ECONOMYNEXT – A guidance rate mandated by Sri Lanka’s central bank is not found in the real world and the monetary authority has no ability enforce a managed float (soft-peg), with negative reserves, a top economist and ex-Central Bank Deputy Governor W A Wijewardena has said.
Sri Lanka’s central bank started quoting a guidance rate for interbank market at around 360 to the US dollar in May, about 20 to 30 rupees below the market rate at the time where a higher level of middle remittances were also starting to come from exchange houses.
Banks are quoting telegraphic transfers around 365 rupees to the dollar.
The guidance seems to be an attempt to do officially what was done unofficially earlier.
No clean float, no credible peg
“I speak to importers everyday and they tell me that when they go to banks to buy dollar at 365 they are told to wait at least one to two months,” W A Wijewardena, Former Deputy Governor, Central Bank of Sri Lank told a Central bank forum in Sri Lanka’s latest currency crisis.
“They have to wait in a queue.”
“In my view the present exchange rate policy to fix the exchange rate at middle rate officially, what was done unofficially earlier.
“You can’t do it without having a sufficient stock of exchange.”
Foreign exchange shortages happens in a non-credible or soft-peg (also called a managed float or flexible exchange rate) which collapses whenever the central bank injects money to mis-target interest rates.
A pegged central bank runs out of reserves when money is injected to enforce the artificial policy rate and dollars are sold to mop up the rupees hold the exchange rate, in self-feeding spiral when domestic credit is strong either due to a deficit or a recovery in private credit.
A central bank then gets into a sterilization trap where liquidity shortages coming from dollars sold to defend the exchange rate (reserves for imports or to provide ‘convertibility’ to the newly created money) are sterilized (offset) with new money, preventing reserve money and credit from slowing.
A central bank which steadily continues to provide reserves for imports then ends up financing the private sector with central bank credit, by injecting money into banks through open market operations to cover the liquidity shortage from dollar sale, preventing a contraction of reserve money and credit.
In a sterilized intervention cycle (reserves for imports) the soft-pegged central bank then loses control of reserve money in the process of trying to enforce a policy rate after the intervention.
Later the injected money shows up as deficit finance because Treasury bills or bonds (sometimes issued to cover past deficits) end up in the central bank balance sheet, altering the loans to deposit ratio of banks.
At the moment state banks in particular have large volumes of overnight borrowings from the central bank from sterilizing dollars given for imports and debt repayments, creating severe asset liability mis-matches.
The private sector re-finance by bank credit, is then classified as deficit finance because the instrument used to inject money is a government security.
In the days of the classical economists of UK for example this error was not made as bankers’ acceptances were used for open market operations and central bankers could not get away blaming the deficit instead of their fixation with interest rates, as they started to do after World War II, analysts say.
When dollar shortages emerge and exchange and other controls are imposed, market participants who fear a currency collapse, then hold back dollars and try to take counter measures to protect their savings from the central bank leading to a loss of credibility of the peg.
To restore the credibility of the peg domestic credit and economic activities have to be smashed to make outflows fall below inflows.
If the deficit is high, private sector credit has to be smashed to a greater degree and de-leveraging has to take place in a typical IMF style ‘stabilization measure’.
Sri Lanka’s central bank has raised rates and market rates have moved up in the first step towards reducing private credit and outflows.
The government has also announced some tax measures.
India is giving credit lines which when given the private sector, or fuel is market priced, also generates rupees for the deficit.
However in this cycle of money printing to fix interest rates, Sri Lanka’s central bank has not only lost its reserves but also lost borrowed money leaving it about 4 billion US dollars in debt by March 2022.
Wijewardena said the central bank’s gross debt was in the region of about 6 billion US dollars while the net debt was over 4.0 billion dollars.
“The central bank debt is 6 billion dollars while the reserves are minus 4.4 billion dollars,” he said.
“So putting money in central bank is like sinking well. No matter how much water you put, it won’t fill.”
At the moment the central bank is accumulating more debt from Asian Clearing Union payment arrears to India.
A central bank that runs out of reserves and cannot exchange dollars for rupees (provide convertibility and enforce an external anchor) can then float the currency (suspend convertibility) and shift the regime to a float.
The currency then stabilizes after a fall, and forex shortages disappear as long as new money is not created to generate excess liquidity in money markets.
“For a central bank to hold on to an exchange rate at a given level, it should have reserves to do so,” Wijewardena said.
“If we don’t have reserves then we are holding on to a kite that this floating freely without any direction by the person who is holding the thread.”
“So when you have a negative foreign exchange position, central bank cannot fix the rate. We have lost the battle already with the exchange rate.”
“What we have to do now is to allow the exchange rate to fall to whatever the realistic level the rate would take.”
In a float reserve money is no longer altered by forex interventions ending the need to sterilize any liquidity shortages with new printed money.
The central bank then regains the ability to enforce both a policy rate and control the reserve money.
The central bank can then peg reserve money to a single domestic anchor (inflation target) instead of an external anchor (the convertibility rate) via its policy rate.
Dual anchor intermediate regimes
However Sri Lanka’s central bank attempted to float with a surrender requirement (forced sales of dollars to the central bank for new money) the rupee fell steeply. The surrender requirement is still in place and interventions are made in both directions of the peg.
Soft-pegs or managed floats collapse when domestic credit picks up because an intermediate regime central bank tries to enforce two monetary anchors (domestic and external) simultaneously (anchor conflict), eventually losing control of the policy rate, reserve money, broad money and also inflation.
Dual anchor regimes (which violate the concept of impossible trinity of monetary policy objectives) were promoted by the US before especially after World War II in the course of setting up the Bretton Woods system of failed soft-pegs.
Among its advocates was US economist John H Williams. (Sri Lanka use of reserves for imports is a deadly false choice: Bellwether).
Under an IMF program the currency is re-pegged after a float (usually a prior action) to prevent its loans being used for imports, and inflows sterilized to re-build reserves after credit is compressed.
IMF programs usually advocate structural reforms.
However the IMF reforms do not advocate the ending of the soft-peg or managed floats towards a single anchor regime (clean float or hard peg) and the anchor conflict comes up again to trip the managed float when the economy recovers in a few years.
Instead IMF gives clues to developing country central banks to ‘modernize monetary policy’ further towards those operated by clean floating central banks which do not collect any forex reserves and gives zero forex reserves for imports.
The anchor conflicts are worsened by monetary policy modernization (the latest permutation being flexible inflation targeting/flexible inflation targeting) and all interest rate mis-targeting of the monetary policy committee is compensated for by currency depreciation and social unrest in some cases.
The dual anchor almost guarantees that the country will go to the IMF again, a phenomenon labelled ‘IMF recidivism’ or sometimes ‘Many Happy Returns’.
Sri Lanka has gone to the IMF 16 times.
The trips to the IMF ends when either a clean float where reserve money is pegged to an inflation index with suitable accountability imposed on the central bank governor who fails to hikes rates on time is set up or a currency board (hard peg) linked to an external anchor is set up, ending dual anchor conflicts.
A currency board blocks both types of central bank credit: deficit finance (monetization of the deficit) and also private sector finance by re-purchasing bonds from banks after giving reserves for imports with unsterilized interventions.
Wijewardena said Goh Keng Swee, Singapore’s economic architect, who maintained a currency board to give monetary stability and block central bank credit, said hard work made countries prosper and not central bank credit.
The decision to end trips to the IMF and move to a single anchor regime can be made by the people who are hurt most by the soft-pegging and also politicians who are kicked out of power when soft-pegs collapse. (Colombo/June03/2022)