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Sunday May 19th, 2024

Sri Lanka has a corrupted inflation targeting, output gap targeting not in line with monetary law: Wijewardena

ECONOMYNEXT – Targeting an output gap with printed money is not in line with the original intentions of Sri Lanka’s Monetary Law Act and ‘flexible’ inflation targeting is a corrupted version of the original, a top economist and former central banker has said.

Contradictory money and exchange policies (trying to maintain an exchange rate after printing large volumes of money to keep rates down and boost growth or target an output gap) has led to the collapse of the rupee from 131 to 202 so far in three currency crises since 2015.

However Sri Lanka’s Monetary Law Act, the constitution of the central bank does not have a growth mandate, to target the output or growth.

Violating MLA intentions

“Output gap targeting does not comply with the original intention of the economic and price stability objective that has been incorporated in the Act,” former Deputy Governor of the Central Bank W A Wijewardena told EconomyNext.

The MLA says “the Central Bank is hereby charged with the duty of securing, so far as possible by action authorised by this Act, the following objectives, namely –

(a) economic and price stability; and
(b) financial system stability,

with a view to encouraging and promoting the development of the productive resources of Sri Lanka.”

Wijewardena says the Central Bank is trying to push the aggregate demand curve to the right by injecting liquidity.

However the MLA does not give any authority for the central bank to print money to try shift demand higher and de-stabilize the balance of payments and the overall economy.

Wijewardena has explained why the then-Central Bank Govenor Jayewardene put the ‘economic and price’ stability as an objective because only focusing on an inflation index may lead the central bank astray.

Wijewardena in his previous writings recalls Jayewardene telling him: “…if you have only price stability, then you would fall into the trap of attempting to stabilize a price index which is not what is meant by price stability, in the context of a central bank. The attainment of price stability for a central bank means elimination of both excess demand and excess supply in the market so that the market is free of potential inflationary or deflationary pressures”

Analysts say when classical economists originally coined the word ‘inflation’ it did not refer to just an index compiled by a state agency.

Inflation referred to the expansion of reserve money (inflation of fiat injections) beyond the specie stock (gold reserves) of a central bank which led to assets price inflation, balance of payments trouble (export of gold like modern forex shortages) and mal-investments by an over-expansion of credit.

The problem was graphically shown when the US Fed, targeting a core-inflation index which excluded commodities, triggered a massive housing and commodity bubble, which collapsed in what is now called the Great Financial Crisis.

In 1971 the Fed had already ended a gold standard by trying to target an ‘output gap’.

Eliminating Conflicts

The danger of focusing only on an inflation index also was that it could be manipulated.

Then Governor A S Jayewardene had transferred responsibility of calculating both the output and inflation to the Census Department to avoid any conflict of interest, Wijewardena said.

Jayewardene revised the Monetary Law Act as part of a drive to shift to inflation targeting which however requires a fully floating exchange rate.

An earlier requirement to maintain the external value of the rupee was dropped.

When a US Federal Reserve official built the central bank in 1950, to join the Bretton Woods system of failed soft-pegs, the rupee was defined as 2.88 grains of gold, .

The peg would have put the brakes on credit expansion and maintained the exchange rate, if rates were allowed to rise in time and credit curtailed.

Under the Bretton Woods both Germany under Austrian economic influence (4.2 to the US dollar) and Japan (360 yen to the dollar) showed that it could be done .

However in Sri Lanka the central bank placed import and exchange controls to maintain the exchange rate, while financing the deficit, instead of allowing the credit system to adjust to the balance of payments.

Before the setting up of the soft-peg in 1950 which brought forex shortages and currency crises, Ceylon had a hard peg (currency board) from 1885, where the exchange rate was fixed by allowing short term rates to float in line with the balance of payments.

Given the experience of trade and exchange controls up to 1977 and the currency collapses and high inflation after that, the Monetary Law Act was revised to clearly maintain stability so that economic agents could carry out real growth generating activities.

Jayawardene also stopped central bank re-finance of rural credit which had directly contributed to the currency collapses, high inflation and the inevitable high interest rates, that are required to stabilize the economy the 1980s.

Corrupted Inflation Targeting

Sri Lanka has triggered three currency crises in 2015/2016, 2018 and is now in the middle of the third as rule based monetary policy was jettisoned in favour of highly discretionary ‘flexible’ inflation targeting and ‘flexible exchange rate’.

Under ‘flexible’ inflation targeting, the real effective exchange rate, the yield curve and also lending and deposit rates were controlled to target an output gap targeting (growth).

The International Monetary Fund has been advocating ‘flexible inflation targeting’ to many countries which is a more discretionary form of monetary policy than that is followed by successful inflation targeting like Sweden, New Zealand and Australia.

“Inflation targeting has now been corrupted by a new concept called flexible inflation targeting,” Wijewardena said.

The IMF as part of technical assistance taught the central bank to calculate and output gap and may have been complicit in the economic instability that followed from the ‘flexible’ policy.

Whether the IMF broke the MLA by teaching the central bank to target an output gap which led to the money printing bout in 2018 and the subsequent currency crises and growth collapses has not been tested in court.

Supreme court justices in many countries including the US has not upheld monetary laws, due to the general lack of understanding monetary policy, though counterfeiting is generally understood by most.

However public awareness of central bank policy errors are growing in Sri Lanka.

Earlier in 2021, Chandra Jayaratne, a public interest activist made a public appeal for the central bank to engage in a public debate about its monetary policy as the balance of payments continued to deteriorate.

“I request that the Central Bank (CBSL) arranges a public participative intellectual debate, on a virtual platform, between the CBSL Team and invited economists, bankers and business managers with practical experience in business, consultancy and banking/finance, with the subject of the debate to be on the present external sector monetary management policies and practices,” Jayaratne wrote in February 2021.

“I make this appeal as I fear that the public image of the CBSL and the independence, professionalism and intellectual integrity of yourself and the CBSL Team, may come in to question, if not now, in the near future or even in the long term.”

The central bank declined to take up the offer.

In 2019 after the 2018 output targeting exercise triggered a currency crisis, despite taxes being raised and oil being market priced and import controls being placed, the central bank sent out a long statement about its monetary policy actions.

However in 2020 Sri Lanka is in another crisis.

Related: Sri Lanka’s central bank defends discretionary monetary policy

Not the People’s Fault

Sri Lanka is now mired in some of the worst import controls since 1970s when the central bank was injecting money by purchasing Treasury bills in a large scale.

In 2020, unprecedented volumes of Treasury bills had been purchased by the central bank under so-called Modern Monetary Theory.

The central bank’s Treasury bill stock has topped 900 billion rupees, central bank credit to government has exceeded reserve money – it is not clear whether there is any historical precedent for it in Sri Lanka, and forward exchange rate premiums are negative despite a run on foreign reserves due to low rates.

There is greater public understanding of the policy errors of the central bank, and the import controls that come in their wake.

Import controls imply that the public is doing something wrong to depreciate the exchange rate and not the central bank which is failing to manage reserve money.

Despite the worst import controls since 1970s, the rupee is continuing to fall. The rupee also continued to fall despite last administration ending gold imports and vehicle imports, blaming the people for a failure of the state.

Ross McLeod an Australian economist says, who studies East Asia currencies say the people cannot be faulted for currency depreciation, which is always the case of the central bank mis-managing, reserve money, a monetary variable that only it can created and control.

When central banks try to control both the exchange rate and interest rates (by expanding reserve money) the currency falls.

“Well, it’s not the people at all. It’s the policies of the central bank in all cases,” McLeod said in an interview with Advocata Institute in Colombo.

“There’s a demand for money from the people but the supply is determined by the central bank,”

“If then supply is made too large relative to the demand for it, or if the growth rate of supply is too rapid relative to the growth of demand for it, then just like everything else, the value falls.

“The value of money is its purchasing power. That’s kind of the inverse of the inflation rate. If you have the value of the currency falling, it is equivalent of saying prices are rising.

“So it’s never the fault of the people. It’s always attributable to the policies of the central bank.”

Countries that severely mis-manage reserve money could end up in dollarization. (Colombo/Apr12/2021)

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Sri Lanka may have to depend on India or nuclear to reach low carbon target: researcher

DOUBLE WHAMMY: In Sri Lanka’s driest period, wind potential also goes down, a researcher and policy advocate says

ECONOMYNEXT – Sri Lanka will need to either connect to India or set up a nuclear power plant if the country is to reach its renewable energy targets due the country’s weather patterns, a researcher and policy advocate has said.

Sri Lanka has set ambitious goals for renewable electricity generation by 2030, apparently without much prior study or any costs being revealed when the target was set by President Gotabaya Rajapaksa.

Rohan Pethiyagoda, a taxonomist and researcher who had also been senior state officials involved in policy at one time said overall Sri Lanka used a large volume of biomass (firewood) for cooking.

“We need to recognize, of course, that about 60 percent of Sri Lankan households still use firewood as their primary fuel,” Pethiyagoda told a climate forum organized by Sri Lanka’s Ceylon Chamber of Commerce.

“Bless them, because they reduce our dependence on fossil fuels for cooking. Even the tea industry, one of our largest exports, uses biomass as its primary fuel for about 90 percent of its production.”

In the electricity sector, where the renewable lobby and other activists oppose coal on the basis of carbon emissions based on international trends, as well as dust, base load still has to be generated if thermal generators are replaced.

Solar power is available only for a few hours in daytime and it can also vary depending on cloud cover.

Hydro power (run of the river plants) is more stable but is dependent on rain. Large hydros with storage can be used for peaks, industry analysts say.

Wind is available throughout the day but can also be unstable. The problem of variability (non-firm energy) can be solved to some extent through ramping and battery storage at additional cost, analysts say.

A renewable plant in Poonakary with battery storage was priced at around 48 to 49 rupees (about 15 US cents) based on public statements.

Meanwhile Pethiyagoda said Sri Lanka’s weather patterns created an additional problem.

“We have this unusual thing for our renewable energy in Sri Lanka, that at the tail end of the northeast monsoon, from about December to April, we have a dry period in this country, which means that our hydro potential during those months goes down,” Pethiyagoda said.

“Now, as luck would have it, our wind potential goes down at the same time.”

As a result, Sri Lanka needs a reliable alternative to the current coal baseload.

“So for that reason especially, we need to look at either connecting to India’s grid in the long term or having a nuclear facility in Sri Lanka if we want to be low carbon. And of course, we need to replace our vehicle fleet.”

“And our base load can probably come from nuclear,” Pethiyagoda said.

“But whichever way we do it, the cheaper way would be for us to connect to India’s grid.

“Whichever way we do it, we’re looking at an investment of about 40 billion dollars. And then we have the problem of looking at how wind and solar will behave.”

It was not clear what the 40 billion dollar investments would be made up of.

Sri Lanka’s external debt as at December 2024, including unpaid principal after default was 37.3 billion US dollars.

In 2021 when the 70 percent target was unveiled in President Gotabaya Rajapaksa’s election manifesto power engineers said a 53 percent energy share planned for 2030 in a general plan at the time was was equal to that of Germany.

Pushing up the share to 70 percent would require billions of dollars of extra investments, they said.

Related

Sri Lanka generation plan renewable power share for 2030 equal to Germany: CEB engineers

After the central bank cut rates and triggered an external default however, Sri Lanka growth, and power demand in the next few years is expected to be lower than before extreme macro-economic policy.

Related Sri Lanka to invest US$11bn by 2030 to meet renewable target

In 2023, the CEB said about 11 billion US dollars would be needed to meet the 70 percent target. (Colombo/June19/2024)

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Sri Lanka President discusses Starlink with Elon Musk

ECONOMYNEXT – Sri Lanka President Ranil Wickremesinghe has discussed connecting the island to the Starlink satellite system with its founder Elon Musk, his office said in a statement.

President Wickremesinghe has met Musk at a World Water Forum High-Level Meeting in Indonesia.

President Wickremesinghe discussed “the implementation of Starlink in Sri Lanka & committed to fast-tracking the application process to connect SL with the global Starlink network,” the statement said.

Starlink is a low earth orbit satellite network, connected to Musk’s SpaceX group. (Colombo/Jun19/2024)

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Sri Lanka’s CEB March 2024 profits Rs84bn with capital gain, fx strength

ECONOMYNEXT – Sri Lanka’s state-run Ceylon Electricity Board group has reported profits of 86 billion rupees with the help of 25.9 billion rupees of capital gains from a transfer of shares, interim accounts show.

The rupee also appreciated in the quarter which keeps imported fuel prices low.

As a standalone entity, the Ceylon Electricity Board, made profits of 84.6 billion rupees in the March quarter.

CEB’s revenues rose 38.5 percent to 167 billion rupees in the March 2024 quarter, while cost of sales fell 26.1 percent to 105.0 billion rupees giving gross profits of 62.7 billion rupees.

The CEB also reported 30.6 billion rupees of other incomes and gains in the March quarter, up from 3.1 billion rupees last year.

Other Income and Gains

The utility said it made a 25.9 billion rupee capital gain from transferring LTL Holdings shares to West Coast Power an IPP in which other entities have a majority holding.

In the quarter the rupee also appreciated.

A rupee appreciation will help reduce the carrying cost of dollar loans and also reduce the cost of imported thermal fuels and maintenance costs of spares.

The central bank allowed Sri Lanka’s exchange rate to appreciate from 324.40 rupees in December 2023 to 300.17 on March 2024 amid deflationary policy and weak private credit allowing imported fuel costs also to fall.

Especially after 1978, after rate cuts drove the country into balance of payments crises, the central bank had collected reserves with free market interest rates, but has not usually allowed the exchange rate to re-appreciate despite generating a BOP surplus with deflationary policy.

Un-anchored Bad Money

Before 1978, when an apparently doctrinally foxed International Monetary Fund abandoned both external and specie anchors simultaneously after the Fed closed its gold window triggering the Great Inflation period, Sri Lanka also did not depreciate its currency, analysts have pointed out.

Related Why the IMF is hated now and is backing bad money in Sri Lanka and Latin America

Since it was set up in 1951, the central bank has printed money under various dual anchor conflicting Saltwater-Cambridge ideologies (re-financing rural credit, sterilizing outflows, potential output targeting, yield curve targeting) to create forex shortages and currency crises and started to go the IMF from the mid-1960s.

From 1978, after the IMF’s second amendment to its Articles denied the central bank a credible external and domestic anchor simultaneously, the currency stated to depreciate steeply.

The government was therefore unable to balance its budget and state enterprises were also unable to balance their budgets running large losses whenever the rupee fell and energy prices went up.

After abandoning its external and specie anchor the central bank followed a anchor conflicting regime involving money supply targeting without a floating exchange rate in the 1980s.

The ideology was rejected in toto by Singapore, Malaysia, Hong Kong, Thailand and China.

Since the end of a civil war macro-economists have followed inflation targeting without a floating exchange combined with extreme macro-economic policy to target potential output, eventually driving the country into external default.

Budgets went haywire in the early 1980s as the rupee fell, despite then President JR Jayawardene cutting subsidies and ending price controls (administered prices) two years earlier, in reforms that Singapore’s economic architect and one-time Finance Minister Goh Keng Swee said were “economic reforms which most people had considered politically impossible.”

Goh who set up a currency board in Singapore rejecting Cambridge-Saltwater ideology, warned JR not to destroy the rupee.

“Exchange rate policies involve many complicated technical issues which I do want to discuss here,” he said.

“On balance, the disadvantage of a depreciating rupee will, I believe, outweigh the advantages. Most of the products whose prices are administered are ether wholly imported or contain a high import content. About a quarter of rice consumption is imported.

“All wheat from which four and bread are produced is imported. The same holds true of kerosene and milk powder.

“Bus fares ware largely determined by the rupee price of imported oil and spare parts. Fertilizers are also mostly imported.”

At the time Sri Lanka had hydro-electricity.

Capital Injections

Some of the CEB’s dollar loans were been taken over by the central government after the steepest currency collapse in the history of the central bank in 2022 and external default.

The CEB’s contributed capital as at end March 2024 was 991.4 billion rupees up from 865.1 billion rupees.

With the March quarter profits with some financial engineering involving the asset sale and the government equity injection, the CEB’s group accumulated losses reduced to 456 billion rupees from 575 billion rupees.

The CEB ran large losses as the regulator failed to raise tariffs as macro-economists printed money to target potential output over the past decade.

From 2011 to 2022 the rupee fell from 113 to 370 to the US dollars as the central bank ran un-anchored monetary policy the regulator only raised prices in 2022.

Energy Minister Kanchana Wijesekera said the last price cut was also made possible due to rupee appreciation.

With no potential output targeting (no inflationary open market operations), the country has started to recover from the stability that has been provided up to now amid weak private investment credit.

Sri Lanka’s private credit is now starting to recover.

Based on past trends of using statistics instead of classical economic principles (cutting current current interest rates with inflationary open market operations of a money monopoly based on historical inflation rates under ‘data driven monetary policy’ without regard to domestic credit) analysts have warned of a return to monetary instability under potential output targeting. (Colombo/May19/2024)

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