ECONOMYNEXT – A decision by Sri Lanka’s central bank to intervene in foreign exchange market and keep printing money to keep interest rates makes no economic sense and such policies will have to be given up sooner or later, a top economist has warned.
"To keep low interest rates, it has to keep on printing more money but it would threaten future price stability," W A Wijewardene a top economist and a former Deputy Central Bank Governor wrote in Sri Lanka’s Daily FT Newspaper.
"To defend the exchange rate, it has to keep on intervening in the market by losing its foreign exchange reserves.
"Sooner or later, like in Thailand in 1997, the Board will come to a situation where it no longer has foreign exchange to support the exchange rate. At that stage, it is inevitable that the rupee will have a free-fall."
When foreign exchange interventions are sterilized with newly created domestic money, monetary and exchange rates are contradictory. A float is needed to correct it.
Pre-Obituary Notice
The monetary board in its March statement has kept policy rates unchanged despite the exchange rate coming under pressure, core inflation rising, foreign reserves falling and domestic credit rising.
"The monetary policy review of March 2016, issued on behalf of the Monetary Board, is a confusing statement that does not stand with any economic logic," Wijewardene said.
"The review is like a ‘pre-obituary notice’ heralding the continuing deterioration of all macroeconomic indicators.
In January credit to the private business was up 25.7 percent from a year earlier and credit to state was up 19.9 percent.
"The review has presented a picture of worsening money supply and credit growth in the recent past," Wijewardene noted.
"But, the Board has expressed the expectation that the market will correct the situation by itself in the period to come. This is where the Monetary Board has failed.
"It is like a physician, having noted that the condition of the patient has worsened on all counts, refraining himself from administering the needed medication expecting a paranormal power to cure the patient.
"Despite the alarming macroeconomic picture, the Board has chosen to keep its main interest rates and the statutory reserve ratio unchanged from the previous month. This decision of the Board does not go with the accepted economic laws."
Other analysts have also noted that the central bank for most of the past year has resisted market rises in interest rates.
Now with liquidity being mopped up with foreign exchange sales banks are borrowing from its 8.0 percent window and using it to give loans or buy Treasuries, worsening the foreign exchange problem.
Arbitrage
Market participants are also getting printed money at 8.0 percent from the central bank’s discount window and using it to buy Treasuries or give loans in an arbitraging process.
"Arbitraging by itself is not a bad practice," Wijewardene said. "It allows markets to eliminate shortages in some markets by moving goods from markets with surpluses.
"Therefore, it is an accepted process for markets to reach their equilibrium – a condition without shortages or surpluses.
"However, the arbitraging opportunities created by the Monetary Board by keeping interest rates low when the markets aspire to have high market clearing rates will result in a continuation of the market disequilibrium.
"The Central Bank will have to pump money continuously to the market without ever reaching the equilibrium level.
"In the process, it gives wrong signals to banks that they could make profits out of Monetary Board’s anomalous monetary policy without lending to customers.
"These low interest rate regimes have unintended repercussions for sustained economic growth, exchange rate stability and future inflation."
Some primary dealers – who also have access to the discount window – have bought Treasuries at 14.5 percent.
On Monday overnight borrowings from discount operations rose to 65 billion rupees from 20 billion rupees before the auction.
Bond Games
Long term yields have also plummeted giving large profits to primary dealers who bought bonds less than a week ago and low prices (high yields).
"This transaction with sudden declines in rates, it appears, is suggestive of another Treasury bond scam now rubbing on the face of the Monetary Board," Wijewardene warned.
"The experiences in other countries show that, even after many years, such scandalous transactions can be reopened for public scrutiny.
"This makes it necessary for Board members to exercise utmost due diligence when assessing such transactions."