ECONOMYNEXT – Sri Lanka’s economy has stabilized faster than some other countries that went into crisis recently, State Minister for Finance Shehan Semasinghe said.

“Our economy is on a progressive trajectory,” Semasinghe told parliament in a debate to pass a tax linked to domestic debt restructuring.

“Compared to other countries’ whose economies collapsed we have been able to in the shortest time stabilize the economy.

“Other countries are commending our progress.”

Sri Lanka’s inflation is near zero, and the exchange rate has appreciated from March, when a surrender rule was relaxed, though there is uncertainty under a so-called flexible exchange rate.

Bangladesh is also facing currency depreciation as interventions are sterilized to maintain a fixed policy rate and the monetary base.

READ MORE Sri Lanka has managed to bring inflation down tenfold. Why are we still struggling with ours?

Currencies issued by central banks with anchor conflicts (flexible exchange rates or soft-pegs which neither clean floats nor hard pegs but are highly unstable intermediate regimes) depreciate and collapses when rates are cut and enforced with liquidity injections claiming that inflation is low, analysts say.

The higher the inflation target of an intermediate regime central bank, the more likely the currency will collapse when rates are cut with open market operations (printed money) and end up in the International Monetary Fund.

As the currency comes under pressure from OMO money, dollars are sold to stabilize the currency (which should make rates go up) but interventions are sterilized (money is printed) to fix a policy rate, or gilt yields, preventing the exchange rate from stabilizing.

Governor Nandalal Weerasinghe in 2022 jacked up policy rates and allowed free market gilt yields, leading to a credit and economic contraction but possibly ending a further meltdown of the currency and full blown hyperinflation. The move however possibly prevented market dollarization, which would have ended Sri Lanka’s monetary woes forever, analysts say.

A couple of months later Sri Lanka ran out of reserves to intervene and sterilize. A peg was enforced with a surrender rule and selling back the same dollars, while high rates slowed credit.

The surrender rule (a convertibility rule), which analysts blamed for a failed float, was removed in March 2022 several months after the BOP turned into surplus allowing the currency to appreciate, a departure from usual IMF-prone central banks.

In a floating rate regime, rate hikes lead to automatic currency appreciation, reversing the effects of commodity bubbles trigggered under ‘macro-economic policy’, but it’s not common in IMF style intermediate regime central banks.

Sri Lanka’s 12-month  inflation was only 4.0 percent in August, with the Colombo Consumer Price Index growing only 0.42 percent from September 2022. The BOP turned into a surplus in September.

Supermarkets are offering foods at discounted prices in Sri Lanka, as global commodity prices including wheat, sugar and also tea have fallen from last year’s highs.

The Sri Lanka rupee appreciated from 368.00 in December 2022 to 322.50 levels by September 2023. The central bank has largely refrained from engaging in inflationary open market operations.

Analysts have warned that based on past IMF programs, if the central bank cuts rates as domestic credit recovers, and enforce them with inflationary open market operations under so-called flexible inflation targeting, the currency will fall, reforms will be discredited and IMF reserve targets will be missed.

In a reserve collecting central bank, the IMF reserve target (essentially the BOP) determines the interest rate, not inflation, analysts have warned, and any attempts to target a domestic anchor will end up in tragedy.

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Flexible inflation targeting (targeting a domestic anchor without a floating rate) is the latest dual anchor conflicting monetary regime peddled to hapless third world countries without a doctrinal foundation in sound money, critics have said.

In the 1980s it was a money supply (another domestic anchor) targeting a without clean floating exchange rate. At the time floating central banks, struggling to find an anchor to replace gold after the collapse of the Bretton Woods, had resorted to targeting money supply, with partial success.

In a reserve collecting central bank, the IMF reserve target (essentially the BOP) determines the interest rate, not inflation, analysts have warned, and any attempts to target a domestic anchor will end up in tragedy.

Pakistan’s 3-month Treasury bill yield rose to 24.4 percent at this week’s auction from 22.8 percent last week, The News reported.

The 12-month yield rose to 25.08 percent from 22.94 percent. In Pakistan inflation is at 27.4 percent. The policy rate is 22 percent.

The Pakistan rupee has collapsed from 227.18to the US dollar in January 2023 to 307.2385 yesterday within an IMF program. In Sri Lanka there have been statements made that the rupee collapsed due to the lack of an IMF program.

Pakistan has been in an IMF program for several years and jumped into a new one in 2023 with the earlier one halted mid-way after reserve losses from money printed to maintain its fixed policy rate as well as refinancing private credit.

In Ghana, a country which has defaulted, the cedi fell from 10.22 in December 2023 to 11.39 to the US dollar yesterday. The currency has since shown signs of stabilizing in recent weeks.

The Suriname dollar fell from 7.45 in December 2019 to 31.8749 in Dec 2022. The Suriname dollar collapsed further to 38.1810 this month within an IMF program.

Suriname is trying to target reserve money. Classical economists including David Ricardo explained as far back as in 1809 that it was not possible to fix reserve money with inflationary open market operations without losing the backing reserve, which is a law of nature.

“..[i]f the Bank assuming, that because a given quantity of circulating medium had been necessary last year, therefore the same quantity must be necessary this, or for any other reason, continued to re-issue the returned notes, the stimulus which a redundant currency first gave to the exportation of the coin would be again renewed with similar effects; gold would be again demanded, the exchange would become unfavourable.”  

Any central bank that sterilizes interventions (uses reserves for imports under an ARA metric or any other statistical idea) under a fixed policy rate, is also implicitly targeting reserve money.

Most East Asian central banks collect foreign reserves by under-supplying reserve money using deflationary open market operations.

The central bank of Sri Lanka has also been operating broadly deflationary open market operations, but concerns have been raised on complex two way operations. (Colombo/Sept07/2023)