Sri Lanka targets trade deficit in monetary dominance of fiscal policy
ECONOMYNEXT – Sri Lanka’s central bank which is operating an unstable dollar soft-peg is increasingly relying on fiscal policy to target the trade deficit by nudging the finance ministry to hike taxes and second guess consumption and investment decisions of ordinary citizens.
Finance Minister Mangala Samaraweera had admitted to monetary dominance of fiscal policy saying car taxes were raised at the request of the central bank.
"Based on a request from the Central Bank, we had lengthy discussions and then decided on this policy,” he told reporters.
"Through this, our foreign exchange came under a lot of pressure."
The use of taxes to limit imports is better than hiking interest rates, Central Bank Governor Indrajit Coomaraswamy said.
"At this point, given that growth is well below potential, if one can achieve the same objective in terms of balance of payments using fiscal policy, that for me is a better instrument at this point," he told reporters.
"If we increase interest rates to tackle the deterioration of the trade balance that would suppress growth even more."
Sri Lanka is now recovering from a balance of payments crisis triggered in 2015/2016 when the central bank delayed a rate hike and accommodated one of the worst budgets in recent years by terminating term repo deals and later outright purchases of Treasury bills.
Balance of payments and currency problems are linked to so-called soft-pegs where a central bank tries to target both the exchange and interest rates (by printing money) simultaneously which is not possible in the real world.
However analysts who closely study the central bank say that the issue is not just that of the rate, but of quantity, what classical economists who pushed for reforms of the Bank of England used to call the ‘superabundance of paper money’.
Superabundance of paper money
Sri Lanka’s ceiling policy rate at 8.50 percent which is far above that of the US, which analysts say is more than enough to keep a dollar peg stable, if the domestic operations department of the central bank can be reformed to operate prudent policy consistently and halt ‘quantity easing’ style moves.
In March and April 2018, Sri Lanka’s credit system was hit by an unusual barrage of liquidity tools from all directions, not just to maintain the rate, but to generate excess liquidity of tens of billions of rupees as credit spiked.
In March, term repo deals were terminated. In the first week of April the ceiling policy rate was cut.
Then Treasury bills were purchased outright, bills purchased temporarily through term reverse repo auctions, cash was injected through overnight term repo auctions and money spigots were also opened through the standing overnight liquidity facility.
Terminating term repo deals is a new and significant tool of instability identified by analysts in recent years, after the central bank stopped selling its medium term CB Securities to mop up liquidity and build foreign reserves.
After generating the liquidity, the central bank then failed to guide the forex market in late April and May when the excess money came for redemption in forex markets, under a ‘flexible exchange rate policy’, creating loss of credibility in the peg and a run on reserves.
Sri Lanka has suffered balance of payments problems from shortly after a money printing central bank was created in 1951, abolishing a currency board (an agency with floating interest rates), laying the foundation for exchange and trade controls and deficit spending.
Earlier in the year the central bank also engaged in monetary dominance of fiscal policy to hike taxes on gold.
Trade Deficit Targeting
The most extreme trade deficit targeting was practiced in Sri Lanka in the early 1970s when almost the entire economy was closed as the Bretton Woods system of soft-pegs collapsed when US Fed printed money during the tenure of Arthur Burns amidst the Vietnam War.
Since imports are results of consumption and savings behaviour, targeting of one import such as cheaper small cars, may also drive money and credit towards other goods such as building materials or even slightly more expensive cars.
But Governor Coomaraswamy said that the country now requires increases in investment and production to fuel growth and cutting down imports of consumption goods is better.
“If these are particularly consumption goods, then it seems better to use the taxation policy to target those things which are causing the pressure,” he said.
"As long as credit then shifts to intermediate goods and capital goods, that’s fine," Coomaraswamy said,
Sri Lanka earlier slammed taxes on gold imports also over balance of payments fears. But the central bank had been happily collecting forex reserves amid rising gold import in 2017, as it was mopping up liquidity until and curtailing credit.
Gold traders were allegedly earning easy foreign exchange by smuggling the metal to India to arbitrage an import tax in India, and the profits may have been used to under-invoice imports.
But Governor Coomaraswamy defended the move saying it had minimal negative impact.
"If there’s an increase in motor vehicles and even gold—we don’t have a serious gold manufacturing industry—then I see no reason why one shouldn’t discourage that, and then hope that the money gets diverted into more productive activities," he said.
The latest moves to hike taxes on smaller cars and target the trade deficit has also created a political backlash for the United National Party, which promised opportunities to own cars for ordinary people.
Stories have popped up in the media that its leader Ranil Wickremesinghe had asked for a time limit on the new car taxes.
However the soft-peg was created by a former leader of the UNP, J R Jayawardene and the party has no one but itself to blame for not effectively reforming the central bank, observers say.
Sri Lanka’s rupee depreciates permanently even when credit is weak, unlike the currencies of high performing East Asian nations.
Most recently in 2017 when currencies of the best managed East Asian nations appreciated – amid underlying weakness in the US dollar – the Sri Lanka rupee fell, ostensibly to target a Real Effective Exchange Rate.
According to Sri Lanka’s central bank the Korean won appreciated 13 percent, the Renminbi 6.6 percent, Thai Baht 9.5 percent, New Taiwan dollar 8.5 percent, Singapore dollar 8.1 percent, the Malaysian Ringgit 10.4 percent in 2017, while the rupee fell.
Even India which has a weak central bank appreciated its rupee in 2017. India also hiked rates recently.
Policy makers also conspicuously ignore Hong Kong when talking about emerging market currency movements.
In 2018 when the US dollar strengthened and well-managed East Asian currencies, except Hong Kong also fell, the Sri Lanka rupee again fell.
Hong Kong which has a currency board (floating interest rate) has an unchanged exchange rate of 7.8 to the US dollar since 1982.
Most mainstream global financial media do not even report daily on the Hong Kong dollar rate as are there no exciting real economy reasons to attribute to the non-movement of a currency board generated currency.
In addition to Sri Lanka currencies that fell in both 2017 and 2018 were generated by the worst central banks in the region in Indonesia and the Philippines. Both countries export labour to the Middle East and to others East Asian nations with sounder currencies after destroying real wages with currency depreciation.
Analysts have called for meaningful reforms (What Sri Lanka can do to improve the credibility of its dollar soft-peg: Bellwether) of the central bank’s operations to remove a so-called ‘cost of living’ factor from the political discourse in Sri Lanka and allow real wages to grow and stop free trade reforms being rolled back and protectionism being promoted to ‘save foreign exchange’.
By August 2018 Sri Lanka’s rupee had stabilized at around 160 to the US dollar with credit slowing and market participants believing that the central bank is willing to defend a peg around the level and exporters selling when the rupee weakens a little below the latest peg, at least for now.
How long the status quo will remain is unclear, with the central bank only publicly committed to defending the peg to smooth out ‘excessive volatility’ through short term nominal interest exchange rate targeting.
Sri Lanka averted another balance of payments crisis because of wide policy rate band where overnight rates went quickly to 8.5 percent as soon as liquidity injections stopped and rupees were sucked out with dollar sales to defend the currency.
The central bank has said it will narrow the policy corridor, which analysts warn will make the credit system more vulnerable to balance of payments trouble.
Analysts say that with the economy and credit picking up, Sri Lanka’s trade deficit is likely to expand regardless of fiscal measures to curb selective imports though the recent currency fall will put a temporary damper on the economic recovery.
Economists have warned President Donald Trump, who is also raising taxes to target trade deficits with individual countries, that it is a pointless exercise and merchandise or current account deficits are essentially result of a surplus financial account – in short savings and investment behaviour.
When foreign direct investment picks up and more money is invested in Sri Lanka, the trade and current account deficit are likely to expand. Even higher tourism receipts will drive the trade deficit.
Government foreign borrowings – if spent domestically and are not used to settle debt – will also drive the trade and current account deficits.
"Fundamentally a trade balance – basically the current account – is a reflection of the spending patterns of the nation," Robert Lawrence, a professor at Harvard University’s Kennedy School of Business told an economic forum organized by Advocata Institute in Colombo.
"And it tells you that a country with a (current account) deficit is borrowing. So it tells you that it is not saving enough domestically and it can’t finance its domestic investment, it has to borrow.
"One component of that will be fiscal policy. If the government runs a surplus, the country will have a smaller trade deficit. If private citizens save, the country will have a smaller trade deficit."
"So when it comes to the (trade) deficit, it seems to be much more about spending patterns in the country, its savings and investment behaviour, than whether it is going to export more or import less," he said.
That imports have something to do with the exchange rate or balance of payments is a classical mercantilist idea that was busted as far back as 1810 by David Ricardo (The High Price of Bullion, a Proof of the Depreciation of Bank) when the gold-backed Pound fell as money was printed by the Bank of England.
Ricardo and several other economists had pointed out at the time that the problem had nothing to do with imports but all to do with the excess paper money issued by the Bank of England.
Now, as then, analysts have called for reforms of the domestic operations of the central bank to cure the problems.
In 1844 under then Prime Minister Robert Peel, restrictions were placed on the Bank of England and other free banks, and Corn Laws were abolished two years later setting the foundation for free trade and prosperity. (COLOMBO, 13 August, 2018)