Sri Lanka’s path to debt and destruction paved by currency collapse, REER targeting: Bellwether
ECONOMYNEXT – The collapse of Sri Lanka’s soft-pegged rupee, partly due to policy errors of the Central Bank and partly due to the false doctrine of unsound money, has sown debt and destruction not only on citizens but also on politicians who were demonstrably willing to make difficult decisions on taxation, freer trade and energy pricing.
Unsound money has worsened an external debt problem and sown the burden of depreciation upon a population that was called upon to pay higher taxes, wiping out the benefits of free trade and import duty cuts.
A Lost Generation
Friedrich von Hayek, who debated with Keynes when he was alive, got the Nobel Prize after Bretton Woods collapsed.
Hayek said the dangers of applying Keynesian economics to manage economies were proved but troubles will not end.
“..[I]t has left us with a with a lost generation of economist who have learnt nothing else,” he said, and added in unusually strong language:
“One of our chief problems will be to protect our money against those economists who will continue to offer their quack remedies, the short-term effectiveness of which will continue to ensure them popularity. It will survive among blind doctrinaires who have always been convinced that they have the key to salvation
“In consequence, though the rapid descent of Keynesian doctrine from intellectual responsibility can be denied no longer, it still actively threatens the changes of a sensible monetary policy. Nor have people realised how much irreparable damage it had already done, particularly to Britain, the country of its origin.
While Germany guided by the likes of Hayek, Ludwig von Mises and Wilhelm Ropke created a strong Detsche Mark and a social market economy after its defeat by the Allies, Britain, which led the war, retreated with Sterling crises.
Due to the widespread belief in the so-called false doctrine of ‘lost generation economics’ (in reality, not economics but Mercantilism) that became prevalent especially during Bretton Woods era soft-pegs, it is difficult for people to understand the following two concepts:
a) that there is no prosperity at the end of permanent currency depreciation or the destruction of money, and
b) the strength or weaknesses of a currency is simply based on a monetary rule implemented by a central bank that has the monopoly on issuing money, and has nothing to do with the real economy or how people behave, or fate.
In Sri Lanka, where people widely believe in fate, it has been easy for Mercantilists and central bankers to instill in people a false belief that the rupee is doomed to depreciate because there is something wrong with their behaviour, or the country, or imports.
But no mention is made of the agency that issues the depreciating paper, whose over-issue is responsible for the decline in value.
It was clearly seen in 2018 when outright lies were told to politicians about the reasons for the currency collapse.
There is hardly anyone alive who saw a fixed rupee during their adult lifetimes.
Day after day, the popular press, financial media including the international financial press, reinforces a false belief by attributing to all kinds of real-economy reasons to exchange rate movements – imports, remittances, exporter conversions, securities sales or purchases – rather than to monetary policy.
Currency boards like Hong Kong are ignored because reporters and regional analysts and economists whom they quote do not really understand the peculiarities of monetary regimes. Everyone talks of Dutch disease (that a discovery of oil appreciates a currency) but no one mentions Dubai, Qatar or Oman whose exchange rates, hey presto, apparently do not appreciate.
The Central Bank itself happily throws more dirt into the mix by comparing apples (floating rates like Australian dollar) and oranges (Singapore, which has no policy rate) with rotten eggs (soft pegs like India and Sri Lanka), while ignoring currency boards that are fixed, when comparing exchange rate movements.
It is an uphill struggle to go against more than half a century of lost generation economics/Mercantilism, but this column will try to explain it to some extent.
A Monetary Rule
A currency’s strength or weakness is based on a monetary rule and how it is implemented (the volume of notes and the demand for the bills during a given period), and the same two bases of the currency to which it is compared.
When laymen refer to currency depreciation, they do not refer to depreciation against specie, like gold, and silver or commodities like oil or wheat, but to the product of a central bank that implements a rule more successfully than another, such as the US Fed, which issues dollar notes.
It is now clear that an agency with fully floating exchange rates can implement its rule better (inflation targeting or targeting a domestic anchor) or fully floating interest rates having a fixed exchange rate (hard peg or currency board with an external anchor) rather than one that tries to do both (a soft-peg).
While the Fed has its own faults – and they are many, according to classical economists – it is better than most. As a result, currency depreciation usually refers to depreciation against the US dollar.
But the US dollar itself depreciates against real commodities or precious metals, or other stronger currencies like the Singapore dollar or the Yen, over the longer term. Since the break-up of the Bretton Woods, the Singapore dollar has appreciated to 1.2 from 3.0 and the yen to about 110 from 360 in 1971.
Running in One Place
Drip, drip, drip depreciation or REER targeting makes people run in one place, undermining salary increments and savings made by breadwinners of a family every year and large soft-peg collapses reverse decades of savings and gains made through hard work, promotions and salary hikes.
This is true not only for an individual family but also for a company or a government, and therefore for an entire nation that is made up of these building blocks.
The opposite is true for liabilities if they are dollar denominated – hence the bloating of national debt in 2018.
It has already been shown that Sri Lanka’s central government debt shot up to 84 percent of gross domestic product, despite lower budget deficits, mostly due to trying to target the REER without floating interest rates and inflation without a floating exchange rate.
But how does currency destruction work?
Currency Destruction Made Simple
One example that may make sense of the destruction of REER targeting and depreciation are the expressways.
The budget for 2019 proposed an increase of Rs100 on peak hour fees for expressway users, which were built with loans denominated in foreign currencies. Following the collapse of the soft-pegged rupee, it will still not generate the same dollar revenues as before, though people will have to fork out a bigger portion of their salaries after the Central Bank busted the rupee.
The expressways are built with US dollars, yen or yuan debt. This column will simply compare US dollar debt.
Expressway fees were brought down in the infamous 2015 budget by then Finance Minister Ravi Karunanayke, though people were asking for better governance, not subsidies.
The current fee from Kottawa to Godagama (Galle) on the Southern Expressway is Rs550, which will generate $3.71 to repay its debt.
At the 2014 exchange rate, before the 2015 soft-peg policy errors (terminating term repos like Argentina’s central bank repurchased its sterilisation securities as the economy recovered strongly triggering a collapse of the rupee), a Rs550 fee would have generated $4.23 to repay debt.
After a Rs100 fee hike to Rs650 by the latest budget, only $3.71 would be generated to repay debt, through car owners would be out of pocket for an extra Rs100 (or Rs50) for each ride.
The citizen is back two steps, but the government is also back one step.
If the user fee of Rs600 was unchanged from the Rajapaksa regime, and Sri Lanka had a currency board or was dollarized, $4.62 would be generated to repay debt.
If the fee was hiked to Rs650, fully $5.0 would be generated to repay debt. The citizen would be back one step, but the government would have been a step ahead.
In the case of the Colombo-Katunanayake expressway, the increase would be steeper, with a Rs100 hike equivalent to 33 percent.
In 2014, Rs300 generated $2.31. At the current exchange rate of 175 to the US dollar, from Rs400 about $2.29 would be made.
The citizens are one step back, and the government is running in one place.
In the case of highway fees, there is an administrative decision to raise fees to bring back the status quo. The restoration of the status quo generates an increase in nominal prices – in other words, this is how currency depreciation causes inflation – in the non-traded sector.
In the case of the traded sector, let’s say fuel, prices would automatically rise and if there was a 10 percent tax revenues would also rise by 10 percent, restoring the status quo.
Some time ago, Sri Lanka’s central bankers disputing ex-Central Bank Governor Nivard Cabraal on an earlier currency collapse, said that currency depreciation will bring more revenue not less. They were referring to this inflationary effect.
Finance Minister Mangala Samaraweera had been fed with the same false doctrine apparently by ‘economists’.
He told reporters that Customs had failed to collect more revenues despite currency depreciation and he understood that it was possible when he was giving reasons for changing a head of the department. (Read link – ‘Cusoms Department not fully able to reap the benefits of rupee depreciation as expected’)
Inflationary revenues go up to after an year or so, after incomes go up, not in the same year. Stretching the earlier example – because salaries do not go up automatically with currency depreciation – people cannot spend more on BOTH fuel and expressway fees.
This is because people have to give up a part of their spending to accommodate currency depreciation.
The inability to expand spending exactly in step with depreciation is the same reason central bankers say the currency has to depreciate to account for excess demand (recently over-issued money).
But in Sri Lanka, the same ‘economists’ who say revenues go up due to currency depreciation will say in the same breath that depreciation will account for excess demand and bust the currency.
When a pegged exchange rate is floated, it falls due to recently printed money, and stop falling after the float takes hold and printing halts.
The reason the currency stops after a certain amount of depreciation is because people run out of money to buy goods and no new money is created in defending and printing to stop interest rates going up. So their total spending will remain the same – unless they dipped into savings – which in turn will reduce the money available for credit to other lenders.
There is no linear relationship between currency depreciation and tax revenues as Mangala Samaraweera has been misled into believing.
If 2018 was bad with depreciation hitting from April, Minister Samaraweera should see how it will be in the first half of 2019, when depreciation was even worse.
Officials get away with these patently contradictory and therefore false claims because ordinary people do not probe too deeply into these issues. Ordinary people assume that economic reason is being used when in fact Mercantilist unreason is holding sway.
After inflation takes place (imported goods go up in price, and non-traded items also go up in price later and salaries catch up), nominal revenues will also go up.
When currencies collapse and credit contracts (savings are not loaned out) in fact the currency can be appreciated as it now happens. In that case, nominal revenues will not go up sharply either, since total imports will also slow due to credit contraction in the short term.
But to the extent that the rupee bounces back, real revenues will go up.
Debt and State Revenues
A country that has a lot of liability dollarisation require real dollar revenues, not nominal rupee revenues. In Sri Lanka now, government debt including state-guaranteed loans of agencies like RDA, airport and energy utilities make up about half or more of the national debt.
Despite increases in taxes including personal income taxes, there has been slow growth in real dollar revenues.
It will happen later when the currency stabilises, economy recovers, inflation goes up and salaries go up and the people had slid back two steps.
In 2018, where REER targeting really saw its full effects, real revenues had fallen by $1.4 billion.
Reporters including at EconomyNext had been portraying the August 2018 excess liquidity spike which led to the second run on the rupee in 2018, as policy errors of soft-peggers who do not know how to operate a peg (this is, of course, true by definition – that is why soft-pegs collapse).
But it could well have been a deliberate bust of the currency to target the REER which had climbed to 104 by June and 105 by July 2018 as the Reserve Bank of India made policy blunders depreciating the Indian Rupee steeply, and other currencies also fell.
The REER appreciated despite the Sri Lanka rupee collapsing from 153 to 161 mostly because other currencies in the basket were unstable. This column warned earlier that Sri Lanka would import all policy errors and that of the lowest denominator central bank like the RBI through REER targeting.
Salary Catch Up
To the extent that salaries do not catch up, a currency fall will benefit special interest darlings, especially hard goods exporters. But services exporters like software will see brain drain, unless salaries are jacked up fast for their qualified globally-mobile workforce. To the extent that wages do not catch-up, politicians will pay the price at the elections.
But the central bankers who destroyed the money, and the family, will get away scot free as they have been doing so for decades.
Salaries usually do not catch up completely. That is why soft-pegs are ‘miserable third-world countries’, as Singapore’s first Finance Minister and Currency Board chief Goh Keng Swee said, leaving gaps with other countries.
Even when salaries catch up, the country and its people will only be back to square one. Make no mistake; there will be no progress.
But based on the REER index or due to policy errors, the currency will fall again.
There have to be productivity increases, particularly in labour to have real progress. Productivity increases come from capital investments or now increasingly, education. But when capital is destroyed there won’t be any productivity increases.
Under REER targeting parents who are paying fees to send their kids to universities abroad are among those who are paying the highest price. These parents are giving valuable global skills to their kids mortgaging their houses in the process.
All the fees for foreign exams at even affiliated colleges are up. Immense harm has been done to these people. With lower real salaries at home, there is less prospect of these kids coming back.
REER targeting and lost generation economics/Mercantilism, therefore, is promoting brain drain and discouraging the creation of brains to drain in the first place.
Even in other areas capital is required to boost productivity.
But currency collapses destroy real capital and savings. In countries with depreciating currencies, nominal interest rates have to be chronically higher to give real returns to savers.
Even so, the beneficiaries may be the larger fixed deposit holders and government bond holders, where markets are more efficient. Buyers of large fixed deposits or bonds have bargaining power.
Savings depositors – the weakest members of society – pay the highest price from REER targeting and currency depreciation.
But everyone is paying a price. House builders, factory builders, transport operators, even the IT sector is paying the same price for the wanton destruction of money.
A key reason that countries like Singapore and Malaysia (and China after 1993) has plenty of domestic capital and nominal interest rates are low is due to strong currencies.
Savers make up for low nominal rates with real capital retention and borrowers do not have to pay high nominal interest from their own value addition to make up for wanton destruction of the currency.
It is laughable the way the central bank blames primary dealers and others for pushing interest rates up.
It is the central bank deprecation also monetary instability that requires high interest rates to restore the status quo or correct policy errors as well as preserve real capital.
Capital destruction can be seen in several ways. Some of the largest banks in the world are in Japan.
How did that happen if interest rates are probably the lowest in the world?
One reason is the strength of the Yen or sound money, which has also kept inflation low or zero.
Since the break-up of the Bretton Woods soft-pegs the Yen had appreciated from around 360 to 130 to the US dollar.
If a government in a dollarized country, defaults and there is a – say 15 percent – haircut on defaulted bonds as part of a debt workout, pension funds who own the debt will make a 15 loss, and banks will also lose the real value of their bond portfolio which may be 30 to 50 per cent of the total assets.
If there is currency depreciation the value of all assets will be lost.
However, banks will also see the value of deposits fall. Depositors will lose on a net basis.
In the year ending 2014, the gross assets of Commercial Bank of Ceylon, Sri Lanka’s largest private lender, grew 31 percent to $6.07 billion.
In the subsequent four years, gross assets only grew 17.4 percent to $7.13 billion amid currency depreciation.
Interest rates were low in 2014, with gross revenues growing only 0.7 percent to $568 million.
But net assets were up 15.4 percent to $538 million and net profits were up 6.8 percent to $79.8 million.
In 2018, gross assets fell 4.65 percent from $7.48 billion in 2017.
At Bank of Ceylon in the 2014 financial year, gross assets grew 11.1 percent, to $10.14 billion.
In the whole of the next four years, assets grew a total of 22.38 percent to $12.4 billion, with a 2.8 percent decline in the last year.
Net assets grew 29.4 percent to $570 million in 2014.
Over the next four years, the growth was only 16.4 percent to $664 million with the final year seeing a decline of 8.6 percent with the rupee collapsing to 182 to the US dollar.
One may argue that assets can grow because banks borrow abroad and some banks may be more aggressive than others or that central bank forward guarantees may have an impact.
In that case what about deposits?
In 2014, Commercial Bank’s deposits grew 16.84 percent to $4 billion. In all of the subsequent four years, their deposits grew only 34.9 percent to $5.44 billion, with a 2.98 contraction in the last year.
In that case what about deposits?
In 2014, Commercial Bank’s deposits grew 16.84 percent to $4 billion. In all of the subsequent four years, their deposits grew only 34.9 percent to $5.44 billion, with a 2.98 contraction in the last year.
At NSB, the four-year hit on real deposit is higher.
In 2015, deposits grew 10.15 percent. In the intervening years, deposits grew only 8.6 percent.
Expropriation by deposit caps
The real deposit loss during the depreciating year will be recovered somewhat in the next year as deposit rates fall slowly.
Now there is talk of deposit caps. Deposit caps will expropriate the depositors will feel the effects of currency depreciation even more.
If deposit caps are placed what will be the plight of the people? Maybe the entire banking system will be like the NSB or worse.
This is the reason that ‘developing countries’ find that there is not enough domestic capital for investment.
More often than not the culprit is the soft-pegged central bank which not only destroys capital wantonly but also generates capital flight with depreciation as well as exchange controls to combat the run.
East Asian nations with stable currencies, do not have to borrow abroad much as domestic capital is not destroyed by the central bank. Only laggard Indonesia depreciated despite having a trade or balance of payments surplus on an implicit REER targeting exercise.
Wanton capital destruction requires foreign borrowings because domestic capital is not enough.
In any case, to get back the status quo, will take many months. The bigger the currency collapse the longer it will take for salaries to adjust and for people to be able to either consume or invest as they were able to earlier.
War and Lost Generation Economics
The 2018 currency collapse was very sharp, sharper than in earlier years. The credit collapse is also acute. The level of bad loans is also high due to two busts coming in quick succession.
It was shown in the last column that a return to explicit lost generation economics involving closing a perceived gap between actual and potential growth by printing money as well as REER targeting without a floating rate was responsible for this situation.
Lost generation economics is worse than war. The Weimar Republic collapsed from monetary instability after the end of World War I, not during the war. That should be a lesson to any country.
Only a handful of economists have driven or advised on monetary policy in Sri Lanka using classical economics, while most officials have been driven by lost generation economics.
The handful include A S Jayewardene and W A Wijewardene. Credit also goes to Nivard Cabraal for implementing tight policy amid a global collapse and war.
It is no secret that Cabraal had to battle fiscal dominance of monetary policy. So much so that a second policy rate was created.
The current central bank had no problem with any pressure from Finance Minister Mangala Samaraweera or Eran Wickremeratne after Ravi Karunanayake was replaced.
As a result, it is evident that there was no fiscal dominance of monetary policy for the instability seen in 2018. Rather it was a problem of monetary dominance of fiscal policy. While 2018 was a clear case to open everyone’s eyes, it can be seen that lost generation economics had played a part in earlier instability as well.
Lost generation economics that brought down the Bretton Woods was a peculiar set of belief systems.
These include the Phillips curve (a belief system that higher inflation will lower unemployment), that gap between potential and actual output can be closed by printing money. There are also other ideas like terms of trade shock or the J-Curve which were also related to the credit cycle, but are instead viewed as Mercantilist trade phenomena.
Lost Generation in 2019
In January there is a severe credit and import collapse. To be sure a part of the destruction was due to the political crisis generated by President Maithripala Sirisena by throwing the constitution to the dustbin.
Capital flight worsened after the political crisis, though the soft-peg was pushed to the weak side of its convertibility undertakings and its credibility lost by a liquidity shock in August.
This column has said previously that it wasn’t practical to float a currency without a constitution. It is a bit difficult fault the central bank for its conduct during the political crisis after October 26.
For the 2015/2016 currency crisis, the budget could be partly blamed though ultimately it was central bank releasing liquidity like Argentina’s central bank repurchasing Leliq notes until then-Governor Arjuna Mahendran asked the head of domestic operations to stop it.
It was immortalised in the Bondscam inquiry report as follows.
“On or about 03rd March 2016, Mr. Mahendran had telephoned Mr. Rodrigo (head of domestic operations) and instructed him, that the conduct of Reverse REPO Auctions should be immediately stopped, so as to stop the injection of liquidity into the market through Open Market Operations. “In this connection, Mr. Rodrigo said that the “Governor telephoned me in the morning, and said to immediately stop conducting of reverse REPO Auctions.”.
“When the Commission of Inquiry asked the witness why Mr. Mahendran had issued such instructions, he said, that Mr. Mahendran had mentioned that the CBSL had earlier increased the Statutory Reserve Requirement in an effort to reduce Liquidity and that the intention of the CBSL was to “drain liquidity.” “Mr. Mahendran had said that, in this background, Liquidity should not be injected into the market by CBSL and that the CBSL wanted Interest Rates to move up.”
The liquidity short
This year liquidity is short. The central bank also kept liquidity short during the political crisis. It had no other choice.
It is well known that prolonged liquidity shortages trigger output shocks and warnings have been given earlier.
In a peg, rates have to go up quickly when pressure comes in, and rates have to fall just as fast when the pressure goes away.
After the post New year, the liquidity short should be cleared, preferably through dollar purchases.
The severe import collapse seen in January will hit tax revenues if it continues. This is also the common effect of lost generation economics. Heavier state borrowings may be required.
Interbank liquidity can be filled permanently, and term repos converted to outright purchase of bills after watching how cash comes back to the system. In the wake of the Easter bombings, borrowings may fall further.
Once the peg is on the firm side (data so far shows that the central bank was steadily buying dollars from February on a net basis), it is quite possible to maintain plus liquidity without causing instability.
As long as a part of the liquidity from dollar purchases is mopped up, the peg will be secure.
It is not necessary to keep the markets short and cut the ceiling rate.
Overnight rates will fall naturally through excess liquidity generated from dollar purchases.
Mopping up a part of the liquidity to collect reserves should be enough to maintain exchange rate stability. As rates fall, the floor rate should be cut.
There is no need to put deposit caps, cut the floor rate as long there are net dollar purchases with moderate mopping up of forex reserves.
IMF programs and policy floor
In the past, when senior hands who had knowledge of pegs were in the IMF program, front-loaded disbursements were made through stand by programs to build reserves and instill confidence.
A key reason to give reserves was so that large volumes domestic credit were not contracted by excessive mopping up.
IMF disbursements gave immediate reserves, and domestic reserves could then be mopped up by curtailing credit over extended periods, allowing growth to recover.
All these principles seem to be lost after the IMF started to broadbase hiring. Chicago school or LSE graduates are the best candidates for IMF since they do not believe in lost generation economics.
If the rupee does not appreciate back, inflation will come regardless of the low or high policy rate.
The policy ceiling, in fact, should be kept where it is or even widened so that the peg will be protected by a quick rise in rates if policy errors are made or there is capital flight in the future.
And policy errors will be made.
The recent prudent monetary policy is probably an anomaly. Unless some kind of accountability mechanism is set up this country will continue to pay a high price for the soft-peg and lost generation economics will continue to haunt the country.
The second class peg with a ‘flexible’ exchange rate has done incredible damage to the country since 1950 while countries with harder pegs overtook the island.
Seventy nine years is a long time not to learn. Now another second class monetary framework with ‘flexible’ inflation targeting is planned and the opportunity bring monetary stability is going to be lost again.
The poor had paid a heavy price with currency depreciation and the high nominal rates that monetary instability brings as well as high and un-necessary reserve ratios.
They should not continue to pay the same price. This impunity has to end. It has continued too long already.
This column is based on ‘The Price Signal by Bellwether‘ published in the May 2019 issue of the Echelon Magazine two months ago. 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.
Economic Intelligence Unit of the Ceylon Chamber of Commerce
Jehan Perera - Executive Director National Peace Council