ECONOMYNEXT – Sri Lanka’s planned new monetary law will outlaw two central bank practices that had led balance of payments deficits and monetary instability for 60 odd years, and about 15 years after journalists and economists started a struggle against such policies.
The International Monetary Fund says changes to the monetary law, done with its technical assistance will be presented to parliament in July 2019 as a structural benchmark of its agreement.
"The amendments, prepared with IMF TA (technical assistance), will establish price stability as the CBSL’s primary objective and a flexible exchange rate regime; phase out CBSL’s participation in the primary market and provision of advances to the government, and eliminate other quasi-fiscal functions," an IMF report released in May said.
Fifteen year battle
The struggle by victims of the central bank who had suffered currency depreciation and trade restrictions intensified in 2004, when economists, analysts and journalists started to publicly oppose the central bank’s inflationary pro-balance of payments crisis policies.
In 2004, the central bank printed 65 billion rupees, when the economy and credit system were already running at full steam. The deficit expanded mainly due to fuel subsidies and a graduate employment program.
The rupee went into a free fall which ended in December 2004 with the Indian Ocean tsunami, and aid flows failed to expand the account deficit and import boom as capital inflows usually does in Sri Lanka, because private credit collapsed in immediate aftermath of the disaster.
A few year ago Governor A S Jayewardne, a classical economist, who first reformed the central bank in the 1990s and started to wean it off quasi-fiscal activities, had also started publishing monetary data weekly and daily. The daily data has been made less transparent, with the Treasuries stock understated by disregarding the collateral for term injections.
Governor Jayewardene also took pains to educate the public and journalists on the link between monetary policy and inflation.
His Deputy W A Wijewardene was also a classical economist in the same mould committed to prudent policy.
The data showed to outside analysts that it was not trade – as Mercantilists claim – but monetary instability that cause BOP troubles, just as classical economists from Adam Smith to David Ricardo have shown in other countries.
At the time when economists like Wijewardene was in the central bank, money was printed unwillingly and mostly due to pressure from the Treasury or fiscal dominance.
However, depending on the leadership of the central bank, the agency continued deny its culpability mostly due to political reasons, or due to a genuine belief in Mercantilism, therefore disregarding classical-style economics.
Denial has been the usual practice of most central banks, including the Bank of England, in the face of BOP trouble.
The central bank now responds to critics who call for an end to reckless policy or and end to permanent depreciation of the currency without acrimony, though in the past they have been likened to terrorists.
Some critics believe that some central bank officials may have bought Treasuries from the bill auctions and generated balance of payments crises, even when there was no pressure from the Treasury (fiscal dominance), due to the presence of bureaucratic mindset which made them distrust markets (price signals).
Provisional advances are another money printing tool which expanded reserve money.
However, by and large they have done less damage as the central bank had usually mopped up an equal amount of liquidity quickly. Provisional advances however cause damage if the peg is already under pressure and tends to chip away at central bank forex reserves and profits.
Analysts have proposed that the provisional advances be converted to Treasury bills at par and sold down to build forex reserves with a provision for any loss to be offset against profits transfers to the Treasury in a future year.
Of late, analysts have identified fresh reckless policy tools of the central bank that have replaced direct interventions in Treasury markets.
What was earlier done with Treasury bills is now being done with either LOLR (lender of last resort) operations or unsterilized dollar purchases.
In desperation, victims who have seen their salaries and savings disappear, have to called outlaw or criminalize such practices.
These include a so-called ‘buffer strategy’ where maturing bonds are repaid with bank overdrafts re-financed with central bank lender of last resort windows, purchasing Treasury dollars when the peg has moved to the weak side of its convertibility undertakings.
Another is the termination of repo deals when credit picks up and the injection of term or overnight cash to generate excess liquidity, boosting the monetary base beyond real demand.
In 2018 the central bank also engaged in Soros-style swaps, involving the generation of liquidity shocks with term purchases of dollars, and not intervening when the new rupees hit the forex markets.
The Soros swaps occurred despite the central bank, under IMF pressure, being committed to ending legacy longer terms swaps or quasi-fiscal hedges given to banks.
Another call is to outlaw the practice of giving term money at rates lower than the overnight window rate, especially when the peg comes under pressure.
The lack of central bank securities to mop up inflows has also been identified as a reason for balance of payments crises coming in quick succession.
However as in the case of rejecting bids at Treasury auctions and printing money (or overdrawing the Bank of Ceylon), it may take decade or more for these practices to change.
Sri Lanka’s monetary instability, ever rising cost of living and ever falling rupee, trade controls, which started after the central bank was built in 1950, is basically the result of the central bank targeting both inflation and the exchange rate at the same time.
In Sri Lanka it is also called flexible exchange rate, soft-peg or second class peg.
The Path to Monetary Stability
To end monetary instability, to end the destruction of real domestic savings which generates a need for imports of capital to invest, to end restrictions on the capital outflows (both of which tend to generate a persistent current account deficit in the external account), and re-start free trade which was progressively lost after 1950, analysts have proposed an end to the soft peg or ‘flexible exchange rate’.
They have called for two paths to end monetary instability.
One is for inflation targeting with a fully floating rate where monetary base is altered only by the sale or purchase of Treasuries and not dollars.
There will be no convertibility undertakings to operate a peg and there will be no sterilization in either direction to undermine the policy rate or the monetary base.
It also means there will be no central bank forex reserve collections and the government will lose a ‘sinking fund’ to repay foreign debt, though existing central bank reserves can be transferred to a sovereign wealth fund, which will deplete gradually.
Others have called for a hard peg with US dollar or the Singapore dollar, where the monetary base alters only by dollar sales or purchases.
There is one convertibility undertaking and there is no flexible exchange rate, no policy rate, no lender of last resort facilities and the interest rate will float.
All monetary authority profits will be transferred to a dollar sovereign wealth fund which could be demarcated for stimulus, as a foreign debt sinking fund or for bank bailouts.
A variation of the second option is to have a tighter-than-currency-board like China from 1993 to 2005 or several Gulf countries like Dubai, but without a legal prohibition against lender of last resort operations.
In such a currency-board-like system it is theoretically possible for the peg to break and balance of payments crises to occur or both. However, discretion may be avoided if LOLR operations are provided only against central bank securities.
However, under the IMF backed new law, so-called ‘flexible inflation targeting’ is planned.
The IMF’s program has reserve targets, requiring pegging (convertibility undertakings). Its extended program has repayments running up to 2027, which means inflation targeting is not possible in the near term.
In Sri Lanka inflation falls to near zero about a year and a half after a BOP crisis ends and the credit system is just starting to revive, according to analysts who have studied past crises.
They say the proximate reason for the 2011/2012, the 2015/2016 and the 2018 crises was cutting rates when the credit system revived, which is also de facto inflation targeting with a peg.
As a result there are fears that the so-called ‘flexible inflation targeting’ will also end up as a second class inflation targeting with a peg. (Colombo/May20/2019)