ECONOMYNEXT – Sri Lanka’s higher rates have brought results but full restoration of monetary stability is still eluding the credit system with forex shortages still persisting and interest rates are higher than they need to be due to lack of a credible peg or clean float.
In this currency crisis, Sri Lanka is also burdened with a lack of clarity on whether there will be a Domestic Debt Restructuring (DDR) on top of a High Inflation and Financial Repression (IFR) event which is the usual way debt sustainability is restored, by depreciation and a nominally inflated economy.
Sri Lanka’s current central bank Governor Nandalal Weerasinghe was right to hike rates and allow bank interest and bond yields to go up.
While it is true that small businesses, in particular, are going to be badly hit there was no other choice than to allow rates to normalize to stop the country from being burnt to a cinder with inflation.
Without allowing rates to go up there is no way to reduce credit and outflows and stop further depreciation of the rupee.
Lack of complementary money/exchange policies
To get the rates down, restoring a credible monetary framework is key. Monetary/exchange rate policy conflicts tend to keep rates high.
A clean float or a re-pegging after a float is required to restore credibility. Taxes and energy prices have been raised to account for the currency collapse using the standard playbook in unstable soft pegs.
One reason forex shortages persisted – in addition to money printed to finance some state expenses – is because the central bank was intervening with dollars borrowing from India through the ACU mechanism.
Such interventions for imports are followed by more money printing to maintain the policy rate. Monetary authorities which use reserves for imports and inject liquidity into the banking system encourage banks to give loans without deposits.
The large liquidity shortages in the banking system are a result of using up reserves for imports. It is a classic problem of intermediate regimes. In past crises, it was not evident because liquidity was injected with outright purchases of gilts.
China mercifully did not allow its swap to be used for imports. Otherwise, it would have been busted in bridging finance/reserves for imports and Sri Lanka would be deeper in debt.
The forced dollar sales to the central bank by commercial banks are another reason for delays in reaching external monetary stability.
The main reason the rupee collapsed steeply in 2022, compared to earlier currency crises was also the surrender rule involving forced dollar sales to the central bank by commercial banks, as well as too low-interest rates which were not slowing credit fast enough.
A surrender rule where banks are forced to sell dollars to the central bank (not the rule forcing exporters to sell to commercial banks) deprives dollars to the market on one side and spews new money into the banking system on the other.
While it is possible to restore monetary stability without a float, it takes longer, the corrective interest rates are higher and the output shock or decline in economic activity is greater. The longer high rates persist, the higher the risk of a banking crisis.
A flexible exchange rate country will take longer to recover from a combined currency cum banking crisis than a simple currency crisis which is quickly resolved with a float following a rate hike.
What a float is not
This column has consistently advocated a float as a way to end forex shortages, restore credibility to the exchange rate and also to bring down interest rates.
A float is not a break of the peg as advocated by Mercantilists in Sri Lanka, which is a hit or miss affair.
A float is not a devaluation followed by half-hearted interventions which fire more depreciation since interventions are offset with new money in a flexible exchange rate regime with a policy rate.
Half-hearted floats and interventions followed by injections to offset them simply drive credit and imports as graphically shown in 2012.
A clean float isolates reserve money from the balance of payments.
To establish a clean float the central bank has to abandon its attempts to collect forex reserves through a surrender rule in the form of forced dollars sales to itself (which create money) and it should also stop sales of dollar sales which sucks out money.
In a clean float the BOP no longer plays any role in the growth or contraction of reserve money. There is a complete suspension of convertibility as happened in Russia after the US blocked its foreign reserves.
The central bank gains full control of reserve money, which can be guided with open market operations alone, there a no money exchange policy conflicts compromise monetary policy and outflows are financed with inflows.
However that is not what happened in Sri Lanka after the March float attempt. What happened was progressive devaluation with partial interventions especially in the form of a surrender rule which pushed the currency down.
India’s ACU money which was used for interventions also played a role in forex shortages as did the forced dollar sales. ACU money should only have been used to settle ADB and World Bank loans. They should not have been used for import interventions.
Under a float the reserve money gets fixed except for ATM withdrawal and inflation. However dollar sales against Treasury bills such as to settle multilateral debt, while leading to a loss of reserves, will not alter reserve money.
In other words a float is a complete suspension of convertibility where reserve money is neither created nor destroyed by central bank sales or purchases of dollars.
It is not the sale of foreign reserves (defense of the peg) but the injection of money after the intervention to sterilize the intervention that drives credit and leads to even more losses of foreign reserves. This is happening in Bangladesh and also India at the moment.
In the past Sri Lanka has managed to float and restore monetary stability and the ability in a short time. But in 2022 high rates and forex shortages are persisting for an extended time.
Meanwhile private sector sterilization is seen with foreign banks collecting large volumes of liquidity which is parked in the central bank. As a result weak credit will reduce the BOP impact of any money printed now.
This column warned against this eventuality not only due to Sri Lanka’s past experience but the general ‘fear of floating’ found among soft-peggers. Central bankers who operate ‘flexible’ exchange rates’ are usually too frightened to float as they are psychologically conditioned to ‘manage’ the currency.
Half-hearted floats do not work
Given Sri Lanka’s tendency to float half-heartedly including in 2012 and to try to float with excess liquidity in 2015, this column warned that care should be taken for it not to happen.
But this columnist did not count on the deadly surrender rule, which is very much worse than ‘floating with excess liquidity’.
“However any kind of half-hearted Treasury bill and bond auctions, partially failed bond or bill auctions with some volumes of printed money will lead to progressively higher interest rates but the reserve losses and currency depreciation will continue,’ this column warned in August 2021 (Sri Lanka’s monetary meltdown will accelerate unless quick action is taken)
Soft-peggers are not good at floating. Partial interventions (flexible exchange rate) will lead to even higher interest rates and more losses of confidence.
In Argentina, short term rates went up to 60 percent due to the ‘flexible exchange rate’ (which is neither floating nor pegged) that had caused so much damage to Sri Lanka since 2015 coupled with an unsterilized disorderly market conditions (DMC) rule, which also lacks credibility.
The high interest rates can kill many businesses. The high rates from partial floating can kill finance companies and banks. When dying banks are bailed out with printed money, it is generally even more difficult to control the exchange rate.
If money has to be printed for other expenses, the float will not work. That is why the deficit has to be reduced to some extent. If not, the whole burden will fall on the interest rate. With no growth, it will be a vicious cycle.
If money continues to be printed the currency fall will not stop with a float. A float will also not stop defaults, even if it works and halts the depreciation.
If money is continued to be printed the currency, will continue to fall as it did in 2015 when the central bank ‘floated with excess liquidity’ and Indonesia’s central bank floated with bank bailout money during the East Asian crisis.
A severe currency fall will lead to an inflationary blow off like in Argentina which will lower government cash expenses and salaries of state workers and the unemployed graduates that were hired.
Unfortunately private salaries and pensions of old people will also go up in smoke in the same way. All this shows that stimulus, MMT and soft-pegged central banks are not a joke.
All this has happened. The inflationary blow off has happened. Inflation at the time this column is updated has topped 60 percent.
With private credit now negative, most of the increases in the inflation index in the future will come from the changes to the price structure from the recent currency fall and past printing of money.
A successful float and an appreciation of the currency can reduce some of the inflation.
High rates/flat yield curve will persist until a float and credible peg is re-established
The current high-interest rates will not fall steadily until monetary stability is restored. Conflicting money and exchange policy will keep rates elevated and will require a severe crushing of economic activity to stop further depreciation.
In past currency crises rates have started to fall only after a successful float. In Sri Lanka float has been always been followed by a re-pegging to re-build foreign reserves under an IMF program. The central bank should not buy dollars until the float succeeds.
A clean float, which is followed by an appreciation of the currency, makes dollar holders sell, exporters to convert early and importers settle at leisure.
If not, uncertainty will persist. There will be little incentive to sell forward.
The bunched-up yield of the Treasury bills where the yield curve if flat is testimony to existing monetary instability.
The longer it takes to restore monetary stability the longer higher rates will prevail.
The longer higher rates prevail the bigger hit on the businesses, the economy and bigger the hit on banks.
By August high rates have been in Sri Lanka for six months and there are no signs of them falling as yet.
As soon as a float succeeds and a working regime is established interest rates tend to ease, even if the central bank sells down its Treasury bill stock and buys dollars to meet an IMF reserve target.
In past crises currency was re-pegged after the float under an IMF program to meet the Net International Reserve targets. A float was a prior action in earlier IMF programs and is likely to be this time as well.
However with the program likely to be delayed due to debt negotiations, an early restoration of monetary stability will help stabilize rates.
In past currency crises triggered by the central bank foreign projects continued to operate. IMF and other money also came quickly after a staff level agreement was signed.
Following the default however many projects including those by Japan is halted. Chinese projects are running. Already committed ADB and World Bank projects are also operating but there are no new ones.
On top of all this outflows are taking place due to unwinding of swaps and external market borrowings of banks as well as settling of suppliers’ credit. Some banks also have negative net open positions and some dollar debt is being repaid in dollars.
A back of the envelop calculation shows that Sri Lanka is almost running a current account surplus with reported exports and remittances exceeding imports, while experiencing a BOP deficit due to printing at the margin.
However the fear of a DDR event is keeping rates elevated.
The fear of DDR on top of High Inflation and Financial Repression
Impoverish unstable countries with intermediate regimes (countries which move out of an intermediate regime to a clean float or hard peg rapidly more out of poverty) collapse regularly due to its policy rate injections, which drive unsustainable domestic credit.
They have high inflation and elevated interest rates.
The have volatile growth and output shocks with every currency collapse.
Every currency collapse coming from ‘data driven flexible inflation targeting’ as seen from 2015 to extend a credit cycle beyond that of the Fed by suppressing rates with liquidity injections will cost about two years of growth as the output shock follows the currency collapse.
Central bank purchases of Treasury bills, is an effective domestic default. When countries with intermediate regime become a market access country they default externally as the domestic default leads to forex shortages.
Debt sustainability in these depreciating Latin America liquidity injecting countries is usually restored by high inflation and financial repression (IFR) as long as they do not have market access and external commercial debt volumes are low.
Sri Lanka’s economy expected to inflate to 23 trillion rupees at least in 2022 according to latest projections while bank deposits and pensions funds lose value with savers and old pensioners paying the biggest price.
However now there are growing fears of a domestic debt restructuring (DDR) on top of IMF
Bond holders in banks and the EPF, have faced severe financial repression from around 2015 due to money printed under the ‘flexible inflation targeting/output gap targeting’ to suppress rates through overnight repo, term repo, outright purchases and explicit price controls from 2020.
The three currency crises created in 2015/2016, 2018 and 2020/2022 are ample testimony to the below market rates that spurred credit to unsustainable levels and blew a hole through the BOP and destroyed the savings and investible capital of the people through depreciation.
Flaw in the Framework
The lack of early clarity on whether there is a DDR/IFR even is now driving interest rates up.
The lack of early clarity is a serious flaw in the current default resolution framework developed by Washington for flexible exchange rate countries.
If Sri Lanka can maintain a credible peg for two Fed cycles like East Asia and abandon the flexible exchange rate and aggressive open market operations, interest rates and inflation will collapse to world levels and deficits will come down. Foreign investments will flow in as they see stability.
But that will not happen in Sri Lanka with its policy rate with a narrow corridor and data driven flexible inflation targeting presumably to target an output gap.
Instead now that Sri Lanka has market access, the country will default repeatedly under the flexible inflation targeting regime. Such defaults will take place every two to 2.5 Fed cycles.
Flexible inflation targeting is not inflation targeting. It simply a reserve collecting peg with over-aggressive open market operations.
The ‘data driven flexible inflation targeting’ where money is encouraged to be printed through multiple liquidity windows is the most dangerous multiple anchor soft-pegged regime cooked up by salt-water style pundits in the West sitting in the safe cocoons of their single anchor monetary regimes in post-depression/post World War II history.
Flexible inflation targeting tops the Bretton-Woods failed pegs with miles to spare. It is an attempt to run a reserve collecting non-credible peg with floating rate style monetary policy. When the failed Bretton Woods was set up floating rates were not in existence.
In any case intermediate regime central banks that go to the IMF keeps going to the agency in future crises. Sri Lanka has gone to the agency 17 times including this one. Some Central banks set up by the US in the same style as the Sri Lanka has gone to the IMF 20 times or more.
There will be no difference in this program.
In a new Monetary Law Act to be passed under the IMF program, flexible inflation targeting – the very same regime that created three currency crises including one where taxes were raised to reduce the deficit in 2018 – will be legalized.
Nothing can save this country from another default and another currency crisis, trade controls, depreciation and social unrest.
In fact from August 28, 1950 Sri Lanka was made into a country with trade controls, with exchange controls, and steep depreciation and high inflation after 1978 where only the people on the top of the food chain can survive and younger people can migrate and get jobs in countries with stable regimes.
Sri Lanka is now a country with an ageing population. Future IFR events, under data driven flexible inflation targeting – with or without DDR – will take a terrible toll on them as pension funds are destroyed.
Young people however can migrate to single anchor regimes or find jobs in countries with credible or mostly credible pegs. (Colombo/Sept18/2022)