ECONOMYNEXT – Sri Lanka’s State Minister for Economic Affairs Harsha de Silva, has re-kindled a debate as old as economics itself, repeating the advice David Ricardo once gave the Bank of England on sterilized gold sales in the early 19th century who also recalled the words of Adam Smith.
Sri Lanka’s rupee started sliding in 2018, ending a controlled depreciation achieved in 2017, when dollar inflows were mopped up, and a de facto peg with the US dollar was anchored to a real effective exchange rate index. In the first quarter mopping up inflows suddenly ended weakening the peg.
Mopping up forex inflows (destroying money created by central bank when purchasing dollars) shrinks the real monetary base, keeping the ‘circulating medium’ below what is determined by the balance of payments, generating a strong peg, by contracting domestic credit, which is even stronger than a conventional currency board, analysts say.
However, sterilizing outflows of dollars (printing money to fill cash destroyed by dollar sales by the central bank) resists a contraction of the monetary base (and a rise in interest rates) as determined by the balance of payments, boosts domestic credit with printed money, leading to a continuous loss of forex reserves.
Sterilized Forex Sales Debate
"There’s been some discussion whether to have sterilized or unsterilized interventions, but in this instance I think it was sensible to try and keep a lid on interest rates and not allow interest rates to go sky high," Dushni Weerakoon, Executive Director of the Institute of Policy Studies, a Colombo-based think tank, said at an economic forum earlier this month.
"Because at this time increase of interest rates is not going to stop the exit of investors from T-bills and bonds or the opposite – inflows of new investments."
De Silva, an economist before he became a politician, said he was not asking for sky high rates, but at least to allow rates to go up to 8.50 percent ceiling overnight policy rate and the rest of the yield curve to be market determined.
"I slightly differ from Dushni’s viewpoint whether we should sterilize more or less in interventions in the forex market," he said.
"As you now see, overnight call money rates have almost hit the ceiling at 8.5 percent.
"If it is hitting the ceiling and you’re not injecting money at below 8.5 percent, then it’s alright and there’s no need currently to increase your policy rates.
"But at least let the overnight rates be within the higher margin of the policy rate. It’s prudent.
"Of course it’s going to have a negative impact on growth, but that is what we have to give to have some sort of stability on the exchange rate."
The central bank is still injecting printed money at 8.4 percent and longer term money below the Sri Lanka Interbank Offered Rates, subsidizing the hit on the currency but even that rate is over three times that of the Federal Reserve.
"This is a debate that is going on," De Silva said.
"I trust the economists at the central bank are thinking about this and are trying to balance the two sides."
De Silva, has been a strong critic of the central bank when it was sterilizing interventions and triggering balance of payments crises in the past.
As a government minister he has been careful not to undermine confidence in the agency or its current Governor who commands widespread respect, but is trying to nudge it towards more prudent policy.
De Silva said there was an overshooting of the exchange rate and fundamentals of the economy were strong.
Neo-Mercantilism
De Silva’s advice not to sterilize foreign exchange interventions (or at least limit sterilization by allowing rates to go up) has been given to the Bank of England by classical economists like David Ricardo in the early 1800s, when the Bank of England’s soft-peg (with gold) broke.
The Bank of England suspended gold convertibility in 1797 (floated the pound), after credibility in its gold peg was lost, generating a run on gold.
Analysts say economics per se was defeated after World War II with Neo-Mercantilism coming back to the fore, with the US Treasury and State Department setting up the Bretton Woods system of failed soft-pegs and convincing people that it could work amid Keynesianism.
Large numbers of people, who are perfectly rational otherwise, again now believe that trade or current account deficits rather than monetary instability trigger currency depreciation as in the time of classical Mercantilism or as David Ricardo called it, "an evil of such magnitude."
Post World War II Mercantilists turned their backs on sound economics put forward by the likes of David Ricardo (or Adam Smith) at the beginning of their profession, which then led to widespread currency troubles and trade restrictions as bad or worse than the inter war years that the architects of the Bretton Woods were hoping to avoid.
High Price of Gold/Dollars
Ricardo explained that when gold was money (circulating medium), if a new gold mine was discovered, it will expand money supply and reduce the price of gold.
This will lead to the export of gold (in exchange for some other article) to countries where gold was more ‘expensive’, until gold prices ‘went up’ again in the country with the gold mine, which is similar to an unsterilized sale.
"In return for the gold exported, commodities would be imported; and though what is usually termed the balance of trade would be against the country exporting money or bullion…," Ricardo explained in the High Price of Bullion, a Proof of the Depreciation of Bank Notes in 1809.
"If instead of a mine being discovered in any country, a bank were established, such as the Bank of England, with the power of issuing its notes for a circulating medium; after a large amount had been issued either by way of loan to merchants (such as modern day term reverse repo deals with banks), or by advances to government (directly buying Treasury bills at Wednesday’s auction), thereby adding considerably to the sum of the currency, the same effect would follow as in the case of the mine."
"The circulating medium would be lowered in value, and goods would experience a proportionate rise.
"The equilibrium between that and other nations would only be restored by the exportation of part of the coin."
Regardless of what happened to the money supplies of other countries, Ricardo explained that as long the Bank of England was prepared to pay gold for the notes later (unsterilized gold sales), it could buy gold for notes (unsterilized purchases).
However if new notes were re-issued (if the gold sale was sterilized) and the contraction of reserve money was resisted, the exchange rate will weaken again.
"[I]f the Bank assuming, that because a given quantity of circulating medium had been necessary last year, therefore the same quantity must be necessary (resists a contraction in the monetary base) this, or for any other reason (push growth in modern Keynesian terms, bring rates down), 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.."
If the bank continued to sterilize interventions (fill with new money keeping rates down), all gold reserves would eventually be lost in a classic balance of payments crisis.
"In this manner if the Bank persisted in returning their notes into circulation, every guinea might be drawn out of their coffers," Ricardo wrote.
Penelope’s Web
Ricardo also explained that buying gold in the market and coining them will not solve the problem either, quoting Adam Smith.
"If to supply the deficiency of their stock of gold they were to purchase gold bullion at the advanced price, and have it coined into guineas, this would not remedy the evil, guineas would be still demanded, but instead of being exported would be melted and sold to the Bank as bullion at the advanced price," he wrote.
""The operations of the Bank,” observed Dr Smith, alluding to an analogous case, ”were upon this account somewhat like the web of Penelope, the work that was done in the day was undone in the night.""
Penelope was the wife of Odyssues who was ostensibly weaving a shroud for her dying father in law, and undoing her work in the night, so that the cloth would not be finished and she would not have to accept another suitor and could remain unmarried until her husband returned.
Adam Smith was referring to a case where debased coins were in circulation, and people were melting good coins and exporting them and the bank was minting more new coins with the correct value of gold and releasing them causing them to be melted again.
People could also melt coins and sell gold to the bank itself, repeating the cycle all over again.
This was somewhat ‘analogous’ in concept to a modern soft-pegged bank entering into Soros-style swaps, where the new money from the spot leg is used to hit the peg.
Buying dollars from the Treasury in the midst of currency pressure, releasing new money into the banking system to hit the peg again is also ‘analogous’ to the Penelope’s web, analysts say. (Sri Lanka should stop surrendering Treasury dollar inflows to the Central Bank).
De Silva had also urged the central bank not to engage in Soros-style swaps.
Mercantilist Whipping Boys
In modern Sri Lanka the whipping boy for monetary instability is motor vehicles and the current account deficit. In Ricardo’s time it was corn imports (grain) and merchandise trade deficits. In Sri Lanka gold imported and re-exported (smuggled) to India has also become an additional Mercantilist distraction.
Sri Lanka recently slapped controls on vehicles and some items like footware as the rupee fell due to contradictory policy, leaving the administration’s case for free trade in tatters and with advocates of open markets with egg on their faces.
"I’m not in favour of restrictions," de Silva said.
"If the government goes and puts restrictions on trade, obviously its’s counterproductive to the argument that we’re making that we want to create a conducive trade regime.
"We need to address aggregate demand."
De Silva was again echoing the words of Ricardo on monetary instability: "The exportation of the coin is caused by its cheapness and is not the effect, but the cause of an unfavourable balance."
Despite Ricardo’s work, so-called Corn Laws were enacted to protect domestic farmers, who were powerful politically.
The Corn Laws were abolished in 1846, by Prime Minister Robert Peel, two years after a law was brought to restrain note issuing banks (the Peel Act). (Colombo/Oct23/2018)