easiest because it can be done fastest and can be blamed on external forces."

Sri Lanka’s central bank depreciated the rupee from 153 to 182 to the US dollar so far in 2018 and blamed external forces as soft-peggers are wont to do.

An April mis-targeting of reserve money to enforce a rate cut despite rising US rates, where an expansion in real demand for money was exceeded by 44 billion rupees left the exchange rate at 161 to the US dollar.

What are now called developed countries adopted floating exchange rates after the Bretton-Woods soft-pegs collapsed. Sri Lanka closed her entire economy at the time.

Despite knowing that soft-pegs do not work, developed countries again tried to re-establish soft-pegs through the European Exchange Rate Mechanism amid warnings from classical economists like Alan Walters who called it ‘half-baked’.

The ERM collapsed in 1992, about 20 years after Bretton Woods, leading to a loss of credibility on the economic policy making of UK’s Conservative Party in particular.

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So far calls to reform the peg have been resisted in Sri Lanka at an enormous cost to the country and its peoples and the credibility of the politicians of the day.

Sri Lanka’s United National Party has also suffered a hit on the credibility of economic policy making due to the soft-peg with its entire free trade strategy being torpedoed by the peg. (Colombo/Jan11/2018)