ECONOMYNEXT – Further money printing to finance deficits could lead to monetary instability while trade and private credit could eventually shrink, an International Monetary Fund assessment has warned, as the country reels from tax cuts and liquidity injections made to keep interest rates down.
Sri Lanka had large uncertainties which were tilted to the downside, an IMF public information notice quoting a staff assessment made after annual rticle IV consultations said.
The budget deficit in 2022 was also expected at 10.7 percent of gross domestic product after an 8.9 percent of GDP deficit in 2021.
Sri Lanka has been printing large volumes of money under the so called Modern Monetary Theory (MMT) to keep rates down and finance the deficit. Deficits were also kept large under an anti-austerity ideology.
Money printing however, creates forex shortages as the new money is spent by their recipients (usually state workers and government contractors) and the money ends up as imports.
Former owners of maturing treasury bills which are bought by the central bank and are not rolled over could also end up with printed money as could banks, when reserve sales are sterilised.
Imports soared in 2021 to 20.4 billion US dollars. In January the government announced a billion dollars of handouts including more state salary hikes.
If the budget deficit and money printing (central finance of the deficit) is not contained, the economy could implode with private credit and imports collapsing, the IMF said.
Trade and private credit implosion, monetary instability
“The outlook is subject to large uncertainties with risks tilted to the downside,” an IMF staff assessment said.
“Unless the fiscal and balance-of-payments financing needs are met, the country could experience significant contractions in imports and private credit growth, or monetary instability in case of further central bank financing of fiscal deficits.”
Sri Lanka’s inflation was already at 14.1 percent by January 2021 (risen to 15.1 percent by February after the report).
Parallel exchange rates were around 248 rupees, significantly above the 200 to the US dollar official exchange rate which is undermined by the policy rate.
The policy rate 6.5 percent was far below inflation, which had risen to 15.1 percent since the IMF’s staff report which went to its Executive Directors on February 25.
Sri Lanka’s government debt including treasury guarantees and foreign debt of the central bank had risen to 118.9 percent by end 2021 from 110 percent a year earlier, and 94 percent in 2019, when tax cuts and money printing began.
“Under current policies and the authorities’ commitment to preserve the tax cuts, fiscal deficit is projected to remain large over 2022–26, raising public debt further over the medium term,” the assessment said.
Public debt was unsustainable, and a credible economic programme was needed to address the problem, the IMF said. Unsustainable debt usually also requires debt re-structuring.
Sterilised forex sales
Money is being printed over the past quarter to offset the impact of reserve sales for imports (to sterilise interventions) effectively financing the private banks, with treasury bill auctions mostly successful after price controls on bond auctions were ended.
Sri Lanka has a Latin America style central bank with extensive powers to print money to finance the government, or private sector through re-finance schemes and also open market operations to sterilise reserve sales for imports or any other purpose.
Though forex reserves sales for imports should contract reserve money, push short term rates up, stabilising the exchange rate, the central bank’s commitment to a 6.5 percent policy rate was making it print money to sterilise interventions re-expanding reserve money.
In a quasi-fiscal activity, the central bank was also providing subsidies to remittances amounting to at least 8 rupees per US dollar, further undermining its ability to control reserve money.
The central bank was also engaging in a quasi-fiscal activity giving a premium for foreign remittances coming through the official banking system after parallel exchange rates were triggered by money printing and exchange controls.
Sri Lanka also faced risks of rising bad loans, rising commodity prices, bad harvests, or a COVID-19 spike though the government has taken effective action on that front.
Sri Lanka could grow 2.6 percent in 2022, the IMF said.
The IMF does not usually project what are called ‘disaster scenarios’ but gives advice on how it can be avoided, analysts familiar with the agency’s practices said.
Money printing, taxes
IMF executive directors urged Sri Lanka to stop printing money, hike interest rates and raise taxes and cut spending.
“Directors agreed that a tighter monetary policy stance is needed to contain rising inflationary pressures, while phasing out the central bank’s direct financing of budget deficits,” an Executive Directors assessment said.
“Directors emphasised the need for an ambitious fiscal consolidation that is based on high-quality revenue measures.
“Noting Sri Lanka’s low tax-to-GDP ratio, they saw scope for raising income tax and VAT rates and minimising exemptions, complemented with revenue administration reform.
“Directors encouraged continued improvements to expenditure rationalisation, budget formulation and execution, and the fiscal rule.
“They also encouraged the authorities to reform state-owned enterprises and adopt cost-recovery energy pricing.” (Colombo/Mar04/2022)