ECONOMYNEXT – While Sri Lanka defeated the Tamil Tigers in 2009 and the Coronavirus in 2020 – the battle is not yet over – it is rapidly losing the war with monetary stability, and the country is in a trade and foreign exchange lockdown that was not seen during the height of the civil war.
Sri Lanka’s central bank is printing unprecedented volumes of money, despite upcoming foreign debt and downgrades the country has suffered.
In 2018, Sri Lanka suffered a downgrade despite tax hikes and the deficit being brought down by the then-Finance Minister Mangala Samaraweera, showing very well that no policy framework will work without monetary stability.
As the German (Federal Republic) Minister Karl Schiller said – Stability may not be everything but without stability everything is nothing.
Economic consequences of the peace
Sri Lanka’s monetary policy has progressively deteriorated after the civil war; starting from 2011/2012 balance of payments crises.
As a result, the country is now in severe monetary and balance of payments problems it did not suffer even during the height of the war.
As this column is written more than 220 billion rupees has been printed and 1.3 billion US dollars have been lost.
Amid currency falls in 2018 despite severe fiscal corrections, the sovereign rating had been downgraded to B- as warned in these columns earlier due to the country’s obsession with low non-market interest rates.
This column warned several times that if the central bank continued with these policies that same thing that happened to pre-World War II Weimar Republic Germany would happen to Sri Lanka.
If Sri Lanka is to progress it has to follow the German policies after World War II, followed by the Ordoliberals, which led to the German Economic Miracle.
When John Maynard Keynes wrote Economic Consequences of the Peace, he could very well have been writing about Sri Lanka and in fact this country is under the same illusions.
Sri Lanka’S current monetary policies also have some parallel with what happened in Nazi Germany.
Of ÖFFA bills and Contractor bills
Sri Lanka’s Central Bank is set to monetize billions of contractor bills, after monetizing over Rs100 billion of private bank loans with bank re-finance – money printing.
The contractor bills would be monetized with 1 percent money from the Central Bank in a scheme similar to that hatched in Nazi Germany to circumvent budget and Central Bank rules.
In fact Sri Lanka’s Central Bank promoted by New Dealers in the US – which destroyed the Philippines and South Vietnam by promoting bad leaders and almost destroyed Korea (and Japan) has much more leeway to create money than the Reichsbank.
In 1932, the then German cabinet in consultation with Reichsbank Governor Hans Luther cooked up a scheme to finance government spending without directly printing money for the Treasury.
Bills would be issued through a company (like a contractor) called the German Society for Public Works (Deutsche Gesellschaft für öffentliche Arbeiten AG) which would be discounted (re-financed) by the Reichsbank to finance public buildings.
They were called the Öffa bills. Luther agreed to re-finance only a small portion.
After Hitler became Chancellor in 1933 he wanted the scheme to be expanded.
Hans Luther disagreed and was replaced by Hjalmar Schacht, who started a similar scheme called MEFO bills.
MEFO bills were issued by the Metallurgical Research Corporation (Metallurgische Forschungsgesellschaft) another similar shell company, which would given to banks to get money, and in turn would be discounted/re-financed by the Reichsbank on demand.
MEFO bills carried an interest rate of 4 percent. Though issued for six months, they were extendible by 90 days. Schacht extended the maturity to reduce the chances of the bills coming up for redemption.
Germany resorted to MEFO bills because the Reichsbank law prevented direct financing of the deficit. Under John Exter’s Monetary Law no such prohibition exists and the discounting of contractor bills and the re-financing of COVID-19 loans comes on top of direct financing of the deficit of hundreds of billions of rupees.
On available data over 400 billion had been injected to the banking system so far, and 1.3 billion US dollars had been lost up to June.
The central bank is engaging in swaps like the Philippines central bank to boost reserves. About 150 billion in re-finance is to be issued. The exact volume of contractor bills has not been disclosed.
Nobody knew the exact volume of MEFO bills issued either. However when they eventually matured there was a huge explosion in money supply around 1939.
They created foreign exchange problems for Germany and gold losses (which were boosted with the reserves of new countries that Hitler conquered), leading to Hitler to make his well-know ‘Export or Die’ speech which was repeated by J R Jayewardene during monetary instability after 1978.
In Sri Lanka contractor bills would be immediately discounted, not five years down the line.
The effects would be seen fast. The other reason that Hitler resorted to MEFO bills was to circumvent budget rules set by the Versailles treaty.
By issuing bills which can be discounted though the central bank budget rules were circumvented.
IMF e-libraby: Germany in the Interbellum: Camouflaging Sovereign Debt
“Inflation is anti-democratic,” explained classical economist Ludwig von Mises. “Democratic control is budgetary control. “The government has but one source of revenue – taxes.”
“No taxation is legal without parliamentary consent. But if the government has other sources of income it can free itself from this control.”
There are other troubling facets in recent data released by the Central Bank. The agency had printed Rs50 billion for an ‘energy stabilization’ fund. This fund was supposed to be built out of taxes.
Why is printed money needed? Also how legal are these funds outside of the consolidated fund?
Sri Lanka has made a game of presenting a non-credible budget to parliament and then finding ways to undermine it especially after the war. These include funding the Road Development Authority and the National Water Supply and Drainage Board with guarantees.
The RDA funding tends to understate the deficit in the year debt is incurred. The money is later paid out of capital spending because the agency has no revenue.
Sri Lanka is now under budget problems also due to the lack of elections. That is probably why contractor bills are not settled by selling government bonds which is the simple solution, but a subterfuge like the MEFO bills is resorted to.
However it may also be due to the desire for ‘stimulus’ or the obsession with low interest rates that had led to high interest rates and a slump later.
Keynes Haunts through REER Targeting, Stimulus
Sri Lanka’s latest downgrade came in the wake of a fiscal ‘stimulus’ in the form of tax cuts and monetary ‘stimulus’ in the form of rate cuts and liquidity injections.
However, it is a mistake to blame the troubles only on the most recent ‘stimulus’.
The reason for the ‘Keynesian stimulus’ was the slump in 2019, which was created by liquidity injections and rate cuts in April 2018, the so-called ‘buffer strategy’ and also the July Soros-style swaps in the form of a monetary stimulus.
The reason such a monetary stimulus was done was due to targeting the call money rate and also targeting the potential output gap.
The International Monetary Fund taught the central bank to calculate the output gap. When Fed Governor Arthur Burns, targeted the output gap the entire Bretton Woods system collapsed in 1971. The Great Recession was due to the so-called dual mandate.
Many of Burns’ claims – that there was a component of non-monetary inflation – had been heard in Sri Lanka over the last few years.
The bloating of the debt and the slowing economy is due to currency collapse.
Under Governor Indrajith Coomaraswamy a real effective exchange rate (REER) was targeted by depreciation amid claims that East Asia ‘undervalued’ their currencies – a false charge frequently leveled by US Mercantilist in Western media which was taken to a new level by Trump in a trade war.
In 1993, China, in fact, stopped devaluation and fixed the Yuan. Japan fixed the currency at 360 after its own episode of Economic Consequences of the Peace, luckily because Joseph Dodge, a US banker who worked in post-war Germany with Ordoliberals, was helicopter dropped to Tokyo.
He stopped not MEFO bills but ‘Fukkin bonds’, which were also bought by the Bank of Japan for a reconstruction bank and fixed the currency at 360 and ended dual exchange rates and inflation when up to 600 yen was paid under a multiple exchange rate system.
The Yen exchange rate remained until the Bretton Woods collapsed in 1971 and has since appreciated to 110 to the US dollar amid claims by US Mercantilists that the Yen was undervalued and it needed appreciation to stop the trade deficit.
But Japan’s trade deficit with the US did not disappear, because the US was deficit spending with foreign loans (exporting debt) and getting a lot of FDI (exporting investments), which was the real reason for the gap.
In the same way the trade deficit with China did not disappear either after the Yuan was appreciated from 2005. However China’s growth has fallen and interest rates have been volatile.
Depreciation and REER targeting is a problem with Keynesianism and so-called Lost Generation of economists that follows the Cambridge dons’ teaching.
Despite lessons from East Asia’s best performing nations including Singapore, Taiwan, Thailand, Korea (and Japan earlier) that strong currencies create stability and preserve domestic capital, facts are ignored in favour of ideology.
“The days are gone in which most persons in authority considered stability of the exchange rates to be an advantage,” wrote Mises as far back as 1944 but he could have very well been talking of the REER targeting exercise of the last administration.
“Devaluation of a country’s currency has now become a regular means of restricting imports and expropriating foreign capital.
“It is one of the methods of economic nationalism. Few people now wish stable foreign exchange rates for their own countries.
“Their own country, as they see it, is fighting the trade barriers of other nations and the progressive devaluation of other nations’ currency systems.
“Why should they venture to demolish their own trade walls?”
The words were echoed by then-Governor Coomaraswamy in early October after the rupee fell sharply amid liquidity injections.
“Things like potatoes and onions, we are producing more which can compete with imports,” Coomaraswamy told reporters.
Each time the rupee collapsed other Central Bankers, including Arjuna Mahendran, have also claimed it made Sri Lanka more ‘competitive’, while Singapore’s exchange rate appreciated from 3 to 1.2 from the collapse of the Bretton Woods, Hong Kong fixed it though a currency board.
Malaysia, Korea and Thailand also pegged strongly and had only one East Asia crisis.
“The Keynesian school passionately advocates instability of foreign exchange rates,” noted Mises.
Spurious Transfer Problem
Sri Lanka not only believes in devaluation to promote exports, but also believes that their foreign exchange shortages are caused by the lack of exports or imports or both, rather than monetary instability.
This is also an idea dating back from Keynes’s Economic Consequences of the Peace.
Before World War II, Western leaders were led to believe that German war reparations were triggering forex shortages in Weimar Republic Germany and not money printing.
“The Allies were from the very beginning of the negotiations handicapped by their adherence to the spurious monetary doctrines of present day statist economics,” wrote Mises.
“They were convinced that the payments represented a danger to the maintenance of monetary stability in Germany and that Germany could not pay unless its balance of trade was ‘favourable’.
“The truth is that the maintenance of monetary stability and of a sound currency system has nothing whatever to do with the balance of payments or of trade.”
“If a country neither issues additional quantities of paper money nor expands credit, it will not have any monetary troubles.”
“An excess of exports is not a prerequisite for the payment of reparations. The causation, rather, is the other way round. The fact that a nation makes such payments has the tendency to create such an excess of exports.”
“There is no such thing as a ‘transfer’ problem.
“If the German Government collects the amount needed for the payments (in Reichsmarks) by taxing its citizens, every German taxpayer must correspondingly reduce his consumption either of German or of imported products.
“Thus collecting at home the amount of Reichsmarks required for the payment automatically provides the quantity of foreign exchange needed for the transfer.”
To retain the ability to pay foreign debt, Sri Lanka’s government must sell debt domestically at auctions (which is a type of default of domestic debt) without the Central Bank printing money to take up a part of the issue or the whole of it as has happened recently.
Whether the money is taxed or borrowed, the private citizens will be crowded out and imports will be reduced and there will be a surplus of dollars to buy. If it is borrowed rather than taxed, the rationing is done through the credit system via interest rates.
External Sector Lockdown
Instead of flying high – or at least moving forward with some confidence like Vietnam with sovereign bonds trading at a premium with Coronavirus under control – Sri Lanka is now in an external lockdown with import and exchange controls and unable to rollover bonds.
If money printed to boost credit and rates are kept low, not only will there be balance of payments problems but prices will also rise or inflation in current terms – in classical terms inflation was an inflation of the money supply.
Recent currency collapses did not lead to proportionate rises in prices partly due to negative dollar inflation at times (falling commodity prices) but also due to private sector productivity gains made in the years prior to deprecation.
Unlike in the past the component of food has been reduced in the Consumer Price Index following basket changes made over the last decade, which tends to keep prices low as private sector productivity absorbs part of the depreciation.
A part of the deprecation was also absorbed by falling margins of private firms. But now firms can hardly pay salaries, much less absorb more losses.
Import controls will not only strangle the economy, but it will also lead to losses of revenue. Import substation tax arbitrageurs will, in the meantime, have a field day collecting taxes that would have gone to the state.
There will also be increased smuggling which may also lead to the transmission of Coronavirus. This country was not put in this kind of economic straight jacket even at the height of the war, when Deputy Governor W A Wijewardene was running monetary policy and Nivard Cabraal was Governor.
In 2008 foreign financing was a negative -Rs4.4 billion when the entire deficit was financed domestically for the first time in post-independence history. Not even in 1955 when there was a budget surplus was foreign financing negative.
That was the year direct placements were started outside of auctions after giving high rates of interest to savers and the EPF, which came under fire after the bond scam.
Direct placements made in 2008 helped avoid money printing and probably headed off an even severe external meltdown.
“All Governments, however are firmly resolved not to relinquish inflation and credit expansions,” Mises said.
“They have sold their souls to the devil of easy money.”
Sri Lanka needs to radical shift away from the policies involving monetary instability, nationalism (economic and otherwise) and the regime uncertainty of pulling the rug from under the private sector with fluid policies and expropriation which has kept the country back from independence.
Otherwise, the devil will come to collect. This time the interest will be high.
This column is based on ‘The Price Signal by Bellwether‘ published in the July 2020 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here. (Colombo/July23/2020)