ECONOMYNEXT – There are pronouncements that Sri Lanka is like Greece from both sides of the political divide, but that is not correct. Sri Lanka has a Latin America style soft-peg which can put the country on a dangerous slippery slope unlike a strong floating rate like the Euro.
Greece had a debt rollover problem like Sri Lanka and went into sovereign default. There was no problem with the currency or private debt default or disappearing incomes.
The central bank has put Sri Lanka in a Latin America style strait-jacket. Sri Lanka escaped the worst LatAm effects up to now, because there was no large commercial debt. But from 2005, after Sri Lanka started tapping international bond markets everything changed.
What is Greece?
Greece had a monetary union with a strong floating exchange rate, which was the Euro. When it came to light that the Greece had been fudging debt numbers, amid an economic downturn, lenders refused to roll-over debt and there was sovereign default.
But the currency did not fall. There was no destruction of salaries. Though some people lost jobs in the overall downturn, their deposits in banks that did not fail were intact.
There was no explosion in inflation because Greece had the Euro. To understand what that means, imagine that everyone in Sri Lanka get dollar salaries, have dollar bank deposits and paid taxes in dollars. The government could use the ‘dollar’ taxes to pay salaries and also repay bonds to foreign or local lenders.
When the economy contracted and tax revenues fell, Greece had to employ ‘state austerity’.
That is to cut state sector salaries, and raise taxes of people with higher incomes. This is like a Sri Lanka state worker having a dollar salary, losing 5 or 10 percent and then the richer people paying higher taxes or everyone paying some taxes if value added tax is raised. Even if VAT was raised from 15 to 20 percent, people will only lose 5 percent of their salary.
Under Euro a local company can still repay foreign loans. They can also borrow domestically or use their bank deposits to repay foreign loans. There is no problem with importing goods as the Euro is accepted abroad.
The prices of fuel or electricity did not go up steeply. They were same as any stable country in the Euro area like Germany or France. As there was no explosion in inflation the value of bank deposits were intact. While there is sovereign default and possible hair cuts on state debt there is no private default or haircut.
But a falling currency imposes a hair cut on all state and private debt including bank deposits in solvent banks. Pensions are made worthless hitting old people the hardest.
A collapsing soft-pegged currency will put all citizens other than the very rich, in severe difficulties unlike a strong floating exchange rate like the Euro.
Three sins and a currency collapse
In a soft-pegged monetary regime like in Sri Lanka, the currency continues to fall each time the central bank intervenes in forex markets and then prints money to keep interest rates down.
As long as the currency is not floated, there is no end in sight for exchange rate depreciation, especially if interest rates are not raised and credit does not slow. What usually happens in Sri Lanka and other soft-pegs is that in the end rates have to be hiked and the currency floated. This is the phenomenon been referred to as ‘rawulath ne kendeth ne’ in this column.
When inflows are steadily mopped up at market interest rates (the rate required for banks to buy securities from the central bank), the peg is strong as there is a virtuous cycle.
Sri Lanka’s central bank failed to mop up inflows in February 2018, losing its grip on the peg in the first major sin committed.
It will be interesting to find out how the monetary board gave approval for domestic operations to halt term repo mopping up, after a series of auctions failed.
And the central bank then printed money in April cutting rates to de-stabilize the peg further.
In August after the currency stabilized, liquidity was allowed to build up for a second time (including through Soros style swaps) pushing the currency down. This was the third great sin.
In September more liquidity was injected after a 2013 swap matured. The 2013 swap involved taking on a quasi-fiscal risk in the style of the once-bankrupted Philippines soft-pegged central bank.
Since then forex sales have been sterilized with more new money, generating a vicious cycle of interventions. Interventions may be direct with banks in forex markets or under-the-counter to accommodate capital flight.
The statutory reserve ratio cut in November has injected zero interest money.
Now interventions are steadily filled with newly created money in a vicious cycle of sterilized forex sales, triggering more credit, imports. The newly minted money helps speed up capital flight by keeping rates low.
When a currency is floated, this cycle of sterilized intervention is broken.
After the political crisis, there is very little confidence in the market.
The central bank must also take responsibility for targeting a Real Effective Exchange Rate without having the tool (floating interest rates) to target an exchange rate.
Soft-pegs are a horrific slippery slope, not like Greece
Latin America has soft pegs and central banks which inject money in multiple ways through different windows and tenors like in Sri Lanka, which is one of the most dangerous monetary regimes in the world.
Sri Lanka’s central bank not only injects money overnight, but also through longer-term reverse repo deals at overnight rates during currency pressure. This is not an official crime in Sri Lanka.
The central bank also injects overnight money below the ceiling rate despite currency pressure. This is not listed as a crime against the nation in the penal code.
The central bank also buys Treasury bills at auctions to inject money during currency pressure. Mercifully in the current episode it has been minimal. This is not listed as a crime either.
All these actions have to be re-examined in detail prevent economic collapses in the future.
In Latin America – unlike Greece – when the currency falls steeply, prices go up, and people ‘s living standards melt as most of the money goes to food and medicines. This makes the many businesses fail as demand collapses.
Then banks have bad loans and suffer losses.
Unlike in Greece, the government of a soft-pegged country cannot raise money from domestic markets and repay foreign loans even at prohibitive interest rates. The government may default. Downgrades will compound the problem, pushing interest rates up.
As prices move up with currency depreciation the value of bank deposits evaporates. If the currency falls by 50 percent, local companies will now have to borrow more to repay foreign loans, making massive holes in their balance sheets even if forex was available to buy.
If exchange controls come, there will be no dollars to buy with the domestic money they have borrowed.
It is not possible to import goods freely when a soft-peg collapses because there will be forex shortages due to sterilized intervention. Import controls may also come.
As the cost of fuel or electricity goes up (oil prices are now falling and there is rain in Sri Lanka) if prices are not raised, more money will be printed to subsidize energy, pushing the currency down.
In Latin America, energy price controls have led to money printing and rationing. There can be power cuts and fuel shortages.
In Sri Lanka because of price controls of the National Medicines Regulatory Authority medicines, drugs can go off the shelves.
In Latin American soft-pegs many price controls were imposed. Instantly goods go off the shelves and black markets appear.
With import controls more businesses will fail. People will be laid off as revenues fall. Banks will make more losses. Rates will rise eventually. More businesses can fail.
If this situation continues for several months, there may be runs on banks. If money is printed to bail them out, the currency falls even more. This phenomenon was seen in many Latin American soft-pegs and also Indonesia during the East Asian crisis.
Debt to GDP will explode until inflation catches up. The share of foreign debt will also increase.
This is what happens in Latin America. It is not Greece.
The Banker Magazine prophetically said this in an opinion piece on Ceylon’s planned central bank in July 1950.
“This law had been drawn up under American tutelage and along the lines that have been the subject of experiment in certain Latin American countries for some eight years past.
“The step from an ‘automatic’ currency system (such as that which Ceylon inherited with its old Colonial Currency Board) to an ultra-modern "managed" currency system is necessarily fraught with great dangers and there may be some who will regret that Ceylon has decided to run such risks at this time.”
Ricardo and Soft-peggers
A floating rate central bank does not print large volumes of money like a soft-peg engaged in sterilized forex sales. Interventions contract the reserve money (the quantity of domestic money in the banking banking system) and with the public.
The central bank then prints money (sterilizes) to stop the reserve money from contracting (and interest rates from rising). In a float reserve money is not contracted in the first place.
That is why a float stops a balance of payments crisis by breaking a cycle of sterilized intervention of the currency. Floating stops the interventions and resulting liquidity shortages which are then filled by printed money to keep the policy rate and the size of the reserve money.
The central bank made a statement recently directly challenging the wisdom of classical economists like David Ricardo saying it was printing money not to finance the government but to maintain reserve money (the circulating medium).
To maintain reserve money the central bank is re-issuing rupee notes it took back when selling dollars in the forex market via ‘open market operations’ or reverse repo deals.
Let’s compare David Ricardo and the Central Bank of Sri Lanka.
Sri Lanka Central Bank in 2018: Reserve Money, which was at Rs. 939.8 billion at end 2017 and at Rs. 1,010.5 billion at end September 2018, was recorded at Rs. 1,020.8 billion on 2 November 2018. This is a year-on-year growth in Reserve Money of 11.6 per cent, which is well within the CBSL projections for the year.
Meanwhile, rupee liquidity in the domestic money market has been in deficit since mid- September 2018, requiring the CBSL to conduct open market operations (OMOs) to provide adequate liquidity to the market, in addition to allowing market participants access to standing facilities at policy interest rates.
In view of the large and long term shortages of liquidity in the market, the CBSL conducted longer term reverse repurchase auctions and made outright purchases of Government securities mainly from the secondary market.
David Ricardo in the early 19th century warned the Bank of England which had a peg with Gold (not the US dollar like Sri Lanka’s central bank) against this very same printing of money to maintain reserve money, when it ran into a balance of payments crisis.
David Ricardo 1810: “;[I]f 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 year, or for any other reason (CBSL said an 11.6 percent growth of reserve money was within its target), 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; gold would be again demanded, the exchange would become unfavourable.”
It seems Sri Lanka has learned nothing in the past 218 years. It is important to note that neither has Latin America.
Fear of Floating
Currencies slide under soft-pegged arrangements because the Governor of the soft-pegged central bank and other officials are too scared to float. This is a well-known phenomenon known as ‘fear of floating’.
Sri Lanka’s program with the International Monetary Fund advocated the same mistakes that led to the collapse of the Bretton Woods: cutting rates and printing money because inflation or growth seems low.
There were no public calls by the IMF to allow rates to go up in the first quarter 2018, despite having a program to collect forex reserves.
There was also no caution against REER targeting despite clear evidence that Sri Lanka did not have floating interest rates to target any kind of exchange rate whatsoever. To target any exchange rate, interest rates have to float (a currency board or modified currency board like Singapore).
In contrast to Sri Lanka, the IMF team that went to Argentina or one person in the team to do the first review seems to have taken a good hard look at the Banco Central de la República Argentina after its program failed to stop the slide of the Peso in the first three months.
Argentina raised policy rates to 60 percent and the Reserve Ratio by 5 percent to halt the slide.
Note that Sri Lanka cut its reserve ratio recently accelerating the slide of the rupee.
There is no accountability for this type of action. Cutting the SRR amid a balance of payment crisis is not a crime that is in Sri Lanka’s statute books either.
The IMF team found that there was no rhyme or reason for interventions.
The IMF team immediately dumped the ‘inflation targeting’ program Argentina’s central bank followed despite having a pegged exchange rate, forced a float, put a brick wall of 15 percent a day to stop interventions and then prohibited sterilization of any interventions that were done.
The IMF team explained their strategy as follows: "Adopting a simpler, stronger, and verifiable monetary policy framework that decisively lowers inflation and inflation expectations. To this end, the inflation targeting framework has been replaced by a monthly target on the growth of base money.
"Allowing the exchange rate to float freely. The authorities will undertake rules-based FX intervention only in limited, pre-specified circumstances to prevent a significant overshooting of the peso.
"All such FX intervention, if it occurs, will be unsterilized."
Severe restrictions were placed on the interventions. Interventions were allowed after a 15 percent fluctuation. The IMF committed the central bank to a zero reserve money target and matched it to any interventions like a currency board.
"Specifically, the central bank is committed to undertaking no FX purchases or sales within a wide, non-intervention zone" (of AR$39 per US$ ± 15 percent).
"In the event the currency were to move outside of this zone, the BCRA would have the option (but not a commitment) to announce a competitive auction to either buy or sell up to US$150 million per day.
"The central bank is committed to ensuring that all FX purchases/sales are unsterilized, which would result in an expansion/contraction of base money (i.e. base money would grow at a faster/slower rate than the announced monthly targets)."
The IMF closed multiple liquidity windows and a commitment to create a secondary market by BCRA for its own securities, which was one of the worst windows.
The Peso soft peg was first floated. Then the interest rate was also floated, Singapore style.
The peso appeared to have been first floated in August when it plunged from 31 to 38 to the US dollar after kicking up rates to 60 percent.
The IMF made an emergency disbursement, indicating that this seems to have been a prior action.
But the Peso continued to slide to 41. Then the lid was taken off the 7 -day policy (Leliq) rate to keep interventions unsterilized as described above in currency board style.
The peso then floated back to 35 and was now around 36 by late November.
In early December the 60 percent policy rate may be cut as market rates are now falling. (This column was written in late November 2018)
In Sri Lanka the rupee can fall after a float because of under-the-counter dollar sales to foreign investors or to the CPC.
Sri Lanka had reserves of 7.2 billion dollars by mid November according to the central bank. In the last two months, about 300 million dollars a month were lost in interventions to liquidity injections. (This column was written before the December dollar reserve fall)
In any bad situation the rupee can be floated. The rupee will end somewhere. If rates are hiked before a float, the fall will be less.
The sooner the rupee is floated the less reserves are lost.
Over the last week of November there have been signs that the interventions have reduced and the rupee may be floating. Whether this is temporary or the central bank has the courage to hold back from correcting a ‘disorderly adjustment’ remains to be seen.
Rates that are hiked to support a float can always be brought down after a currency settles within weeks if necessary like in Argentina.
However it is unlikely a float will hold with an unstable administration. As soon as there is a stable administration Sri Lanka should hike rates and float the currency to stop sterilization. Rates can be cut after the rupee settles like in Argentina, within weeks if necessary.
Like in previous BOP crisis or IMF programs, this float will not stop Sri Lanka’s troubles.
After building up reserves for two years the central bank will say inflation is down or there is an output gap, and it will cut rates, print money and plunge the country into another debacle, just like it did in the first quarter of 2015 and the first quarter of 2018.
Sri Lanka can reform the peg into a hard one or float.
But Sri Lanka can also dollarize and stop the central bank’s ability to de-stabilize the lives of the people of this country forever.
By using 5.5 billion dollars the reserve money can be dollarized at 185 to the US dollar (5 billion and 200 rupees) and use the rest of the rest of the reserves to repay urgent loans and set up a liquidity facility.
That will end depreciation forever. Sri Lanka can have free trade, import cars, and not worry about gold smugglers making profits by hand carrying foreign currency from India.
If more reserves are lost, it will not be possible to dollarize at these levels.
Another option is to set up a currency board after a successful float.
By collecting seigniorage profits, a bank bailout fund or even a sovereign wealth fund can be built for counter-cyclical stimulus like in Hong Kong.
Either of these moves will help Sri Lanka escape the Latin American path that the country embarked on in 1951.
This column is based on ‘The Price Signal by Bellwether‘ published in the December 2018 issue of the Echelon Magazine. It was written in the last week of Novermber before the end of the political crisis and before the data on 500 million of interventions in November was publicly available. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.
To contact the author BellwetherECN@gmail.com