ECONOMYNEXT – Sri Lanka has printed money in 2020 to finance the government as tax revenues fell and foreign financing dried up, officials said as deteriorating balance of payments triggered rating downgrades.
Sri Lanka’s Central Bank has purchased unprecedented volumes of Treasury bills to finance deficits and also target interest rates at various points along the yield curve.
“If you talk about money printing, as the figures I showed in the presentation, the central bank now holds 566 billion rupees of treasury bills or government securities,” Central Bank’s Director of Economic Research Chandranath Amarasekara told reporters on November 26.
“And most of those have been purchased from the primary market.”
The central bank’s Treasury bill stock rose to 568 billion rupees on November 30, as a more Treasury bills were unsold at an auction to real buyers and debt was monetized or money was printed expanding reserve money.
Total central bank credit to government including provisional advances to the Treasury (which are mostly legacy injections which have been sterilized to neutralize their effects in past years) reached 735 billion rupees in October 2020, from 577 billion a month earlier, data shows.
“On money printing the definition differs,” Amarasekara said. “There was a need for the government to find funds, especially because of the reduction in revenue due to lowering tax rates.
“And also because the government did not has the benefit of increasing financing from abroad. So there was necessity for the government to find funds from the domestic market and CBSL was a one source for these funds.”
Sri Lanka’s central bank has a history of printing money – usually pro-cyclically as credit recovers – and creating currency collapses and balance of payments crises which then lead to a collapses in output (low or negative GDP growth).
“And usually when the credit to the central bank from the government increases, there is an argument that inflation can rise,” Amarasekara said.
“What we have to identify is that we are in a different situation particularly in this year. Because aggregate demand is low, economic activity is low and without a pickup in these two there will no demand driven inflation in the economy.”
According to classical economists any liquidity injections in a pegged regime is money printing, which will create balance of payments troubles, mal-investment (asset price bubbles) as well as price increases in consumer goods when a cascading expansion of credit takes place over a longer period.
In the period of the classicals money was pegged to specie (gold or silver) not to another anchor currency like the US dollar, which is backed by foreign reserves.
In a depression or credit collapse, money printing (expansion of reserve or base money) may not immediately result in a cascading expansion of credit though any currency depreciation will also raise the price structure of a country, even as firms cut margins.
However after Keynes’s General Theory, which involved countering a depression, when credit was negative, the definition began to change, allowing central banks to print money and generate monetary instability.
“The term inflation was initially used to describe a change in the proportion of currency in circulation relative to the amount of precious metal that constituted a nation’s money,” explains Michael F. Bryan of the Cleveland Federal Reserve in The Origin and Evolution of the Word Inflation.
“By the late nineteenth century, however, the distinction between ‘currency’ and ‘money’ was becoming blurred. What was once a word that described a monetary cause now describes a price outcome.”
“This shift in meaning has complicated the position of anti-inflation advocates. As a condition of the money stock, an inflating currency has but one origin — the central bank – and one solution, a less expansive money growth rate.”
Classical economists at the Feds in St. Louis, Richmond and Cleveland led the fight back against Mercantilists in New York that helped Paul Volcker to save the US dollar after its collapse in 1971, students of monetary history say.
In Sri Lanka reserve backing of the rupee (the proportion of currency relative to the amount of dollar reserves) has now plunged close to 50 percent with rising central bank credit to government and fall in forex reserves.
In the US, before the Fed was created in 1916 triggering the Great Depression in just over a decade, the 1970s Great Inflation and the 2008/9 Great Recession, money was minted in specie (primarily gold) by Congress and a number of free banks issued their own paper, supposedly fully backed by specie.
“The era between the mid-1830s and the Civil War—a period economists refer to as the “free banking era” — saw a proliferation of banks,” Bryan explains.
“Along with these institutions came “bank notes,” a private paper currency redeemable for a specific amount of metal. That is, if the issuing bank had it,”
“At times, banks did not have enough gold or silver to satisfy all of their claims. Bank notes, like the public notes that preceded them, also tended to depreciate.
“It is during this period that the word inflation begins to emerge in the literature, not in reference to something that happens to prices, but as something that happens to a paper currency.”
A massive banking crises occurred in the US after so-called ‘Greenbacks’ or paper money was printed by the Union, while the South’s Confederate paper dollars or ‘Greybacks’ completely collapsed.
Around 450 million Greenback paper dollars were later mopped up by the US Treasury with gold leading to deflation.
In Sri Lanka also money was issued by free banks and the Oriental Bank Corporation, which acquired Bank of Ceylon in 1849 which had a charter (an authorised bank). The Oriental Bank Corporation collapsed in 1884 around the time of the Shanghai crisis, which was silver related.
The British administrators replaced it with a currency board in 1885 which maintained monetary stability until 1950, when a soft-peg was set up, triggering chronic forex shortages and depreciation.
The Fed triggered the Great Depression in the 1930s after the inflation it created during the 1920s (the Roaring 20 bubble) collapsed, ending in a banking and stock market crisis (mal-investment).
Keynes then came out with a his theory, which was further refined by others, to what critics say is a more nuanced version of John Law’s proposals in the classical Mercantilist era.
In the run up to the Great Recession in this century, the Fed targeted a ‘core’ inflation which ignored the effects of monetary policy on both commodities (a depreciating dollar) and asset prices such as housing, until it was too late. Housing prices were delayed by the use of ‘imputed rents’ critics have said.
“Linking inflation to the price level proved to be another important turning point for the word,” Bryan says. “With the publication of John Maynard Keynes’ General Theory in 1936, an assault on the quantity theory of money commenced, and it dominated macroeconomic thought for the next 40 years.
“By appealing to the belief that resources could be regularly and persistently underemployed — an idea given support by the worldwide depression of the time — Keynesian theory challenged the necessary connection between the quantity of money and the general price level.
“Moreover, it suggested that aggregate price increases could originate from factors other than money.”
Depression Era Keynesian central banks
Analysts have said the 1950 soft-peg was set-up in the style of several depression-era Latin American central banks initiated by the Federal Reserve inspired by Argentina central bank creator Raul Prebisch, which was also an extension of Keynesian ideas.
In theory it was supposed to run counter-cyclical policy with sterilizing powers keeping a firm peg. In pegged systems, the liquidity injections hit the balance of payments quickly as domestic credit picks up.
“The Keynesian system is a closed one, that is, it takes no account of foreign trade,” explained Goh Keng Swee, a classical economist and ex-Finance Minister of Singapore, who set up its Monetary Authority in a firm rejection of Keynesianism.
“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 governments do not exercise restraint in time.
“In the immediate post-war years, Keynesian economics won widespread acceptance in both academic and government circles in Britain and the United States,” Goh said.
“Confidence increased in the ability of governments to maintain full employment and stable economic growth through Central Bank credit policies and government fiscal (budgetary) polices
“However by the mid 1960s, certain stubborn difficulties appeared and refused to go away. In Britain, this took the form of balance of payment troubles which led to the devaluation of the pound in November 1967.”
Depression era central banks in Latin America and Asia as well as Keynesian soft-pegs in the Middle East and African countries did enormous damage to their populations as monetary instability ratcheted up and exchange and import controls were imposed.
“Financing budget deficits through Central Bank credit creation appeared to us as an invitation to disaster,” Goh said.
“There was no effective way of exchange control in an open trading economy like ours to deal with the inevitable balance of payments troubles.”
A part of the increase in printed money may disappear from the credit system without causing domestic inflation through the balance of payments as imports come in and the peg is defended.
Though private credit has been weak at least up to August 2020 (which makes a case that the central bank is running counter-cyclical policy), the budget deficit has soared partly due to Coronavirus lockdowns as well as import controls, which is also a consequence of a monetary policy error.
A part of central bank credit extended has been to repay foreign loans, keeping total reserve money stable with foreign asset derived money going down. In October a billion US dollar bond was repaid, supported by central bank reserves.
In Latin America, domestic asset expansion by Depression-era central banks had another outcome, sovereign default, as foreign assets fell and forex shortages emerged.
After 2005 when Sri Lanka got a credit rating and started to tap capital markets, increases in money printing and balance of payments troubles have also been accompanied by rating downgrades as foreign reserves fell.
In 2019, December the sovereign rating outlook was cut on sudden tax cuts, before money printing began and started to pressure the balance of payments.
The tax cuts to ‘stimulate’ growth came after two currency crises were triggered by the central bank with pro-cyclical money printing in 2015/2016 (as the credit system recovered from a 2011/12 crisis) and in 2018 (as the credit system recovered from the 2015/2016 crisis).
In 2018 fiscal policy was tight after tax hikes and the crisis was triggered by a rate cut enforced by liquidity injections in April, and a dollar rupee swaps in July/August apparently made to finally target an output gap and/or the Real Effective Exchange Rate.
Analysts had warned that downgrades were inevitable if rates are kept down with money printing under a ‘flexible inflation targeting regime’ (a discretionary domestic anchor) which conflicts with a ‘flexible exchange rate’ (a discretionary external anchor with a shifting convertibility undertaking).
As money was printed from February 2020 and the rupee fell from around 185 to the US dollar under a shifting convertibility undertaking which was enforced around 200 to the US dollar in March and April amid a Coronavirus crisis, more downgrades followed. (Colombo/Nov30/2020)