ECONOMYNEXT – Sri Lanka’s newly re-appointed Central Bank Governor Nivard Cabraal has been warned on the usual pitfalls that that monetary authorities that produce unstable money fall to as positive economic action on bond auctions were contradicted by other bureaucratic moves.
Cabraal removed price controls on bond auctions which could eventually allow a widened budget deficit to be financed by private savings once rates move to market clearing levels.
In the recent past money had been printed to pay state workers who buy goods and drive imports to unsustainable levels.
Some money was also printed to repay maturing government securities which were been turned into rupees giving resources for banks to lend to customers for consumption or investment, also driving imports up.
Cabraal had said he would place stability before growth (stimulus) shortly after taking office.
W A Wijewardene, a former Deputy Central Bank Governor wrote in his column in Sri Lanka’s Daily FT newspaper that Governor Cabraal had also indicated in several interviews that he wanted to stop money printing and reverse asset purchases.
“This is an encouraging development,” he said.
In 2008 and 2009, when Sri Lanka was facing an intensified civil war and the fallout of the Greenspan-Bernanke bubble, Wijewardene was Deputy Governor and Cabraal was Governor.
At the time rates were allowed to rise high levles and some bonds were also sold on ‘tap’ or placed, to avoid money printing and create monetary instability. Some who mis-understood the move criticized it later. However others said it should have been ended after conditions normalized.
Wijewardene had dubbed the cascading policy errors in 2020 and 2021 that led to balance of payments deficits, crippling of bond and forex markets and the loss of confidence in the national currency, the ‘Lakshman shock’ which was apparently achieved in the pursuit of Modern Monetary Theory.
Even developed countries with fully floating rates cannot print money without triggering commodity and asset price bubbles as had been seen in the past. Global commodities are now rising in the so-called Powell Bubble.
Peg Without Convertibility Undertaking
In 2020, amid money printing, the central bank suddenly decreed that the exchange rate should be 203 to the US dollar and banks were barred from finding dollars and selling them to importers at higher rates. At the time importers were buying dollars around 225 – 203 to the US dollar.
The central bank had already suspended convertibility at 203 the new rupees it was producing for trade transactions (dollars were not being sold to enforce the rate) making the rupee fall to around 230 to the US dollar in forex markets (effectively a float).
Importers were getting dollars by settling part of the money outside the foreign exchange market.
However the banks have now been informed to strictly adhere to the rate and discourage such settlements.
“Instead of freeing the market from these crutches, the Central Bank under Governor Cabraal’s leadership has issued a confidential warning letter to CEOs of banks that they should strictly adhere to the limits given in the Lakshman Shock by enforcing the regulation on both exporters and importers,” Wijewardene said.
“This is untypical of Governor Cabraal who had been raised and trained in the private sector and who had held that post previously.
“He should have known that unless the Central Bank was prepared to supply an unlimited amount of dollars to the market (provide convertibility), commercial banks cannot hold on to the fixed rate of Rs. 203 per dollar.
“The result was the lengthening of the queue for dollars and the expansion of the black market further.”
Under a consistent peg, such as in Hong Kong (against the US dollar), Brunei (against the Singapore dollar), Bhutan (against the Indian rupee) or Nepal (against the Indian rupee) when convertibility is provided by the monetary authority through dollar sales, liquidity tightens and rates move up.
There area also other mostly consistent pegs such the Saudi Riyal, UAE Dirham, Qatar Riyal, Kuwaiti Dinar against the US dollar.
The rising rates and tightening liquidity ‘rations’ rupees, keeping the exchange rate stable.
However under a policy rate targeting framework, if new rupees are provided in unlimited quantities to enforce interest rates, resisting a contraction reserve money, preventing a tightening of domestic credit, the currency will weaken.
However under a policy rate targeting framework, new rupees are provided in unlimited quantities to enforce interest rates, resisting a contraction of reserve money preventing a tightening of domestic credit and maintaining the peg.
The central would then lose its reserves.
“..[If the Bank assuming, that because a given quantity of circulating medium (reserve money) had been necessary last year, therefore the same quantity must be necessary this, or for any other reason, 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,” classical economist David Ricardo explained this early in the 19th century.
“In this manner if the Bank persisted in returning their notes into circulation, every guinea might be drawn out of their coffers.”
Sri Lanka’s forex reserves are now at a low level and the central banks reserve related liabilities are up.
A ‘float’ however prevents interventions and can stabilize a currency – usually after a fall – as long as new money is not printed to pay state workers.
Cabraal lifted price controls on Treasuries auctions allowing more money to be raised from private savings. At the last bill auction at least 2.0 billion rupees was printed.
The central bank’s domestic operations department also injected 103 billion rupees in the banking system to partially reverse a previous statutory reserve hike, which had created large asset liability mis-matches in some banks.
However raising concerns, some money was injected for 87 days at rates as low as 6.08 percent far below before the 3-month bill yield of 6.38 percent.
Meanwhile in another move raising concerns the central bank published a statement explaining an apparent need to expand enforced surrenders of US dollars, which also create new liquidity.
Such policies are usually followed by many third world central banks which trigger forex shortages, currency collapses and social unrest.
Zimbabwe earlier this year raised the surrender requirement to 40 percent from 30 percent. (Colombo/Sept26/2021)