ECONOMYNEXT – With just about six months of allowing people to get on with their economic lives peacefully, Sri Lanka’s central bank has bombarded the monetary system with tens of billions of printed rupees to unleash another bout of instability.
The current administration’s economic performance – which was lacking in growth boosting liberalizations, but continued state expansion and worsened price controls – was badly hit by successive bouts of monetary instability, currency collapses and trade controls that came from the deadly ‘flexible exchange rate’.
As pointed out earlier (President throws monkey wrench at central bank reforms) it is difficult for a soft-pegged central bank to generate a full-blown balance of payments crisis when private credit is weak as now and it is also easier to get the credit system out of a collapse.
But with sufficient excess liquidity injections instability can be generated. Instability will get worse, when state or private borrowings spike.
Given the excessive monetary instability generated by the central bank in the past few years – let’s face it we have a gold-taxing, Nixon shocking central bank, what more needs to be said – the public should view the planned reforms to the central bank with great suspicion.
Monopoly Mercantilist Power
A modern central bank, by virtue of being a state agency with a monopoly, has powers drawn from the state which is no ordinary Mercantilist has, except perhaps archetypical agencies like the British East India Company, which had its own army.
The Governor and the Company of Bank of England was also a classic Mercantilist organization, but it was privately owned, and was therefore subject more public scrutiny and parliamentary oversight. It was also kept in check by the gold standard.
Sri Lanka’s central bank and that of India is wielding its monopoly power, with the same ruthless discharge of the control mindset but with greater powers than any 17th century Mercantilist ever had with the ability to issue paper money and depreciate the currency at will.
The Bank of England for example had to get parliamentary approval to float the currency (The Bank Restriction Act), or depreciate.
Given what was done to the people since 2015 in particular with a collapsing currency, REER targeting, gold taxes, car taxes, LTV controls on three-wheelers no less, the planned monetary reforms should be viewed with the most considerable caution.
What Adam Smith said of private Mercantilists can also be applied to Sri Lanka’s central bankers or that of India or Pakistan who bust currencies and impose controls with the same vigor.
“The proposal of any new law or regulation of commerce which comes from this order ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous but with the most suspicious attention,” Smith wrote in the Wealth of Nations.
“It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.”
Monetary window dressing
What is confusing is that the central bank is now promising to end money printing, apparently genuinely. But is then printing money through open market operations and other means to generate instability.
Unlike a classical Mercantilists, the intention may not be bad. But it does not matter how the excess liquidity injections are made, the effects are the same.
If the promise to end money printing was genuine, what happened in August 2019, and the liquidity disruptions should not have taken place.
The current printed money land mines were set off by the central bank barely days after this columnist wrote is support for the planned controls on money printing.
Up to around July 2019 dollars were bought by the central bank to create base money but rupees were mopped up steadily by selling down Treasury bills (see blue area). There were also overnight repo auctions to mop up cash. On July 17, 17 billion rupees in excess money was deposited at the floor rate window.
Then mopping up stopped and excess liquidity started to build up, probably from dollar purchases (see green area). On August 08, 20 billion rupees was printed suddenly on top of unsterilised excess liquidity. There were also term injections and outright purchases around the time.
These cash bombshells show that even if by law the central bank is stopped from taking large volumes of bills from the auctions, it will take them through other means and dump reckless quantities of liquidity on money markets. It will then be justified on the basis of conducting ‘monetary policy’.
When one avenue is blocked, the central bank’s domestic operations department finds another to generate instability.
Then on August 16, the central bank suddenly brought down its Treasury bill stock to Rs77.8 billion from Rs106 billion. Before that, up to Rs25 billion of money was printed overnight and also through term reverse repo contracts.
A few years ago, the bank stopped showing the total bills it takes against central bank credit to the public and understated the bill stock. Was it done to hide the actual bill stock from the people?
The great window dressing exercise left Rs50 billion of excess liquidity in the banking system. The rupee went sliding.
Whom are we fooling?
Floating with excess liquidity: A crime?
A look at recent spikes in excess liquidity tells its own story.
In April 2018, the central bank printed tens of billions of rupees, after releasing liquidity in March. In April the exchange rate can be seen absolutely flat. The central bank was buying dollars (even as it was printing money) in April when remittances come, and export firms convert dollars to pay salaries.
It was pegging with a strong side convertibility undertaking – i.e. preventing the rupee from appreciating.
Then after excess liquidity spikes and the pressure on the exchange rate develops, the exchange rate is floated without mopping up excess liquidity.
The central bank, which was stopping appreciation and buying dollars with great enthusiasm, is markedly reluctant to do the same in the opposite direction. In fact, to deploy weak-side convertibility undertaking the fall has to be ‘disorderly’.
Why not also buy dollars only if the appreciation is disorderly? Talk about a weighted dice.
Not only is there a bias to depreciate, but the central bank also floats the rupee with excess liquidity, built up during the pegging period with the acquisition of foreign assets (dollars) or Treasury bills (domestic assets). Or both, as in the case of August 2019.
No attempt is made to withdraw the liquidity to make the monetary system ready for a float.
As a result, the currency slides, importers and foreign investors panic, then exporters hold back. This bias against the helpless rupee should be outlawed or criminalised as fast as possible.
In August 2018 (last year), after the rupee stabilised the central bank against bought dollars at around 160 to the US dollar, and built up a liquidity spike.
In a tragic-comedy, the central bank also bought dollars through a swap – Singapore has outlawed swaps even for third party banks though Hong Kong hasn’t – and dug its own grave.
Does the central bank believe that rupees created from dollars are different from rupee created from T-bill purchases, and they cannot push the peg down?
There are two reasons which make rupees created from dollars better than rupees created from T-bill purchases, but both have the same downward pressure on the peg.
One is that there are dollars in reserves to defend. The other is that when the dollars are sold, liquidity tightens and the overnight rates go up, to strengthen the peg.
But if dollars in a swap has to be retained to unwind the swap, the reserves cannot be used to sell and defend the currency.
It’s the call money rate, stupid
It is not necessary to have substantial cash shortages to tighten the system. A cash short of about 5 to 10 billion rupees in enough. Then banks can borrow from the lending window at the ceiling policy rate, and the currency can be floated.
James Carville, campaign manager for Bill Clinton, once said [its] the economy, stupid.
All that this columnist can say is that ‘It is the call money rate, stupid. The greatest virtue of buying dollars to expand reserve money is that it can be sold, and when it does the call money and repo rates go up.
In any case none of this will happen if the call money rate is targeted with new printed money.
Repo rates are a good indicator of actual market conditions, and since the feedback loop is very fast.
This central bank, in the run-up to the August/September 2018 monetary debacle, kicked the primary dealers out of the system because they were bidding at high rates for money? Can anyone believe this? Yet it is true.
According to recent media reports, the central bank officials had told the media that it was trying to control the call money rate.
Money Market Killer
In the July to August 2019 debacle the central bank completely killed the overnight money market.
This should be a lesson to all students of classical economics in general and soft-pegged Mercantilism in particular.
In June there was a credit spike. A couple of weeks later repo and call money market became active as existing money was exchanged to clear transactions and keeping a reign on instability.
As rates started to edge up, massive liquidity injections were made to keep call rates low, expanding base money suddenly, taking away all restraints.
Liquidity is not just provided to just to cover any short but billions of excess cash is provided.
All activity is killed. During this time, primary dealers were out of the open market operations, which makes the effect more pronounced.
The targeting of rate below the window rate, with liquidity shocks, shows an unusual recklessness for any central bank, but particularly one that that is trying to build a ‘reserve buffer’ and is facing problems repaying foreign debt.
Why is there a two-way policy rate? It is to help keep the exchange rate strong. Wider the better for the exchange rate.
This central bank recently made a lengthy statement about its monetary policy framework and flexible inflation targeting – whatever that is – and the impossible trinity of monetary policy objectives. It was an absolutely anti-bullionist, banking school type of work, which was full of contradictions.
But that is fine. If the anti-bullionists did it, why not Sri Lanka’s central bank one may ask?
But then how come the rupee is defended – only after a disorderly fall, mind you, showing the bias to depreciate – while the call money rate is targeted? Why isn’t there a floating exchange rate?
If that is the thinking, if August 2019 is a sample of things to come, this columnist shudders to think what may be in the amendments to the Monetary Law Act.
This country has suffered too long at the hands of soft-peggers. From 1951 to 2019. But there is no end in sight to this suffering and hardships. It seems that the deadly downwardly – disorderly – biased, ‘flexible exchange rate’ is going to stay.
In 2019, there is also unprecedented financial repression. Is this 1971 or 2019? Is Sirimavo Bandaranaike the Prime Minister or is it Ranil Wickremesinghe?
Sri Lanka’s markets are working. In fact, the banking sector is competitive enough so that deposit rates are high enough to compensate poor savers as well as the less poor with financial savings when the currency collapses due to state failure.
It is one market that is working efficiently against the massive state failure that is the central bank and its flexible exchange rate and call money rate targeting and flexible inflation targeting.
To compensate for its state failure, the central bank has hit depositors with price controls. Borrowers are now to get a subsidy, and banks are going to be hit with price controls. Not a single banker lifted a finger to stop deposit controls. In fact, they made a pact with the devil.
Now let them sell their soul.
All of this will not take the country anywhere. A Nixon shock is a state failure. Currency collapse is state failure. Sri Lanka’s chronic high interest rates are a state failure. Even China had high interest rates before the 1993 peg. Then rates plummeted.
The structurally high rates are a direct result of monetary instability. Banks are working to save the people from state failure.
This columnist, as well as other observers, had assumed that the central bank was withdrawing liquidity at 7.70 percent above the 7.50 floor rate, out of an abundance of caution.
The August debacle, where money was injected recklessly, shows that there was no such prudence at all. The CB was mindlessly targeting the call money rate it seems, going by media reports. There is no point in talking about monetary reform if large volumes of money are printed to generate liquidity spikes.
In Sri Lanka someone who counterfeits a 100 rupee note is take to court. But the central bank can print massive amounts of money with impunity.
Will criminal punishments work? In an earlier age, those who generated monetary instability and high inflation with large volumes of printed money were guillotined or beheaded.
No such gruesome punishments are needed. But some type of accountability is a must.
The other aspect is that politicians are being blamed for errors coming from targeting short or long term rates with printed money.
People will kick out politicians, and they will pay the price, regardless of whether they do or do not pressure the central bank to print money. In Argentina a President who had a relatively small deficit lost the election.
But soft-pegged central bankers have continued to commit the same errors all over the world. They do the same in Turkey, in Russia, in Nigeria, In Argentina and in Iran.
Actions which caused the most significant damage in recent years which have to outlawed or criminalised are as follows.
1. The buffer strategy (repaying long term bonds with central bank re-financed lender of last resort money injected to state banks).
2. Soros-style swaps. The damage is less if the dollars in reserves and they can be sold to mop up the liquidity – as long as the liquidity has not been borrowed already and used for imports. Then the cash short has to be filled with new money. In the final analysis is it is the same as printing money through a reverse repo transaction.
3. Filling liquidity shortages after giving dollars for maturing 2013 swaps without allowing rates to hit the ceiling rate. A maturing swap is a capital outflow. Overnight rates have to rise after swap matures depending on the size (see above).
4. Injecting cash after going without sterilising dollar purchases for more than 2 weeks. This is what happened in August 2019.
5. Operation twist (a two-leg operation that contributed to the 2015/2016 BOP crisis where long term rates are manipulated)
6. Floating without taking away excess liquidity and allowing rates to move up to the ceiling policy rate. This happens all the time under the deadly ‘flexible exchange rate’. It is not necessary to have large shorts. About 5 or 10 billion rupees is enough. The critical outcome is for rates to move up quickly and then come back down. Prolonged liquidity shortages trigger output shocks
7. Cover-up moves to delay rate hikes. Nixon shock style import controls, gold taxes are covering up for call money rate targeting or other policy errors and delaying corrections.
The following central bank actions cause less damage, but they should also be restricted or some penalties set.
1. Going for more than 2 weeks without sterilising inflows.
2. Going for more than 4 weeks with sterilising inflows – double the punishment for two weeks.
3. T-bill window dressing, like that seen in August.
The 50 billion rupee liquidity bubbles that led to sharp downward pressure on the rupee in 2018 indicate that strict limits must be brought against excess liquidity to keep domestic operations on a tight leash.
A limit must be placed to stop excess liquidity from exceeding 2 percent of the monetary base. If the central bank is willing to allow short term rates (call money and repo) to move up and is ready to defend the rupee with the same enthusiasm that it buys dollars to prevent appreciation, then higher volumes of excess liquidity could be tolerated.
It now turns out that most of these individual wrong policies have been undertaken to target the call money rate.
All this problems with contradictory central bank policies will become much more critical next year when private credit picks up on top of expanding state spending.
This column is based on ‘The Price Signal by Bellwether‘ published in the September 2019 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.