ECONOMYNEXT – Sri Lanka should not use foreign reserves for imports, because under a 6.5 percent policy rate an equal amount of money will be printed, which will prevent a contraction in credit and reserve money, encourage imports, perpetuate forex shortages and bring the country closer to default.
There has been flurry of calls to use reserves for imports rather than repaying debt.
No person who advocates Sri Lanka going to the International Monetary Fund can also advocate using reserves for imports with a straight face.
The first step the IMF takes is to hike rates (if they are too low) and force a float of the currency to stop ‘reserves for imports’ and implied sterilization of such reserve sales with printed money.
Such a float – at an appropriate interest rate that is sufficient to finance the residual deficit after a tax hike – will stop the currency crisis in its tracks within a few weeks. IMF will not make any disbursements unless ‘reserves for imports’ are stopped.
The agency gives money to boost reserves, improve confidence and give a breathing space, not to bust them up on import consumption.
If reserves are given for imports, how will any debt, re-structured or otherwise be repaid? As long as reserves for imports are given, Sri Lanka will then default on the re-structured debt.
Any imports have to be financed by inflows only. Not only that, there has to be a little left over to re-build reserves. At the correct interest rate, that can be done.
So giving reserves for imports vs debt is a false choice and a deadly one, made apparently from the lack of knowledge of pegged exchange rates and currency crises.
That reserves can be used for imports as domestic credit picks up is a myth. It is a naked Mercantilist myth. Countries that do so, including those with budget surpluses have come to grief.
For 70 years Sri Lanka has been using reserves to repay debt. Reserves are needed for debt because payments are lumpy. While it is beyond this column to explain the exact mechanism suffice to say, it can be done without altering reserves of multiple banks almost similar to an IMF transaction with the central bank.
However Sri Lanka now does not have a working currency regime. Sri Lanka neither has a credible pegged regime nor a floating exchange rate.
To balance imports with inflows, to repay debt, one or the other is needed. The surrender rules prevent any peg from operating, because they create new money.
Sri Lanka now does not have reserves. The central bank foreign liabilities exceed assets by a big margin.
To say reserves must be used for imports is a statement that has no basis with reality.
Sterilized Currency Defence
When a pegged exchange rate central bank sells dollars to an importer, it is not the same as an exporter selling a dollar or even the Treasury selling a dollar.
A central bank dollar sale reduces liquidity in the banking system and shrinks the monetary base. A 100 million dollar sale of reserves for fuel by the central bank leads to a 20 billion rupee liquidity shortage in the interbank market at the current rate.
This reduction in rupee reserves in the banking system (as long is it is unsterilized) also kills off credit that the 20 billion would have generated keeping the external sector and the exchange rate in balance. An unsterilized currency defence immediately deducts the outflow of real wealth from the banking system as a fall of rupee reserves of banks.
However if this rupee shortfall is pumped backed into banks to maintain the policy rate, re-expanding reserve money, banks do not have to collect new deposits to replenish rupee reserves. It prevents the correction in the credit system that is required to stop the currency crisis.
It is not relevant whether money is printed to finance the deficit or sterilize reserves given for imports, as the economy and credit recovers. The effect is the same.
The injections will will completely mess up the prices in the economy, trigger further imports and reserve losses, even if there is no overt excess liquidity seen in the banking system, like now.
In a clean, ‘fixed’ exchange or credible peg rate there is no sterilization. An outflow of dollars leads to an equivalent fall in the local money, just as if the money supply was dollars.
In consistent peg, net foreign assets (NFA) will move parallel to the growth in reserve money.
In a float net credit to government (NCG) will go in parallel to reserve money.
In a (soft) pegged country, the intervention is sterilized with new money.In a soft-peg prone to crises, the two will go in opposite directions creating crises when NCG goes up (sterilizing reserve sales), and re-building reserves faster than the growth of reserve money when it goes down (sterilizing purchases of dollars).
Fluctuating levels of foreign assets of the central bank and credit to the domestic economy as a share of the monetary base is inescapable sign of a (soft) pegged exchange rate or intermediate regime. To pretend that it is otherwise is foolish and an invitation to disaster.
Gold standard central banks, free banks, and currency board operated on the principle of reserve money changing in step with foreign assets (or gold as the case may be). The Sterling Area operated on this principle for almost a century (with no IMF).
In the currency and economic collapses seen in the 20th century and 21s centuries, came from the artificial manipulation of the interest rate advocated by academic economists who had no banking experience or knowledge unlike classical economists.
The problem was well known to parliaments and bankers of Europe in earlier centuries.
The primary blame for the present day lack of knowledge probably goes to Mercantilist theoreticians from Harvard, Princeton, Cambridge and Oxford, though there are others.
Unlike in the 19th century when the UK parliament debated the question of resumption of gold payment (Select Committee on High Price of Gold Bullion – read report here) with logic and reason and a deep knowledge banking by the 20th century all knowledge of balance of payments problems seems to have disappeared.
Mercantilist ideas about the balance of payments (economic snake-oil if you will) which were discarded after a rigorous analysis in earlier ages became the subject of university education after the Great Depression.
In countries with high inflation and balance of payments trouble, classical economic ideas faded as the societies descended into chaos, though there were beacons of enlightenment from time to time.
In Sri Lanka the B R Shenoy report was one such issued to the government at the time, but not was issued to the parliament.
After repeated failed bailouts of Latin America a rare report was issued under the hand of Jim Saxton who was Chairman Joint Economic Committee of the United States Congress at the time.
That many countries had currency troubles and defaults even without budget problems (East Asia crisis is the most prominent, though it also happens in Latin America) is something that is generally ignored.
The Saxton report, backed by economist such as Kurt Schuler tried to ‘dumb down’ the problem of currency crises in simple terms.
Saxton to US Congress
“The defining feature of a pegged rate is “monetary sterilization,” also known as “sterilized intervention,” explains the report ‘‘Why-currency-crises-happen’‘, which sought to educate US congressmen in the 20th century about currency crises.
“Sterilized intervention occurs when the monetary authority (typically a central bank) offsets its dealings in the foreign-exchange market with dealings in domestic securities that leave the monetary base unchanged.”
When the peg is defended and dollars are sold from reserves, the central bank will also sell rupees against securities through open market operations to try and fix the money base, unlike in a true fixed exchange rate.
Here is how it was explained to US congressmen, which present day parliamentarians would be well advised to read:
“Under a fixed exchange rate, when the foreign reserves of the monetary authority increase as a result of people buying or selling foreign currency to it, the monetary base increases in a fixed proportion, and when foreign reserves decrease, the monetary base decreases in a fixed proportion. The monetary base is on autopilot.
“Under a “clean” floating exchange rate, the central bank does not try to influence the exchange rate at all. It can stay out of the foreign-exchange market, which is on autopilot. Under a fixed exchange rate, when the foreign reserves of the monetary authority increase as a result of people buying or selling foreign currency to it, the monetary base increases in a fixed proportion, and when foreign reserves decrease, the monetary base decreases in a fixed proportion. The monetary base is on autopilot.
“Under a (soft) pegged exchange rate, in contrast, neither the foreign-exchange market nor the monetary base is on autopilot.
“The sterilized intervention characteristic of a pegged exchange rate allows the central bank to control the real supply of money for a time and to hinder the real supply from adjusting to changes in the real demand.
“The delay reduces the accuracy of prices as signals for guiding economic activity. Consider the case where the central bank prevents the doubloon monetary base from falling when real demand for it falls. The central bank maintains in circulation 10 billion more doubloons than people want.
“The cycle continues as long as the central bank refuses to reduce the monetary base. The central
bank eventually loses so many foreign reserves it either must finally reduce the monetary
base or it must abandon the pegged exchange rate and go to a floating rate.”
Argentina’s attempts to create a ‘currency board’ on top of an existing monetary law failed 10-year later because BCRA started to sterilize interventions. The underlying law – which was not changed – allowed sterilization of up to 30 percent of the monetary base.
David Ricardo to Parliament
Here is how David Ricardo wrote in High Price of Bullion shortly before a Select Committee on High Price of Gold Bullion issued a report which was to be the basis of the restoration of the gold standard of the Bank of England.
In 1797 convertibility was suspended (the Pound floated) with UK usury laws preventing the discount rate (like policy rate now at 6.0 percent) from rising above 5.0 percent
He explained that people exported gold after exchanging for Bank of England notes (like sending dollars abroad after exchanging rupees) for useful purposes and they should be allowed to do it.
“Some people might be alarmed at the specie leaving the country, and might consider that as a disadvantageous trade which required us to part with it; indeed the law so considers it by its enactments against the exportation of specie; but a very little reflection will convince us that it is our choice, and not our necessity, that sends it abroad; and that it is highly beneficial to us to exchange that commodity which is superfluous, for others which may be made productive.”
As long as the bank issued notes only against gold which was exchangeable on demand there would be no problems.
“The Bank might continue to issue their notes, and the specie be exported with advantage to the country, while their notes were payable in specie on demand, because they could never issue more notes than the value of the coin which would have circulated had there been no bank.”
If they printed money (issued paper in excess of reserves of specie) there will be reserve outflow from the bank (and the country) contracting the paper.
“If they attempted to exceed this amount, the excess would be immediately returned to them for specie; because our currency, being thereby diminished in value, could be advantageously exported, and could not be retained in our circulation. These are the means, as I have already explained, by which our currency endeavours to equalize itself with the currencies of other counties”
However a crisis occurs if the central bank continues to print money to replace the money it took back in selling reserves, let us say for imports as is happening now to fix the monetary base or circulating medium.
“…[B]ut if 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, and gold bullion would rise…”
“In this manner if the Bank persisted in returning their notes into circulation, every guinea might be drawn out of their coffers.”
So every guinea (reserves) are now being drawn out of the coffers of the central bank.
Suspension of Convertibility
A float will prevent a further erosion of reserves as money will neither be taken out of the banking system or put back, since there will be no reserve sale in the first place.
However a float will not work if the interest rates are too low, and money is printed either to finance the government through failed bill auctions, or banks are financed through the reverse repo window.
However if interventions are made for imports, and they are sterilized, a total currency collapse and an economic collapse comes closer.
The foregoing shows that foreign reserves are not there for imports as claimed by Mercantilists.
Reserves are there in a peg as a restraining influence or in technical terms to ‘anchor’ the monetary base and prices by triggering a tightening of the quantity of money which in turn will trigger a rise in rates and savings and a contraction in credit.
Conserving reserves for imports will not help.
A rate rise will help. However with the credibility of the peg being lost now, and a very large parallel premium having emerged a very high rate is required to maintain the current exchange rate.
A float will prevent a further erosion of reserves as money will neither be taken out of the banking system.
However a float will not work if the interest rates were too low, and money was printed either to finance the government through failed bill auctions, or banks were finance through the reverse repo window.
Interventions are made for imports, and they are sterilized, a total currency collapse and an economic collapse comes closer. And its effects will be made worse.
Reserves as the foregoing shows foreign reserves are not there for imports as claimed by Mercantilists.
Reserves are there in a peg as a restraining influence or in technical terms to anchor the monetary base and prices by triggering a tightening of the quantity of money which in turn will trigger a rise in rates and savings and a reduction in credit.
Conserving reserves for imports will not help. It is a road to nowhere.
Rate rises help by boosting savings and reducing consumption. However with the credibility of the peg being lost now, and a very large parallel premium having emerged a very high rate is required to maintain the current exchange rate.
That sterilized interventions are possible was claimed by the architects of the Bretton Woods and the European Exchange Rate Mechanisms.
It was mostly Americans like John H Williams (Harvard), who were behind the idea of the key currency who led intellectual support to such a claim originally found in Latin American central banks.
He and others, including Arthur Bloomfield who built the disasterous Bank of Korea also operated on that principle based on the Fed/Latin American orthodoxy of the time, advocated such ideas.
Sri Lanka’s central bank also operates on that principle but John Exter in his initial paper, warned not to do so when interest rates were clearly out of line.
The root of the evil is not the fixed exchange rate (which had been the basis of monetary systems until 1971) but the liquidity injections made to enforce an unrealistic policy rate.
Liquidity injections made to outright finance the deficit such as in 2020 or to mis-target reserve money in both 2015/16 and in 2018, eventually reduces growth and also generates inflation due to the liquidity injections made in the run up to the crisis.
“The structureof prices that existed during the period of sterilized intervention contains mistakes that must now be corrected, perhaps at the cost of a recession,” explains the congressional report.
“Mistakes in targeting the real supply of money create opportunities for arbitrage in foreign-currency markets and elsewhere: the bigger the mistakes, the bigger the opportunities. Monetary authorities that in effect target the real supply of money by maintaining pegged exchange rates encourage speculative pressure to build until it forces a devaluation.”
“Currency crises can be viewed as the foreign-exchange market’s way of forcing adjustment of the real supply of money to the real demand when the monetary authority is trying to prevent it.
“”The absence of sterilized intervention does not mean that adjustment will always be smooth; it might be painful. However, the likelihood is that it will be even more painful with sterilized intervention because price signals are likely to become less accurate.”
In Sri Lanka there is no overt speculative attacks like in East Asia, which were done with liquidity created from swaps. In Sri Lanka at the moment, liquidity is created by sterilizing ‘reserves for imports’.
Sri Lanka is heading for more pain.
In 2018 when the central bank embarked on a similar escapade this column warned that Sri Lanka was not Greece where inflation was stable, bank deposits and pensions and salaries retained value and there was no shortages of goods.
At the time severe fiscal corrections had also been made.
At the time the Fed had already tightened policy and oil prices were falling and there was also good rain, which reduces losses and credit pressure from energy utilities. Now a drought is on. Fed tightening is ahead.
But budget are already in dis-array due to the 2019 tax cuts though some new taxes are coming in.
If the 229 billion rupee ‘relief package’ is printed, and more money is printed, things will get worse. At the moment with the rise in Treasuries rates, most of the deficit is financed.
However large volumes of money are printed at 6.5 percent to sterilize interventions. It cannot continue. (When this column was originally published in December, the rate was 6.0 percent)
Earlier the correction, the lesser the pain.
This administration has done well to get finances from India. However they can be frittered away in imports. The credit lines can be effectively used to finance the budget, as long as goods are market priced. Using the fuel credit lines on a loss – making CEB is not a good idea. The food and medicine credits can also be used to finance the budget.
But for this an overall program is needed. This is where the IMF will come in useful. (Click here for other elements of an overall program – Sri Lanka has to hike rates, tourism recovery will not help end forex crisis).
Sri Lanka is not Greece, It is Latin America
Many of the problems seen in recent months, the goods shortages, the price controls (now abandoned in an improvement in policy) fuel shortages had been predicted in these columns, when disastrous monetary policy was followed in 2018, after budget corrections had been made.
The problem is not really politicians though they get the blame. It is the prevailing economic ideology propagated in the West (outside of Germany, Switzerland and Sweden) that is largely to blame. Politicians with economic knowledge are worse than others.
“It is not possible to import goods freely when a soft-peg collapses because there will be forex shortages due to sterilized intervention. Import controls may also come,” this column warned at the time.
“As the cost of fuel or electricity goes up if prices are not raised, more money will be printed to subsidize energy, pushing the currency down.
“In Latin America, energy price controls have led to money printing and rationing. There can be power cuts and fuel shortages.
“In Sri Lanka because of price controls of the National Medicines Regulatory Authority medicines, drugs can go off the shelves.
“In Latin American soft-pegs many price controls were imposed. Instantly goods go off the shelves and black markets appear.
“With import controls more businesses will fail. People will be laid off as revenues fall. Banks will make more losses. Rates will rise eventually. More businesses can fail.
“If this situation continues for several months, there may be runs on banks. If money is printed to bail them out, the currency falls even more. This phenomenon was seen in many Latin American soft-pegs and also Indonesia during the East Asian crisis.
“Debt to GDP will explode until inflation catches up. The share of foreign debt will also increase.
“This is what happens in Latin America. It is not Greece.”
Sri Lanka is not Greece where the anti-austerity brigade created mischief misleading politicians backed by Western financial media. The pain of depreciation, high inflation, un-affordable food and energy shortages are real.
It is Latin America. It is Ecuador before dollarization.