Sri Lanka’s central bank caught between peg and a hard place
ECONOMYNEXT – Sri Lanka’s central bank which is operating a non-credible pegged exchange rate with brief and violent swings to a floating regime is caught between an International Monetary Fund program, the need to provide dollars for the state and targeting a domestic inflation.
The central bank is now under an International Monetary Fund bailout program where it is re-building foreign reserves lost in the 2015/2016 balance of payments crisis.
The central bank has to re-build foreign reserves – a tell-tale characteristic of a pegged exchange rate – which are ultimately also needed to repay the bailout loan.
The IMF meanwhile is also calling for a ‘flexible exchange rate’.
"There is a lack of logic in IMF position," Central Bank Governor Indrajit Coomaraswamy says.
"Because the central bank has not for the last 18 months sold dollars to the market. That is as flexible as it possibly can be.
"At the same time we are being told that we should purchase dollars they have given as a target to build up reserves."
Up to March 2018, Sri Lanka’s central bank was operating a strong peg backed with complementary monetary policy where it bought dollars and mopped up (sterilized) the new money by selling down its Treasury bill stock acquired to generate the 2015/2016 BOP crisis.
Such a policy (sterilized forex purchases) is ‘tighter’ than a currency board (fixed exchange rate) found in countries like Hong Kong where interventions are unsterilized and Sri Lanka had before the central bank was created in 1950.
Mopping up the new rupees by selling down Treasury bills prevent commercial banks from loaning the newly created cash to customers who would then import goods or services with the money, demanding dollars.
Sterilized dollar purchases therefore creates an excess of inflows over outflows preventing pressure on the currency.
During such times, if the central bank wants, it can appreciate the currency at will. In years like 2009 and 2010 it did. In 2017, under a policy of targeting the Real Effective Exchange Rate, the central bank depreciated the currency on top of currency collapses in 2015 and 2016.
The central bank however claims that it no longer operates a peg or crawling peg from 2001 when it ‘floated’ the currency.
Deputy Governor Nandalal Weerasinghe says the monetary authority stopped quoting two way daily, in 2001 and ended its ‘crawling peg’.
Classical monetary economists go beyond the political definitions (pegs, crawling pegs, managed floats, bands) to easily identify the type of monetary regime a central bank is operating.
A central bank whose reserve money grows in step with its domestic assets is unquestionably operating a floating exchange rate regime and all its money is ‘printed’ against T-bills, no reserves are collected, any reserves remaining are simply legacy reserves). There is no sterilization.
Such a central bank targets an interest rate and has to allow the exchange rate to fall when rates are cut such as in April, depending on domestic credit conditions. When rates are raised the exchange rate may appreciate against other floating currencies, depending on domestic credit conditions and the policies of other central banks.
Any monetary authority that consistently grows base money by only acquiring foreign assets (building forex reserves) targeting an exchange rate but not an interest rate, is operating a credible peg or fixed exchange rate, also called a currency board. Again there is no sterilization.
Such a regime will not sterilize purchases and will also not sterilize sales of dollars when credit and import demand picks up (exchange rate fixed, the interest rate floats).
Such a regime cannot create money by purchasing domestic assets (Treasury bills) by law and is not really a ‘central bank’ which prints money to resist interest rate increases or expand reserve money. Hong Kong, Macau, Brunei operate such systems as well as some other countries.
Stable countries like Dubai, Kuwait, Oman and Saudi Arabia also operate quite similar regimes (currency board-like-systems) involving a peg which has a lot of credibility. They piggy-back on US policy rates and they are satisfied with US policy.
Pegged regimes are said to be operating an ‘external anchor’ with no independent domestic monetary policy. As long as the currency does not depreciate, inflation will generally be around the anchor currency (which is usually the US dollar), or a little higher,
Singapore Monetary Authority operates a somewhat similar system (no policy rate) but involving long term appreciation against the US dollar, because its architects found the Fed to be running less than prudent policy over time, (a modified currency board).
All other ‘intermediate regimes’ (managed floats, pegs, crawling or otherwise) with their own policy rates are soft or non-credible pegs. They also sterilize interventions.
Because these soft-pegged central banks can generate reserve money by acquiring domestic assets (T-bill purchases by rejecting bill auctions or using term reverse repo auctions) as well as dollar purchases, the peg can get de-stabilized at any time.
In 2015 when Sri Lanka’s BOP troubles were gaining strength, and even the IMF said the island was not yet in a crisis, Steve Hanke, a top economist from Johns Hopkins University in Baltimore, Maryland, and director of the Troubled Currencies Project at Cato Insitute, a think tank, suggested that Sri Lanka should set up a currency board to get out of the problem with the soft-peg.
Only a few months later, Sri Lanka got (yet another) IMF bailout.
A soft-pegged central bank which sterilizes dollar purchases with no problem for long periods will suddenly trigger a BOP crisis if it then tries to sterilize dollar sales (East Asian crisis) or acquires domestic assets to target a policy rate or finance deficits (Sri Lanka) or repay domestic debt.
This is why Central Banks in Sri Lanka, Argentina, Mexico, Venezuela, Iran, Philippines, Indonesia, India and a number of ex-Soviet states, which have soft-pegs, end up permanently depreciating their currencies and generating high inflation and BOP crises.
Sri Lanka abandoned its consistent monetary policy which was backing the peg towards the end of March 2018 and started pumping liquidity into the banking system by purchasing domestic assets.
In April there is a real demand for cash (an expansion of base money) during New Year season which is generally satisfied by dollar and domestic asset purchases by the central bank.
In countries with credible pegs in East Asia, the requirement is satisfied (during Chinese New Year for instance) by allowing banks to go short reserves.
There was also a repayment to rupee bond holders at around in the first week of April by the Treasury.
If a central bank defends a peg, purchasing dollars, (preventing the exchange rate from appreciating) it also has to defend the exchange rate and prevent it falling when excess liquidity goes up, in order maintain the credibility of the peg.
Even in a hard peg or currency board, when excess liquidity builds up from foreign asset acquisitions, (unsterilized forex purchases) and imports or capital outflows return, the peg has to be defended with unsterilized sales (mopping up domestic money with sales of the anchor currency) allowing rates to go up.
Sri Lanka’s central bank was operating a peg for the past 18 months, sterilizing forex purchases (foreign assets rising and domestic assets falling) indicating a policy mix tighter than a hard peg or currency board, where dollar purchases would have been unsterilized.
As the exchange rate came under pressure after the Hindu Sinhala New Year, the central bank made a violent shift from a peg which was blocking appreciation until March to a floating exchange rate, with its monetary base expanded by domestic assets.
The central bank said initially that it will not intervene in forex markets. This policy is consistent with maintaining an overnight interest rate target and an exchange rate which floats and weakens.
It also mopped up some of the printed money by expiring term repo deals and selling down a part of the 73 billion rupees of Treasury bills acquired to keep rates below the policy floor. Open market operations to maintain a target interest rate is also consistent with a floating rate.
The central bank then started to intervene in forex markets switching back to a peg as the rupee continued to collapse amid excess liquidity in May.
Analysts had warned the central bank in 2015, not to float the currency with excess liquidity in money markets, but to force banks which are lending without deposits, to borrow at the highest overnight rate and then float.
As of May 09, forex interventions were unsterilized, indicating that liquidity that gets mopped up by central bank dollar sales are not replaced to create more excess liquidity as the central bank did in 2015.
While foreign assets are falling due to peg defence, excess liquidity is also falling, leading to a shrinking of the overall base money, which is consistent with maintaining a peg and there is no contradiction in policy.
The central bank is also using moral suasion on forex dealers, which analysts say is inconsistent. Moral suasion should instead be used on banks that are borrowing from the standing liquidity facility.
The unsterilized peg defence is also consistent with what usually happens after the end of the New Year season in Sri Lanka, though the same effect can be achieved by selling down Treasury bills.
As long as base money is shrinking, the central bank is not triggering a balance of payments crisis by its interventions. Eventually when excess liquidity runs out with dollar sales, rates will start to move up, in conflict with its objective of keeping rates low (and a domestic anchor).
On May 08 the maximum overnight repo rate went up to 8.20 percent from 8.15 percent. The weighted average rate has moved up from 7.88 percent on April 27 to 7.99 percent on May 08.
The central bank can trigger a BOP crisis when (and if) it continues to defend the currency, and starts to sterilize the interventions to prevent reserve money from shrinking and rates rising. This can be via T-bill acquisitions or reverse repo auctions.
Sterilizing forex sales is neither consistent with a floating rate nor a pegged exchange rate and usually leads to balance of payments crises.
Because Sri Lanka is in fact operating a peg, regardless of claims to have a float or flexible exchange rate, any inconsistent policy will lead to a loss of credibility in the peg among market participants. The first stage of loss of credibility is exporters, holding back and waiting for the currency to fall.
The second stage of the loss of credibility of the peg is when bond holders sell and there is capital flight. Capital flight can trigger a BOP crisis even when credit growth is mild. However it is not clear whether there is a pick-up in credit at the moment.
Helping Government Debt Service
In Sri Lanka, the central bank is also forced to build up reserves and maintain a peg due to its requirement to help service government debt.
Central Bank Governor Coomaraswamy says while there is a strong logic in those who argue that that intervening is a problem, Sri Lanka’s mountain of foreign debt requires a buffer.
"We have to tailor our policies to the circumstances that confront us," he explained. "Our circumstances are that we need to build up reserves
"For instance our short term liabilities to reserves cover ratio was 53 percent in 2015 went up to 63 percent last year and it is well over 70 percent now.
"But the median for comparator countries is 140 percent.
"So we need to build up reserves. There is a is a strong logic to build up non-debt creating reserves and purchasing form the market is one means of doing so."
The government also needs reserves because it does not by itself generate US dollars, Deputy Governor Weerasinghe said.
Governor Coomaraswamy says while the central bank can print money to repay domestic debt, it cannot do so for foreign debt.
Some countries have specific laws restricting reserve appropriations.
Analysts say past experience in Sri Lanka has shown that providing forex reserves to the government to settle foreign debt has no effect on domestic reserve money or the exchange rate as the net effect is a book entry where dollars are effectively ‘sold’ against T-bills (no reserve pass through).
However the government finally has to generate domestic resources to repay foreign debt through taxation or domestic debt sales. When the T-bills acquired by the central bank to ‘sell’ dollars are sold down later domestic (private) credit is eventually curtailed.
On the other hand if the central bank prints money to repay domestic bond holders, reserve money will expand and the exchange rate will come under pressure and there will be no dollars to service foreign debt.
Classical economists have pointed out that if a government raises resources through taxes (curtailing domestic consumption) or issuing bonds in domestic markets (curtailing domestic private credit), an equal amount of forex will be ‘saved’ for repayments.
But analysts say in economic history it was shown to be a difficult concept (the Transfer Problem) for people in pegged countries or those that follow Keynesian policies to understand.
The Central Bank is planning to implement what it calls a ‘flexible inflation targeting’ regime. For orthodox inflation targeting to work the peg has to be abandoned.
That the regime is called ‘flexible’ inflation targeting has raised concerns among central bank watchers who have observed the conduct of the monetary policy in Sri Lanka for decades and who fear that it will give more discretion for policy miss-steps as in the past.
Deputy Governor Weerasinghe says eventually the central bank hopes to stop collecting forex reserves, when a sufficient buffer has been build up.
However he is not sure whether a fully floating rate can be operated in Sri Lanka.
"All the emerging markets that have a flexible exchange rate they intervene whenever they think necessary," he said.
Only countries like Australia and New Zealand have "100 percent flexibility" in the currency in this region, he said.
Weerasinghe says there is no one-to-one price rise with deprecation in Sri Lanka based on past experience and under an inflation target, the idea is to use domestic monetary policy to counter inflation.
Even when the Sri Lanka rupee quoted daily to operate a peg the pass through to inflation from currency depreciation was only about 0.2 percent for every 1 percent fall in the currency, he says.
He did not elaborate on the time period.
However unlike in Sri Lanka, low inflation, independently floating central banks, do not permanently depreciate their currencies.
While a currency collapse immediately inflates the prices of exports and imported commodities (traded goods) it may take time to translate into non-traded items, as there are delays in salaries and rents, transport costs in catching up.
Salaries sometimes may never catch up if the currency continues to depreciate and if US policy is also loose, leading to lower living standards, poverty, political unrest and strikes.
A further complication is that the US dollar also floats. It is not possible to always accurately measure the movement of the US dollar. A so-called ‘dollar index’ has been created which can be useful to some extent.
Tracking the Singapore dollar, which is driven by an explicit exchange rate based monetary policy, may also be a proxy.
When a domestic anchor is targeted, the central bank ignores foreign exchange movements.
"Whatever impact the currency depreciation has on inflation will be adjusted through monetary policy," explains Governor Coomaraswamy.
"If your monetary policy is targeting a particular (inflation) rate then you know whatever impact that currency depreciation has on inflation can be neutralized through your monetary policy."
At the moment however all indications, domestic and foreign asset changes in the balance sheet, the movement of the dollar rupee exchange rate which has diverged from better central banks, and the loss of credibility by market participants in April show that the central bank is in fact operating a non-credible peg.
The targeting of a Real Effective Exchange Rate Index, analysts have warned, doest not just involve outsourcing monetary policy to a better central bank like the Fed, as Dubai and Hong Kong have done, but also results being hostage countries like India and China, which have suboptimal monetary policy.
Under the current IMF program, while a reserve target has been given, no ceilings have been imposed for domestic assets of the central bank, which would have been consistent with collecting forex reserves and operating a peg (external anchor).
Instead, the central bank was given an inflation target band as a performance criterion, which is a domestic anchor, while the reserve target forces it to operate a peg involving sterilization.
Whatever the claims of a flexible exchange rate or domestic anchor, the results of targeting multiple anchors is ultimately experienced by market participants and the electorate.
In 2015 the central bank poured liquidity and printed money because the ‘core inflation index’ was low, (domestic anchor) despite operating a peg at 131 to the US dollar for about 18 months (external anchor) clearly showing the danger of dual anchors.
The BOP crisis that resulted triggered capital flights and led to a collapse of the currency, the full inflationary effects of which are yet to be seen.
Sri Lanka then ended up in an IMF program under which in 2017, Sri Lanka generated the highest inflation in Asia after Mongolia, which had also just emerged from a BOP crisis and currency collapse.
Analysts also say the problem of operating a peg and contradictory domestic policy can be explained in a much simpler way.
When a peg is operated, the balance of payments essentially drives the monetary base and interest rates. Any attempts to resist a contraction in base money (sterilizing forex sales) generates a credit bubble and a BOP crisis.
In the same way, any attempts to resist an expansion of the monetary base and a rate fall (sterilizing forex purchases) will also slow the credit system and lead to a fall in economic output. (Colombo/May09/2018)
Jehan Perera - Executive Director National Peace Council