Sri Lanka on a risky pro-cyclical path as credit expands: Bellwether
COLOMBO (EconomyNext) – Sri Lanka’s latest policy rate cut came when the currency was under pressure, when foreign reserves were falling and when the state ratcheted up spending with higher salaries for the public sector and subsidies to others.
The Central Bank’s pro-cyclical loose policy, on top of loose fiscal policy has come not only as a rates cut but a progressive release of liquidity to the market.
The lowering of the policy rate corridor 8.00 and 6.50 percent to 6.00 and 7.50 percent in April, came two months after a 5.0 percent discount window was removed on February 27, outside the normal monetary policy announcement on the same day as a controversial bond auction sent market rates rocketing up.
Though the fiscal costs rose, the increase in gilt rates in March would have helped stabilize the economy and take the country away from the dangerously pro-cyclical path it entered with a revised budget on January 29.
It is true that inflation is low, due to a combination of private de-leveraging after the last balance of payments crisis in 2011/2012 and global deflationary conditions as the dollar strengthened, sending commodity prices down. But Sri Lanka has a pegged exchange rate.
Therefore targeting a domestic anchor, in the form of a consumer price index, is a serious mistake, which has been made before.
When the finance minister and others are saying that the exchange rate will be kept stable, Sri Lanka is de facto targeting an external anchor not a domestic inflation anchor in word as well as in deed. Any country that accumulates large volumes of reserves (or loses them as Sri Lanka is now doing) is targeting an external anchor in deed.
The build-up of excess liquidity up to August, as the banking system de-leveraged, and the Central Bank bought dollars shows that Sri Lanka has a pegged exchange rate monetary regime, automatically targeting an external anchor.
It makes no sense to target a domestic anchor in the form of a consumer price index, when for all practical purposes, central banking operations are directed towards targeting an external anchor.
Sri Lanka is now tightly pegged to the US dollar at around 132.90 rupees, so-called moral suasion driven unofficial spot rate in the country. Even forward trades under control. One might argue that if an external anchor is targeted, domestic rates cuts do not matter and as long as excess liquidity is present, rates can be near zero.
The problem with that argument is two-fold. The first is that Sri Lanka is used to high interest rates and therefore firms are less leveraged than in the US for example, and they will go get into trouble faster when rates are at historic lows.
Australia for example ticks along with policy rates that brings the US to its knees and avoids the type of crash the US got into. Contrary examples are Portugal, Italy, Greece and Spain or PIGS countries. PIGS countries, which had higher inflation and higher interest rates driven by high state spending, suddenly went on an unsustainable credit boom when rates came down to German levels with Euro integration, resulting in a big collapse.
The other reason is that even before the inflationary credit bubble builds up, in a country with an external anchor, balance of payments troubles will start due to the attempt to target dual anchors.
This is because the Central Bank tries to control interest rate after de-leveraging ends, effectively targeting dual anchors. Dual anchor systems or soft-pegged regimes are prone to both high inflation and balance of payments crises.
Sri Lanka no longer has high inflation and has moved away from rubbing shoulders with Venezuela and Iran generating 20 to 30 percent inflation. Venezuela’s last released inflation was 69 percent in December and no data has been released this year.
While the Central Bank of Sri Lanka deserves credit for generating lower inflation than Venezuela unlike in the past, it remains a BOP Crisis Bank.
As a ‘BOP crisis Central Bank’ it can be counted on to make the wrong moves at crucial times like rate cuts. If it was not Sri Lanka would be like Singapore or some such country. In 2011 for example it cut rates from 9.00 to 8.5 percent. Now rates and the reserve ratio is much lower than at the start of the 2011 crisis.
The Central Bank made another mistake during this credit cycle it had not made before. In the last credit cycle, the Central Bank sterilized almost all excess liquidity permanently and left about 60 billion rupees of liquidity unsterilized. This time the partially sterilized excess liquidity rose to over 350 billion rupees by August 2014.
In November when this columnist warned that ‘Sri Lanka May Lose Forex Reserve Beauty Contest amid Ultra Low Interest Rates’, the Central Bank still had over 8 billion US dollars of reserves. Right now liquidity in the overnight window is over 100 billion rupees, having lost about 2.0 billion US dollars of reserves as forecast.
In terms of market rates, policy rates, reserve ratio and excess liquidity management, Sri Lanka is in unknown territory now.
The original liquidity build-up (in tandem with forex reserves) is a type of private sector sterilization that accompanies a burst credit bubble.
Most people save a part of their incomes. But when bank credit is active, what one person saves is spent by borrowers. In a pegged regime like Sri Lanka excess liquidity or base money is created when dollar inflows come in but are not fully spent.
The cycle started to turn in August. From August private credit started to pick up. Shortly after, state credit also started to pick up.
The CREDIT CYCLE graph shows a composite of all credit from commercial banks made up of private, state and state owned enterprises. Total credit was either negative or around 20 billion rupees a month up to August, allowing the Central Bank to build foreign reserves.
Until that time the Central Bank was collecting about 200 million US dollars a month from the interbank market, not counting any capital inflows to the government. The direction of total forex reserves would show such movements as well as transactions with the International Monetary Fund.
In September 2014, total credit from the banking system rose to 104.8 billion rupees, from 18.7 billion in August.
Up to December, private credit remained around 40 – 50 billion rupees, and the rest came from SOE’s and the Central government. After January, from what can be called the post-election shock, private credit halved to around 25 billion rupees in the first two months of the year. The slack however was more than made up by state credit.
Total credit was 94.9 billion rupees in October, 108 billion in November, 102 billion in December and 165 billion rupees in January, with a 500 million dollar repayment of a dollar bond pushing up Central Bank credit as forex reserves were appropriated and 124 billion rupees in February. The credit spike is seen in the red bars.
These credit levels of 100 billion rupees are BOP crisis level volumes seen in late 2011 and early 2012.Before the 2011/2012 crisis, the banking system was disbursing about 50 billion rupees a month of total credit without much problem at a time when foreign borrowings were also strong. Then it ratcheted up to 90 and 100 billion levels with sterilized forex sales injecting cash and generating a BOP crisis.
In that crisis, most of the credit increase was hitting the BOP directly because they were import credits for oil, given to finance energy subsidies. This time not all of the credit increase is hitting the BOP.
Domestic credit taken to finance foreign loan repayments are hitting the BOP directly and part of the domestic credit is also hitting the external sector. From September 2014 the Central Bank was no longer able to buy dollars from forex markets.
Up to August, the central bank was collecting about 150 to 200 million US dollars from the interbank markets a month. But from September it had to sell about 100 to 200 million US dollars to the market to maintain the de facto peg. (See green bars, which go below the axis).
The central bank has been progressively releasing excess liquidity by not renewing term reverse repo transactions, allowing cash to be used up in state and private credit, which is then hitting the BOP and reducing liquidity and forex reserves. There is nothing wrong with selling dollars and mopping up the excess liquidity through unsterilized sales. That is normal with a hard pegged system.
But the problem is we are not a hard pegged system. We have a bastardized, dual anchor, soft-pegged system, which has zero credibility, and with no guarantees that rates will go up when excess liquidity goes down.
At that time the Central Bank in the past has sterilized forex sales and pushed the country into a fully-fledged balance of payments crisis.
Exporters cottoned onto the problem early, hence the drama with the moral suasion, lack of spot trading and increasing controls on forward trades as well, showing the problem with credibility.
Up to now foreign investors have not been taking much action. Past episodes show that rating agencies and foreign bond investors take time to understand the problem, giving enough time for corrective action.
With foreign investors in debt markets, it is not possible to take the same fiscal risks as the 1980s or 1990s and get away with it. It is also not possible to take the same monetary risks either. Credibility of the peg and policy in general now matters more than it did before.
Gradually rising interest rates does not mean the credit cycle ends. Gradually rising interest rates allows consumption to be curbed and more deposits to be raised to finance higher levels of credit at a market clearing interest rate.
If rates are low, on the other hand, there will be more consumption and more demand for credit and there will not be enough deposits raised for loans.
When a pro-cyclical rate cut is made, (which is what most central banks driven by Keynesian doctrine do), the credit cycle will hit the BOP earlier and the inevitable correction will be a sudden jerk on the reins triggering a hard landing.
The current administration is relying on Central Bank swaps to boost reserves and buy time. But that does not solve the fundamental problem in the credit system.
There are also other problems in Sri Lanka that are not found in other countries, including forex cover given to private banks, which will also come to roost if credibility is lost and investors are reluctant to roll-over debt. It may be difficult to make fiscal reforms without a parliamentary majority, even if there was a resolve to correct the spending bill.
State revenue increases can solve part of the problem. With rising imports and plugging ethanol leaks, there will be a recovery in revenues. But with a second salary hike and other goodies due in June, whether revenue gains made in 2015 will help is a moot question.
But raising rates is not a politically difficult move. In fact many people will be happy to get higher interest rate for deposits. Higher lending rates can also curb a property bubble and mal-investment. The state interest bill will go up widening the deficit.
That is a cost of high living of the rulers. Already due to the 30-year bond scam, unnecessary high rates have been paid for longer tenure bonds, but with the rate cut, its beneficial effects on the economy will be wiped out.
Prime Minister Ranil Wickramasinghe has said that raising spending and giving salary increments will give a boost to the economy, repeating the standard Keynesian doctrine.
If state spending is financed purely by taxes, growth will be neutral, as somebody’s money in the private sector will be forcibly taken and given to the state sector, assuming the money is used as productively as a private citizen would. If the spending is financed by excess liquidity, or actual printed money (central bank credit) expect foreign reserves to go down, though ‘growth’ will go up.
Keynesianism is a false doctrine. If at all it can be applied when the credit system is de-leveraging and liquidity is building up due to voluntary private sector sterilization. It cannot be applied when the credit system is active.
A Keynesian system assumes autarky. But countries are not autarkies. They engage in international trade. That is why countries that engage in Keynesian stimulus get into deep trouble. There is a pithy Sinhala phrase called ‘Homben Yanawa’ that puts the consequences of Keynesian policy neatly into perspective.
Singapore’s first independent Finance Minister, the late Goh Keng Swee put the problem in more technical terms.
"The Keynesian system is a closed one, that is, it takes no account of foreign trade," he said in a speech explaining why Singapore retained a Currency Board instead of setting up a monetary printing Central Bank like other newly-independent countries that rapidly descended into high inflation, currency depreciation and ‘third world’ poverty.
"This is admissible in theory, but in practice, since all modern states engage in foreign trade, a Keynesian stimulus will lead eventually to balance of payments deficits if government do not exercise restraint in time. A part of the increased incomes people receive will be spent on imports and when exports do not increase in proportion a trade deficit will occur.
"None of us believed that Keynesian economic policies could serve as Singapore’s guide to economic well-being. Our economy was and is both small and open. Financing budget deficits through Central Bank credit creation appeared to us as an invitation to disaster."
There was no effective way of exchange control in an open trading economy like ours to deal with the inevitable balance of payments troubles."
When large volumes of money is released to the economy in a short time, there cannot be an instant supply response, so imports come to fill the gap.
What the Central Bank is now doing, by not renewing term-repurchase deals, may not look like printing money, because it has foreign reserves to back the liquidity it is releasing to the market.
But for all practical purposes the Central Bank is taking on Treasury bills to its balance sheet and generating money to fire credit, ‘quantity easing’ style, in a pegged exchange rate system. It is on top of all this, that rates have been cut.
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CORRECTIONS: Credit Cycle colour codes corrected. Net forex sales to banking system in red.
This column is based on ‘The Price Signal by Bellwether‘ published in the May 2015 issue of the Echelon Magazine. The column was written before a rate cut further loosened monetary policy last week. 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.