ECONOMYNEXT – Sri Lanka’s central bank did not contract the economy by hiking rates, but prevented a further contraction and possible hyper inflation by stabilizing the external sector with high rates, Governor Nandalal Weerasinghe said.

“By tightening monetary policy, we minimized the damage,” Governor Weerasinghe told an economic forum organized by the Ceylon Chamber of Commerce.

“If we did not implement tight monetary policy and raising interest rates, we could have had a double-digit contraction and 100 percent inflation or hyperinflation.”

A modern central bank destroys growth or trigger output shocks generally with stimulus where banks are encouraged to give credit with money injected through open market operations to\ mis-target a policy rate and not real deposits.

In a soft-pegged or flexible exchange rate central bank which is not a clean float, such injections also trigger forex shortages long before the results of such inflationary policy shows up in consumer price indices.

Sri Lanka suppressed rates for two years by printing large volumes of money before Governor Weerasinghe took office in2023.

Sri Lanka’s economy is expected to contract around 7-8 percent in 2022.

Economic activity was coming to stop in many areas due to forex shortages before rates were hiked and there were already import controls in place before April 2022. As fuel shortages hit the economy, tourists avoided the country.

Banks stopped opening letters of credit and food imports were in jeopardy despite the country earning over 1.7 billion dollars a month through exports and remittances.

Once confidence has been lost in the currency, a steep credit slowdown is required to stabilize the external sector.

Reserve currency central banks like the Fed which also printed money for employment, and created supply chain shocks and commodity bubbles are now tightening to put the brakes on inflation which is showing up in indices.

The Fed invented aggressive open market operations in the 1920s shortly in the course of triggering roaring 20s bubble which ended in the Great Depression.

The Fed’s policy rate and open market operations also killed the Bretton Woods system of soft-pegs and the gold standard in 1971-3.

Sri Lanka printed money – despite having a reserve collecting central bank – for stimulus (push growth), after the International Monetary Fund gave the country technical assistance to calculate an output gap.

Attempts to push growth with macro-economic policies and not creating space for real activity and competition usually end up in lower growth and higher unemployment.

The International Monetary Fund slashed growth for the 2023 after the money printing during the Covid period. The shocks in a country with a flexible exchange rate however is much greater due to a steeply collapsing currency peg.

Related IMF slashes global growth after monetary stimulus as Sri Lanka reels

The wrong policies in earlier policies have to be pulled back to prevent a hyper inflationary spiral and total loss of confidence in the currency.

“The truth is that by a mistaken theoretical view we have been led into a precarious position in which we cannot prevent substantial unemployment from re-appearing,” classical economist Friedrich Hayek said in his Nobel speech in 1974 as the world was gripped by high inflation and the Bretton Woods soft-pegs was in shambles.

“Not because my view is sometimes misrepresented, this employment is deliberately brought about as a means to combat inflation, but because it is now bound to appear as a deeply regrettable but inescapable consequence of the mistaken policies of the past as soon as inflation ceases to accelerated.

“The manufacture of unemployment by what are called ‘full employment policies is a complex process.

“In essence it operates by temporary changes in the distribution of demand, drawing both unemployed and already employed workers into jobs which disappear with the end of inflation.”

Large numbers of Sri Lankans are now fleeing the country in search of jobs abroad.

Some who have jobs are also leaving due to lost confidence, low disposable incomes after the currency collapse and left-leaning steeply progressive taxes that were imposed this year. (Colombo/Jan25/2022)