ECONOMYNEXT – Sri Lanka government and government guaranteed domestic currency debt broadly considered in debt review has shrunk by a 19.6 billion US dollar equivalent as the economy inflated in the worst currency crisis in the history of the island’s intermediate regime central bank.
Sri Lanka’s central government rupee debt fell to the equivalent of 32.4 billion dollars from 50.5 billion dollars, a phenomenon labeled High Inflation and Financial Repression (IFR).
Sri Lanka had rupee debt of 53.5 billion US dollar equivalent by end December 2021, made up of 50.5 billion US dollars of central government debt and 3.1 billion SOE guaranteed debt, included in an update to creditors on data up to December 2021.
Sri Lanka had 47.3 billion US dollars of central government forex debt with 5.4 billion US dollars of guaranteed state enterprise debt and 3.0 billion dollars of central bank debt included.
In the next six months the rupee collapsed from around 200 to 360 to the US dollar in a float botched with a surrender rule (forced dollar sales to the central bank), sterilized interventions and too low policy rates amid raging domestic credit.
By end June 2022, rupee debt had shrunk to 34.0 billion US dollars equivalent from 53.6 billion US dollars equivalent by end December 2021 in a severe High Inflation and Financial Repression (IFR) event or real ‘haircut’ according to the latest update to creditors.
Sri Lanka’s dollar debt considered in the update had also fallen marginally to 46.6 billion US dollars by end June 2022 from 47.3 billion US dollars in December 2021 made up of 5.5 billion US dollars of SOE guaranteed debt and 3.2 billion US dollars of central bank debt.
The monetary authority however has more forex debt than included in the update according to other data. Considered in the update were 1.1 billion US dollars owed to the International Monetary Fund (negative SDR position excluded) and 2.0 billion dollars in external swaps only.
The treatment of Asian Clearing Union deferred liabilities and domestic swaps are not immediately clear.
The wiping out of the rupee debt to 34.5 billion US dollars by June 2022 from 53.6 billion US dollars six months earlier reduced total public sector debt considered in the compilation to 80.5 billion US dollars from 100.9 billion US dollars over the six months.
There appears to be classification differences between the two updates.
The new update said forex debt was 70 percent out of public debt of 122 percent of GDP in June 2022 compared to 27 percent of 114 percent of GDP public debt in 2020 before the currency collapse.
Sri Lanka’s economy is expected to inflate to at least 23.8 trillion rupees in 2022 from 16.8 trillion rupees in one of the biggest inflationary blow offs since the 1980s when rupee began to be rapidly depreciated in response to money printing, triggering high inflation and social unrest.
An inflating rupee economy boosts nominal tax revenues, bringing automatic ‘debt sustainability’ through IFR as long as the public sector is not expanded and there is wage restraint.
Tax revenues were up 25 percent in the six months to June 2022.
Related Sri Lanka budget 2022, tax revenues surge 25-pct up to June in inflation
On top of the usual flexible exchange rate IFR there are now fears that a domestic debt re-structure (DDR) would also take place.
A DDR will hurt banks, Sri Lanka authorities have said.
In addition pension funds and other debt holders who will in any case pay more tax under contemplated reforms will also be hit on a second hair cut on top of IFR.
Sri Lanka has no final decision yet on domestic debt re-structuring
Sri Lanka rates elevated amid failed float and DDR fears
Sri Lanka’s rupee collapses repeatedly due to the country’s intermediate regime central bank which does not have a consistent monetary anchor but practices discretionary and conflicting policy in line with what is generally known as the ‘impossible trinity’.
Over the past 7 years highly discretionary policy was operated under ‘flexible inflation targeting’ where floating rate monetary tools (open market operations for stimulus) were applied to a reserve collecting peg, in policy comparable or worse than the 1980s, according to critics.
However in the last decade Sri Lanka had become a market access country unlike in the 1980s and the country defaulted in April 2022 after running out of reserves.
In all previous currency crises coming from flexible monetary policy, debt sustainability was reached with High Inflation and Financial Repression. At the moment government rupee debt yields are around 30 percent with historical inflation running close to 70 percent.
But in this currency crisis a debt re-structure is required after the country was locked out of markets by sovereign bond holders from around 2020 and downgrades later in the year.
A new monetary law which will allow discretion to override rules as in the past seven years, legalizing both a ‘flexible’ exchange rate and ‘flexible’ inflation targeting (a modernized version of attempting to defy the impossible trinity of monetary policy objectives with policy errors compensated by depreciation) is to be enacted as a prior action in a deal with the IMF according to critics. (Sri Lanka’s central bank needs accountability and restraint, not independence: Bellwether)
Due to the promotion of flexible policy pegs, a central bank that goes to the IMF keeps going to the Fund again and again in a phenomenon classical economists call recidivism – or in jest, ‘many happy returns’. Sri Lanka is going to the IMF for the 17th time.
Flexible or discretionary policy is a doctrinal foundation of classical Mercantilism (John Law, James Steuart as well as Anti-Bullionists and the Banking School) which was given a new lease of life under Keynesianism and forms the foundation of non-credible soft-pegs (intermediate regimes).
Washington based promoters of neo-Mercantilism including Robert Triffin (propagation of Argentina style Prebisch-Triffin central banks), John H Williams (key currency), and later John Williamson (basket band crawl/REER targeting) peddled impossible trinity flexible regimes to hapless third world nations that did not have a strong domestic classical economic doctrinal foundation.
Flexible monetary policy rejects the rule based principles advocated by classical economists like David Hume, David Ricardo outright as well as Henry Thornton.
Flexible exchange rates – which are neither clean floats nor hard pegs – also reject more modern classicals like F A Hayek, Ludwig von Mises and Wilhelm Ropke whose ideas drove the Federal Republic and Japan from 1948 and later East Asia firm and hard pegs (Why Singapore chose a currency board over a central bank), GCC firm pegs and also ideas of others like Milton Friedman and Bertil Ohlin.
Their ideas drove monetary policy in the US, UK and Sweden in the ‘Great Moderation’ period from the early 1980s until around 2001, and still drive policy in several countries with German speakers including Switzerland.
Germany itself is now under the European Central Bank which printed money to boost jobs riding the ‘supply bottleneck/transient inflation’ bandwagon, taking refuge in non-monetary explanations, along with the US and is now suffering the effects of the Powell Bubble.
In Sri Lanka, there is a strong belief among policymakers that a part of the inflation in a country is non-monetary and the claim is used to delay rate hikes, unleash open market operations to suppress market rates and drive up credit, triggering currency crises.
That inflation is non-monetary (wage-spiral, interest rates, forward market speculation, hoarding) stem from ideas of classical Mercantilists like James Steuart.
That inflation comes from a monetary and non-monetary soup is an idea articulated by talking heads in popular financial media, and persons like Fed Chief Arthur Burns who broke a centuries old gold standard in 1971-73, creating fiat money.
Broadly speaking, cost-push theory argues that prices or costs drive money supply changes, not that there is a causal soup involving an x percent of cost push inflation and y percent of monetary inflation.
In a country with a flexible-policy-reserve-collecting peg, nominal interest rates are high and long term real growth is low due to trade and exchange controls imposed by the soft-pegged central bank which curtail economic freedoms, as well as output shocks that follow currency crises.
In an IMF or other Debt Sustainability analysis, low growth and generally higher nominal interest rates have to be assumed with no exit from anchor conflicting flexible policy that has prevailed from 1950 compounded by depreciation from BBC policy from 1980s and market access over the past decade.
In a four to five year Federal Reserve cycle, a flexible policy soft-pegged country will lose about two years of growth due to monetary instability. The compounding effects of low growth (output shocks) have severe impacts on long term growth and prosperity.
In Sri Lanka’s current currency crisis which led to sovereign default, growth is to become positive in 2024 and remain about 3.0 percent until 2027 according to the update creditors. (Colombo/Sept25/2022 – Update II)