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Friday October 7th, 2022

Sri Lanka to change IMF deal in a Gotabaya administration: Cabraal

HIGH STRUCTURE: Analysts have warned that contradictory monetary and exchange policies that generates monetary instability permanent depreciation led to structurally high rates not just in Sri Lanka but other countries including China. Either a float or a peg backed by consistent monetary policy or a genuine float will lead to rates more in line with countries with complementary monetary policy.

ECONOMYNEXT – Sri Lanka will change a deal with the International Monetary Fund if a new administration under Gotabaya Rajapaksa comes to power, former central bank Governor Nivard Cabraal said.

Sri Lanka is now suffering low growth higher inflation (Sri Lanka in stagflation after flexible exchange rate collapse) and bad loans are ticking up after two currency collapses occurred in quick succession as the central bank printed tens of billions of rupees a at a time to generate liquidity shocks and target a call money rate.


“Recently I had a visit from officials from the IMF who asked us whether we are going to continue with same policies of the current government,” Cabraal said.

“I told them Sri Lanka is a country today where the growth has reduced from 7.4 percent to 1.6 percent.

“Our interest rates have doubled. The rupee has depreciated to such an extent that we cannot do our business in our country.

“The companies are failing, they are reporting much lower profits banks are struggling and the finance companies are struggling because the non-performing loans are rising.

“Interest rates are too high where the macro fundamentals are perished. So do you think we should continue with these policies which this government has implemented over the last five years?”

“Then I think they began to understand how important it is to haw a fresh set of policies that will take the country forward and deal with all these imperfection that have arisen in our macro fundamental policies.”

Cabraal headed the central bank until 2015.

After a currency crisis in 2008/2009, he allowed the rupee to bounce back as private credit fell, triggering a strong period of growth.

However in the wake of a 2011/2012 crisis when the rupee fell to 131, it was not allowed to bounce back in 2013 as private credit contracted, delaying a recovery, analysts say.

The credit system started to recover in the last quarter of 2014. As private credit picked up in 2015, and budgets deteriorated the central bank released tens of billions of rupees tied up in term repo deals and generated a currency crises. The rupee fell to 150 to the US dollar.

Analysts say the rupee collapses as the IMF failed to place ceiling that fall each quarter (except April and December) on domestic assets of the central bank in its program, allowing the monetary authority to print money and manipulate rates down with liquidity shocks generating currency collapses.

In 2017, when private credit eased the rupee was further depreciated by about three rupees, while more than a billion dollars was collected as forex reserves with complementary money and exchange policies, instead of allowing an appreciation.

The IMF itself has now said that Sri Lanka is facing currency risks in the future, without doing anything to reform a highly unstable soft-pegged regime labelled the ‘flexible exchange rate’ which has seen some of the worst monetary instability in the country since the 1980.

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Cabraal said the rupee did not depreciate that steeply during his time.


Central banks run into balance of payments troubles due to a targeting both the interest rates and exchange rates at the same time or trying to target domestic and external anchors at the same time.

In order to maintain an exchange rate, rates have to gently move when credit demand picks up and there is an import surge.

When money is printed to keep rates down, credit balloons further driving imports up, (even if budget deficits are low), and the currency comes under pressure. As the currency weakens, undermining credibility of the peg, there is capital flight, worsening the problem.

Cabraal recalled that the IMF had also told him to depreciate the currency steeply at one time.

“At that time IMF told us to depreciate the rupee till 135 per dollar,” he recalled. “The Sri Lanka rupee was 112 per dollar. So we didn’t do that. We told them we need to have the control of this inflation.”

In the 1970s Sri Lanka’s regressed with 20 percent unemployment and beggars rooted among trash heaps for food, some died on the road, as draconian exchange and trade controls, dual exchange rates, import substitution were followed to support domestic production in a closed economy.

Though the economy was liberalized from 1978, and employment and production picked up as price controls were removed and trade freed, monetary instability continued feeding into budget deficits.

It is not clear why the IMF favours currency depreciation and monetary instability but some analysts believe it is due to its origins in the arch-interventionist New Dealer ideology that prevailed in the US at the time.

The New Dealers were a type of extreme Keynesians who busted the US dollar from 22 to 35 dollars an ounce in 1935 in the first depreciation of the dollar in over a century.

Several countries that came under US influence after World War II, were encouraged to build interventionist central banks that eventually destroyed their economies and generated political instability, analysts say.

Sri Lanka’s central bank was also built by a US Fed official, John Exter, along with that of the Philippines, a country that had also saw monetary instability currency collapses, and the central bank itself went bust.

Dodge Line Stabilization

Many countries have carried out fundamental central bank reforms to end monetary indiscipline.

Japan, which was occupied by the US however, was saved by Joseph Dodge, a US expert who had worked in Germany with the architects of the ‘Social Market Economy’ who were also hard-money classical economists who also did not believe in monetary indiscipline and depreciation.

After World War II Japan was hit by monetary instability and high inflation, due to central bank re-finance (fukkin bonds) of a single development bank, the Reconstruction Finance Bank leading to price controls, black markets, starvation of those who obeyed the Food Control Law.

Sri Lanka’s central bank is now re-financing multiple banks through its open market operations, while trying to control a pegged exchange rate.

Dodge stopped fukkin bonds and the fixed the Yen at 360 to the US dollar by unifying a multiple exchange rate system that had ranged from 150 to 600 yen to the US dollar in the so-called the Dodge line stabilization, helping make Japan into an export power house.

The rate remained until the collapse of the Bretton Woods soft-pegs in 1971-1973 as the US Fed was hit by dual anchor conflicts. President Nixon closed the gold window and floated ending dual anchor conflicts.

The Yen has now appreciated to around 100 in a floating exchange rate.

Bank of Japan went to the IMF only twice. The Bank of England which followed Keynesian policies of trying to target growth and full employment policies by printing money unlike German and Japan, went to the IMF 11 times.

Sri Lanka’s central bank has taken the country with its dual anchor riddled soft-peg to the IMF, 16 times so far.

Cabraal said Sri Lanka rupee fall since 2015 had added had 1,760 billion rupees to the national debt.

He said the fall in 2018 alone had added 1,063 rupees to the debt.

Meanwhile the interest bill was also ballooning, Cabraal said.

“In 2014 the interest paid was 436 billion rupees,” Cabraal said. “But in 2018 it is 852 billion rupees. The interest rate has gone up from 4.2 in 2014 to 5.9 in 2018.”

When currencies depreciate, and there is persistent monetary instability from trying to lower interest rates by printing money, the nominal interest rate structure goes up, which is what happened to Sri Lanka after 1978 analysts, analysts say.

Even countries like the US and China had double digit interest rates during monetary instability. China’s interest rates came down only after the currency was stability in 1993 (initially with high rates to correct imbalances).

Sri Lanka is now heading into unstable territory in 2020, with presidential candidates promising salary hikes, subsidies and tax cuts.

Sri Lanka usually runs to balance of payments trouble when private or state credit picks up and the central bank prints money to cut rates. (Colombo/Nov08/2019)

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