ECONOMYNEXT – Sri Lanka will face credit downgrades and possible sovereign default of dollar debt unless the highly unstable discretionary ‘flexible exchange rate’ is restrained and some monetary discipline is brought in.
Next year will be a critical year as budget deficits are set to expand and the credit system will also go through a cyclical recovery, leading to an expansion in private credit.
Sri Lanka is a country that had mostly kept monetary stability in the worst years of the war with the help of the ideology then prevailing.
But now each new episode of monetary indiscipline is costing the country one notch in the rating scale.
Sri Lanka will soon run out of rating space to tap capital markets if the flexible exchange rate/call money rate targeting continues in the next recovery space.
2020 Sri Lanka is not 2005
When Sri Lanka got its credit rating from Fitch in 2005 it was BB-. That was two notches below investment grade.
Sri Lanka’s downgrades have generally come in the wake of monetary indiscipline.
In 2008, there were external factors also involved and fuel subsidies and global collapse but monetary policy was for all intents and purposes ‘leaning against the wind’.
All downgrades since then (including 2018) have come amid an economic recovery because balance of payments crises are triggered by interest rate targeting or sterilizing forex interventions with new liquidity or both.
Money printing has worsened in recent years due to a more Keynesian interventionism creeping into the central bank and highly discretionary ‘flexible’ policies being adopted, with the approval of the International Monetary Fund.
If money printing is tracked as the stock of central bank credit to government and liquidity injections to the banking system, it can be seen how monetary instability triggered rating cuts in the past.
This is because rating agencies do not downgrade just because the deficit spikes in a single year.
They may even allow high levels of debt and sit out a period of low growth as long as there are no forex troubles from a soft-peg.
The first downgrade from BB- to B+ was followed by an upgrade in 2011. The upgrade happened just before another BOP crisis was triggered by liquidity injections.
Fitch stayed put during that crisis but S & P cut the outlook to negative. Because the rupee was allowed to appreciate after the previous crisis, many foreign investors also stayed put.
When money was printed in 2015 to flush markets with excess cash from terminated term repo deals and push down rates, and the crisis worsened in 2016, the rating was cut to B+.
Following the experience of the 2012 crisis, where the exchange was kept at 130 to the US dollar without appreciating, foreign investors fled.
When the economy was barely recovering from that crisis in the first quarter of 2018 money was again printed by the central bank to target rates and another crisis was triggered, generating two busts in a row.
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In December 2018, the rating was downgraded to B.
A BB rating is generally called speculative. B is highly speculative.
Barely Above Distress
The next downgrade will take Sri Lanka to B-. Sri Lanka will probably be able to access credit markets even at that rating.
Pakistan, whose central bank also prints money with a peg, and frequently runs to the IMF now has a B- rating.
But B- is barely above CCC.
From two levels below investment grade in 2005, Sri Lanka is now a little above CCC, which is a distressed debt level.
It is not a place to take monetary risks in particular.
The same tricks that were done 10 or 15 years ago cannot be done now.
Sri Lanka Lanka’s foreign debt is now much greater than before.
The numbers are also not certain, because many state enterprises have borrowed directly, and not through on-lending like in earlier years.
Chinese debt have at least built some infrastructure, the sovereign bonds have built nothing much.
There will be a recovery in 2020 as the credit contraction from the 2018 currency crisis ends.
It should be noted that in 2018, the central bank’s monetary indiscipline triggered an economic downturn without any fiscal major fiscal indiscipline.
But 2020 will be like 2015, there will be a spike in spending. Any tax cuts will also dampen a recovery in revenues.
While it brings benefits when income taxes are cut, indirect tax cuts will not help.
There will be a stock market and an economic recovery.
The central bank and others are talking about the need to get down interest rates. That is not re-asssuring.
It is doubtful whether China will give loans like earlier to boost growth as it is having its own troubles. China’s flexible exchange rate is taking a toll, as are state owned enterprises. However China may give debt relief to Sri Lanka.
If rates are cut further and money is printed, the recovery in 2020 will be short-lived or not at all, and another currency crisis will be generated and downgrades will follow.
In 2018, rating agencies were more jittery than usual.
When growth is weak for long periods, there is a tendency for rating agencies to be jittery.
The economic fallout from the 2018 currency crisis in Sri Lanka is similar to that of India’s currency collapse.
The difference between India and South America is that Latin American countries end up in sovereign default due to their exposure to debt markets and weak ratings.
Unlike Argentina, Sri Lanka’s central bank got away with lower inflation due to tight liquidity after the crisis began, at the expense of a small output shock, like the better managed countries during the East Asian crisis.
If there was more excess liquidity, an Indonesia or Argentina style meltdown, may have occurred.
However the advantage was not utilized to appreciate the currency during the credit downturn that came in 2019.
The proposed central bank reforms will not help, as it will be more of the same monetary indiscipline with ‘flexible’ exchange rate and ‘flexible inflation targeting.
Argentina also had ‘flexible’ inflation targeting at an absurdly high double digit rate. What is the point of having a double digit inflation target?
In any case Sri Lanka no longer has the rating space for either monetary indiscipline or fiscal indiscipline.
Dollarization and Golderization
None of the candidates of the 2019 presidential elections have seriously talked about monetary discipline, though there is some understanding about the dangers of currency depreciation.
Note: This column was written and first published before the Presidential Elections.
If there is no serious monetary discipline that brings stability, all talk of economic programs are meaningless.
When countries have chronic monetary indiscipline which leads to depreciation and high nominal rates, economic players dollarize. There may be deposit dollarization (like NRFC), when the currency falls, and liability dollarization (getting dollar loans) whenever there is some stability in the peg.
In South American countries like Argentina most individuals have dollarized to protect themselves from frequent currency crises, even if the government has not officially dollarized the country.
In Vietnam the currency was collapsing so fast until the 1989 central bank reforms that paved the way to economic growth, that people dollarized their salaries and bought gold, which the state bank of Vietnam calls golderization.
Despite 20 years of relative monetary stability people are still at it and the SBV trying to discourage it.
Its neighbor Cambodia is almost fully dollarized, which has given the country stability.
This column is based on ‘The Price Signal by Bellwether‘ published in the November 2019 issue of the Echelon Magazine. 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.