Sri Lanka in stagflation after flexible exchange rate collapse

ECONOMNEXT – Sri Lanka is going through a period of stagflation involving low growth and higher inflation for the second time in less than five years after the repeated collapses of a highly unstable soft-peg called the ‘flexible exchange rate’.

Sri Lanka ran into a balance of payments crisis in 2015 as rates were cut and tens of billions of rupees tied up in term repo deals with the central banks was dumped into the banking system to keep rates down, on the argument that inflation was low.

At the time the credit system was recovering from a 2012 balance of payments crisis which was followed by a period of monetary discipline. The liquidity releases had however begun by the fourth quarter of 2014, data show.

By the time the crisis ended the rupee had fallen from 131 to 150 to the US dollar. During 2017, there was no monetary indiscipline, the credit system stabilized, but inflation spiked as the prices adjusted to lagged effects of the previous collapse.

The rupee was weakened to 153 to the US dollar apparently to target a Real Effective Exchange Rate Index, though private credit was wake and money and exchange policies were not in conflict.

Base money injections made through a strong side convertibility of a peg (dollar purchase) were mopped up by sell-downs of central bank held securities during the period, keeping the exchange rate strong.

In 2018, the economy and credit system was starting to recover and inflation was just starting to go down when the central bank again injected large volumes of liquidity through multiple liquidity windows to generate another run on the rupee.

Rates were cut despite inflation being relatively high.

Analysts had warned that an inflation ceiling of 7.8 percent set under a deal with the International Monetary Fund was too high and would lead to instability and stagflation.

Argentina’s central bank – which also pegs – had set itself a 17 percent inflation target before the most recent currency collapse.

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Base money was also injected through unsterilized dollar purchases and rupee dollar swaps in 2018, of a style used by speculators to generate liquidity and attack pegs during the East Asian crises, to target a call money rate and enforce a rate cut.

In the 2018 crisis, where confidence was worsened by a political crisis in October the rupee fell from 153 to 182 to the US dollar.

Sri Lanka has to operate a peg to build a forex reserve buffer, but there has been no ceiling on central bank domestic assets to halt monetary indiscipline.

Sri Lanka is now targeting a ‘flexible exchange rate’ (external anchor) while building a forex reserve buffer, while also operating a ‘flexible; inflation targeting arrangement (targeting a wide domestic anchor).

Rates may have been cut and liquidity injected, despite higher inflation to target a gap between actual and ‘potential’ output with printed money.

Developed nations also went through a period of stagflation in the 1970s when the Bretton Woods system of soft-peg broke and there were no rules to discipline central banks, without a peg to gold.

Floating rate central banks eventually came up with an inflation rule and no pegging.

In Sri Lanka growth fell to 1.6 percent in the June quarter, partly due to attacks on hotels on Easter Sunday. In October inflation had topped 5 percent.

Rates were cut in 2019 despite higher inflation and liquidity was injected to depress the call money rates, weakening the rupee.

Analysts have pointed out that the rupee slides whenever liquidity shocks are given despite generally weaker credit, because of skewed convertibility undertakings.

When the rupee comes under pressure from excess liquidity the central bank waits until ‘disorderly fall’ before deploying a weak-side convertibility undertaking to defend the peg.

Even after the undertaking is deployed, liquidity is injected instantly to stop overnight rates from moving up to stabilize the currency.

However there is no similar strong side convertibility undertaking to wait until a ‘disorderly’ appreciation has taken place to buy dollars and inject base money.

Large volumes of dollar are bought specially from the Treasury to inject base money at market rates.  Such purchases are also made in the throes of a currency crisis. (Colombo/Nov04/2019-SB)