ECONOMYNEXT – A grave new risk had emerged to Sri Lanka’s monetary stability and sovereign credit with the Treasury pressuring the central bank to print tens of billions of rupees to repay maturing long bonds and manipulate rates down.
Such monetary bombshells undermine all and any rate hikes, and also wipes out in one stroke, all the extra taxes the people are now paying to expand the tax to GDP ratio to keep the mega state afloat.
When large volumes of money is printed to repay domestic debt the unfortunate consequence will be that the country will run out foreign exchange and it will be forced to default on foreign debt.
In other worlds the infantile monetary pyrotechnics raises a frightening spectre of the post-World War I, Weimar Republic in Germany.
It is always good to remember that every action the central bank or the Treasury or any arm of Sri Lanka’s European style nation-state does, or socialists do, or the nationalists do in the name of home grown policy, there are precedents in Europe.
For the negative state action that hurt the poor or violate the rights of citizens and dehumanizes them, precedents are mostly in Eastern Europe. For actions that restrain the state and enhances the liberties of the individuals and make them rich, the precedents are mostly in Western Europe.
The central bank’s policy stance was de-railed from November 21, when it started to buy Treasury bills outright and with printed money, even before the monetary pyrotechnics that exploded silently at the dawn of the New Year.
Not content with controlling overnight rates, the central bank was trying to influence the yields deeper along the curve b purchasing Treasury bills held by banks and the public and giving them printed money in return.
As the central bank bought bills, long term bond yields fell. Instead of rates moving up and inflicting losses on foreign investors, the outright purchases allowed them to exit with minimal losses or even profits compared to only a week or two earlier.
Foreign investors must have escaped thanking their lucky stars for the unexpected bounty.
The nasty minded may think that there was some hanky panky going on and foreign investors were up to dirty tricks influencing the central bank to drive down bond rates and protect them from losses.
However others would say this is the misguided type of action that can be expected from a high inflation, balance of payments generating central bank.
If the central bank did not print money and manipulate rates – at the top of the credit cycle – how can this country get into trouble so often?
If there is high inflation, if there is balance of payments trouble, the central bank is doing more wrong moves than correct ones.
The outright purchases of bills started on November 21, 2016 with the purchase of a 59 day bill with two billion rupees of printed money.
By December 09 up to 226 day bills were being bought outright. On December 16, 287 day bills were bought. The policy continued till December 19.
It must be pointed out that in the festive season week the demand for cash goes up – due to festival cash drawdowns – and some of the money printed around the Christmas holidays is harmlessly absorbed by notes in circulation as reserve money expands.
In all, about 73 billion rupees of bills were bought, signalling rates down.
It seems that at the same time the central bank was also selling down some of its bills through bill auctions, in a type of ‘operation twist’, a move devised by the US Federal Reserve as far back as 1961.
It was also employed after the recent credit bubble burst. It is one thing to run a ‘twist’ at the bottom of the credit cycle, but quite another to do it at the top of the cycle.
The Central Bank would have been able to collect a larger volume of dollars in December 2016 if this policy reversal had not taken place.
This is because individual banks makes credit decisions based on their own balance sheet, especially in the short term.
The central bank has in the past also rejected bill auctions and bought bills at various tenors, to influence longer term rates.
The net results of all these actions is higher inflation down the road, or bigger property bubbles, which would have been nipped in the bud, had rates moved with the market.
Rejecting bids at auction, undermining the auction system and printing money is the most dangerous monetary policy tool practised by Sri Lanka’s central bankers.
Here is one way the chain reaction of the central bank buying bills from the banking system with printed money can be explained.
When stock market investors go out, there is little pressure on the balance of payments or the rupee. It is not always so when it happens in bond markets.
Exiting foreign stock investors have to find buyers with real money. Especially when markets are going down, people do not buy on margin on bank credit. In fact margin calls come in. Stock prices also fall discouraging some sellers and in any case inflicting some losses on them. (When interest rates rise bond prices also fall, unless prevented by central bank money printing).
Let’s say a foreign investor wants to sell 2.0 billion rupees of bonds. If a Commercial Bank wants to buy the bond, it will have to find 2 billion rupees from deposits or loan repayments. If it spends 2.0 billion rupees it got from deposits or loan repayments on buying a bond from a foreign investor, it will have to give up the opportunity to extend 2.0 billion rupees in new credit.
But bond buyers can finance purchases with printed money, even if the central bank does not print money by outright purchases of Treasury bills.
But let’s say the central bank called an auction to buy 2.0 billion rupees of bills. A Commercial Bank will now sell 2.0 billion rupees of bills to the central bank and generate printed money of 2.0 billion rupees.
The Commercial Bank will now be able to buy 2.0 billion in bonds and also give 2.0 billion in credit, since deposits were not used to buy the bond. (It is was given to the Ceylon Petroleum Corporation to buy oil, it will end up in the forex market as well).
Even if the central bank did not call an outright auction, a bank will also be able to go to the reverse repo window give the bond and get printed money. This is the reason why stock outflows do not cause much BOP trouble but bond exits do.
But even if bond investors are not involved, a bank will be able to give extra credit, than it would be have been able to with its own deposits, every time the central bank buys bills.
This is how central bank created balance of payments crises before bond investors came to the scene. Bond investors first became a significant feature only in the 2008/2009 BOP crisis.
A central bank that wants to collect reserves and keep the exchange rate steady must refrain from buying bills outright and instead use moral suasion and other tools to discourage continuous borrowings by banks and primary dealers from liquidity windows.
In 2016 in particular it was Perpetual Treasuries that borrowed like no tomorrow from the window, bought bonds and helped lose forex reserves. It was given money without bonds to place in the window, according to leaked reports.
There is no point in employing moral suasion on forex dealers. They are mere pawns of created money.
In this context it would be useful for Sri Lanka’s central bankers to visit Bangladesh and see how they conduction monetary policy, even if they view countries like Singapore, Hong Kong or Dubai as simply ‘too advanced’, or some similar inferiority complex.
New Year Bombshell
It is in this context that the monetary bombshell went off as New Year dawned. We have to re-build what happened from the broken shambles left behind, as official information seems hard to come by.
The entire operation seems shrouded in mystery.
EconomyNext.com had made references to this event without any named sources. The Central Bank Governor at the last press conference had also sidestepped, the issue and instead referred the reporter to the Treasury (Sri Lanka’s monetary bombshell mystery deepens).
He had however gone on record as saying it was not bank ‘policy’, but a procedure involving solving a cashflow issue and advance accounts.
In other words, a milch cow operation, or an ‘arm twist’ operation where the Governor was forced to print money against his better judgement through fiscal dominance.
The Governor must be protected from being forced to engage in this type of transactions, via effective reform of the central bank law.
This is what we know.
On December 30, the Central Bank’s Treasury bill stock went up from 219 billion rupees to 330 billion rupees. But excess liquidity did not go up in proportion.
In fact excess liquidity fell to on December 40, 39 billion rupees from 49 billion rupee a day earlier.
(Part the original excess liquidity in December could have come from dollar purchases. Here was an opportunity lost to mop up the liquidity and build up forex reserves. This is another instance of how reserve collections and dollar payments are directly undermined when money is printed)
There are a couple of instances when liquidity may not go up when T-bills are taken to the central bank balance sheet. One instance is when external loans are settled with foreign reserves.
But this time, liquidity came back again on January 02, when a large tranche of bonds matured but only about half of it was put to the auctions.
The advance accounts reference also points to a clue.
If liquidity generated from Treasury bills was offset against provisional advances given in the past by the Central Bank on December 30, there will be no increase in liquidity.
It then seems then in January the Treasury demanded provisional advances again. Excess liquidity then shot up to 108 billion rupees. On January 03 the excess liquidity was up to 121 billion rupees.
No country suffering balance of payments problems can afford to allow this type of situation to occur.
The central bank acted quickly to contain the damage from the first week of January.
It progressively sold down its Treasury bill refusing to roll-over maturing bills in its portfolio. By February 08 liquidity was back to zero, which took a little over five weeks.
The T-bill stock fell from 330 billion rupees on December 30 to 226 billion rupees on February 09.
In January data shows that the central bank also sold 139 dollars (selling 204.5 and buying 64.66) and in February 152.16 million dollars (selling 297 million and buying 145 million dollars), mopping up some excess rupees that ended as imports.
Liquidity became short again from February 08, as the rupee peg was defended.
Asked whether the central bank will again repay bonds with printed money flooding the market, Governor Coomaraswamy was quoted as saying ‘I hope not’.
This is important because if large volumes of money is printed to repay domestic bonds, it will lead to forex reserve losses and eventually the government will be forced to default on foreign loans, if investors refuse to roll over bonds.
It is a Mercantilist fallacy that government foreign loan repayments are linked to export revenues or export surpluses.
Export revenues do not go to the government. The go to the people who will save some and spend the rest.
Government has to raise money either through taxes or borrowings in the domestic markets to repay foreign loans. Such loan repayments will created a deficit in the financial account and lead to a surplus in the current account or even the trade account.
All this is related to a problem that Keynesians never understood.
The phenomenon was famously underlined by the debates between Swedish economist Bertil Ohlin and Keynes in the 1920s, over what was referred to as the ‘transfer problem’.
Keynes believed war reparations led to balance of payments problems in the Weimar Republic which eventually descended into monetary chaos.
The Allies were misled into thinking that a ‘favourable’ balance of trade was needed to repay foreign loans.
"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," explains economist Ludwig von Mises (words in brackets added by this columnist).
"There is only one thing that endangers monetary stability—inflation. 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 [Sri Lankan] Government collects the amount needed for the payments (in Reichmarks – [in Rupees]) by taxing its citizens, every German [Sri Lankan] taxpayer must correspondingly reduce his consumption either of German or of imported products.
"In the second case the amount of foreign exchange which otherwise would have been used for the purchase of these imported goods becomes available.
"Thus collecting at home the amount of Reichmarks [Rupees] required for the payment automatically provides the quantity of foreign exchange needed for the transfer."
An export surplus was not needed to repay foreign reparations, or in Sri Lanka’s case loans. However fast exports grow imports will grow faster if there is bank credit and money printing.
"All the German political parties shared responsibility for the inflation," noted Mises.
"They all clung to the error that it was not the increase of bank credits but the unfavorable balance of payments that was devaluing the currency."
Like Germany Sri Lanka’s Treasury seems to be playing with a similar dangerous ideology. Like Germany Mercantilists beliefs are widespread among all sections of society, brought about by years or decades of Mercantilist fallacies drummed into their minds.
Mises forecast the Germany monetary problems from 1912.
"But most of those men who between 1914 and 1923 were in a position to influence Germany’s monetary and banking policies and all journalists, writers, and politicians who dealt with these problems labored under the delusion that an increase in the quantity of bank notes does not affect commodity prices and foreign exchange rates," he said.
"They blamed the blockade or profiteering for the rise of commodity prices, and the unfavourable balance of payments for the rise of foreign exchange rates."
. What is needed is in Sri Lanka now is to maintain monetary stability and the confidence of lenders to roll over most of the debt, while generating cash – in rupees – from taxes and borrowings to meet the obligations.
The path to low inflation, currency stability and sound external credit worthiness is stop printing money, auction all domestic bonds for real money.
The current administration is right to pursue a policy of auctions. But if money is printed, to repay bonds – auctions are torpedoed – in the worst way possible. The so-called gilt edge is also a fallacy.
If Sri Lanka prints money to repay domestic debt, creating new consumption and imports, there is no way to collect foreign exchange to repay foreign loans or indeed to re-build forex reserves.
This column warned the central bank from late 2014 not to print money because such risks were no longer possible with foreign investors in rupee bonds. Many have already fled. Blaming fund managers like the Germans blamed the Jews will not help.
With foreign reserves already depleted, additional printing will lead to foreign sovereign default as well.
This column is based on ‘The Price Signal by Bellwether‘ published in the April 2016 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.