ECONOMYNEXT – Sri Lanka’s central bank defended its money printing, which led to forex shortages and fears of repaying foreign debt leading to a credit downgrade as monetary authority came under more scrutiny than in the past for triggering monetary instability and trade controls.
“Especially in unusual or exceptional circumstances we are facing like now, it is the prime responsibility of any central bank, not just the central bank of Sri Lanka any central bank around the world – to provide sufficient liquidity to the banking system,” Deputy Governor Nandalal Weerasinghe said in an online forum.
“And also for the public to have sufficient currency in their hands, especially in the lockdown period.”
However data show that injections not only covered a cash-drawdown and liquidity needs of the period but banks deposited up to 165 billion rupees in excess liquidity in the central bank’s excess cash window by May 05, which was about 15 percent of the pre-crisis monetary base.
Weerasinghe said in some advanced countries money supply has expanded by 10 to 15 percent of gross domestic product.
“This is all over the world, this is how central bank business are conducted,” he said.
Sri Lanka’s central bank however does not operate fully floating exchange rate nor is the rupee an ‘internationalized’ currency which is freely exportable with an international monetary base unlike the US dollar.
The extra money is believed to be printed to enforce rates cuts by targeting a call money rate in the middle of a policy corridor
The injections coupled with a ‘flexible exchange rate’ with a so-called DMC (disorderly market conditions) rule where interventions after printing money are delayed until forex market participants are in full panic mode.
Analysts say this tends to trigger monetary instability as soon as a small credit recovery takes place.
A similar strategy of cutting rates and injecting excess liquidity in a ‘monetary stimulus’ brought down the rupee from 153 to 162 from around April 2018 and triggered another slide in August 2018 which was worsened by a political crisis, analysts have showed.
The central bank had lost some reserves when excess rupees hitting the forex markets were purchased through dollars to keep the peg.
“Our reserve levels have been going down by small amounts from 7.6 billion to 7.2 billion (dollars) which is absorption of liquidity from the market (an unsterilized sale of dollars),” Weerasinghe said.
“And we have to provide that liquidity as well as additional liquidity to have sufficient liquidity in the banking sector (sterilizing in excess of 100 percent).
Classical economists as far back as David Ricardo in the early 19th century Bullionist debate in the UK have told soft-pegging anti-bullionists that re-injecting cash lost in interventions to maintain reserve money will only result in more credit and pressure on the currency.
The Bank of England at the time was then pegged to gold, not dollars.
“[I]f the Bank (of England) assuming, that because a given quantity of circulating medium (reserve money) had been necessary last year, therefore the same quantity must be necessary 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…”, Ricardo explained.
Shortly after the ‘float’ of the UK currency (ending convertibility), a credit collapse was triggered with runs on several banks, and the public lost interest in the debate.
In Sri Lanka similar output and credit collapses have happened after currency crises.
Reasoning of Ricardo and other classical economists that the ‘super abundance of paper money’ was the reason for UK’s currency troubles was concluded in a parliamentary inquiry much later.
Despite this, almost the same anti-bullionists arguments resurfaced in the Banking School vs Currency School debate a few decades later in the UK, just as they are turning up in soft-pegged countries with currency troubles.
New Dealers, a type of Keynesians who built the Bretton Woods were working on some of the same principles (that money can be created by a central bank purchasing both foreign and domestic assets) and built unstable soft-peg with similar results.
The US Fed (collapse of the Bretton Woods gold peg) and the sterling pound (Sterling crises – collapse against the US dollar and gold) faced the similar problems when they operated soft-pegs and printed money.
Sri Lanka central bank also give provisional advances (printed money overdraft) for six months based on a ‘Real Bills Doctrine’ type of reasoning, with a clause in the monetary law in place of a bill of exchange, analysts say.
Curiously, there was broad agreement that injections by provisional advances were bad and it was expected to be outlawed in a planned monetary reform which has since been shelved.
Critics have blamed many of Sri Lanka’s economic problems, involving inflation, cost of living, strikes, currency collapses, forex shortages, (balance of payments problems) and resulting import controls and imports substation rent seeking, on creating the liquidity injecting unstable peg in 1951.
Sri Lanka replaced a system that Singapore and Hong Kong and almost similar to Dubai (moving short term rates) with a collapsing currency in 1951.
Out of all monetary authorities that were originally based on the Indian rupee at around 4.70 to the US dollar, the Sri Lanka’s central bank has been the worst performer falling to 186 so far while Maldives has been the best.
Pakistan has been second worst. Pakistan also has a ‘B-‘ rating like Sri Lanka and is a top customer of the International Monetary Fund, which was created to help Bretton woods soft-pegs which collapsed from money printing.
The 2018 currency collapse led to a consumption and credit slowdown, which in turn led to weak revenues of companies and bad loans in banks.
Sri Lanka’s central bank has injected rupees in to the banking system in multiple ways since late February 2020.
A 24 billion rupee injection was made by a central bank profit transfer in the last week of February after an earlier rate cut.
A statutory reserve ratio cut released another tranche of over 50 billion rupees in to the banking system.
Sri Lanka excess liquidity spike in Feb from central bank profit transfer
On top of it the central bank bought large volumes of domestic assets taking its Treasury bill stock to 307 billion rupee from about 69 billion at the time when prudent monetary policy ended.
Reports had earlier indicated that the cash drawdown was about 140 billion rupees only. Such a cash drawdown which is called private sector sterilization by classical economists does not generally lead to a currency collapse.
Weerasinghe usually money is injected by Treasuries bought from the primary market (in auctions) as well as from the existing holders in the secondary market.
“This is what people in simple terms call money printing, but at the central bank we call providing liquidity,” Weerasinghe said.
“Imagine the situation we would have had to face. People would not have had enough cash and banks would not have sufficient liquidity.”
In the case of bonds bought from the secondary market the second market, the newly minted money will go to banks – who hold most of the traded bonds – or primary dealers and bond investors.
The new money will create demand and imports when loans are used by customers or bond holders who were repaid with newly created money purchase goods and services.
When bonds are bought in the primary market, the newly created central bank credit will go to the Treasury account at a state bank to directly finance the deficit and will be used to who will pay salaries of workers or suppliers or repay maturing bond holders boosting demand and imports.
“Our economy was and is both small and open. Financing budget deficits through Central Bank credit creation appeared to us as an invitation to disaster,” Singapore’s first finance minister Goh Keng Swee said when explaining why the country did not create a Sri Lanka – style central bank.
“There was no effective way of exchange control in an open trading economy like ours to deal with the inevitable balance of payments troubles.”
When excess liquidity triggers excess demand through imports the currency would fall unless it is defended.
However Weerasinghe said minimum interventions had been made in the forex market.
“If we are printing excess liquidity in the market we are going to see it in pressure on the currency,” Weerasinghe said.
“Our interventions have been minimal.”
The central bank sold 174 million US dollars in March a month with strong credit, but the currency still fell as interventions were not consistent. In April 98 million US dollars were spent.
The numbers do include any dollars given from reserves to the Treasury to repay foreign loans, which is also an intervention due to forex shortages.
Sri Lanka’s gross official reserves which also include forex holdings of the Treasury fell to 7,179 million dollars in March 2020 from 7,533 million US dollars in February 2020.
Low Inflationary Pressure
With curfews consumption had been brought to a halt, import controls have also been brought. This had also helped slowed credit and economic activity. The rupee has appreciated to about 186/187 by May 22.
“There is pressure on the currency to appreciate,” Weerasinghe said. “It is held by certain controls on imports as well.
“There is no pressure on inflation.”
A credit slowdown generally leads to a fall in demand which will help keep a lid on inflation. Most analysts are expecting private credit to be in the low single digits in 2020.
After the bullionist debate in the UK people were worried about deflation and gold convertibility was later restored.
If the rupee is allowed to appreciate – Sri Lanka’s central bank generally does not allow the rupee to appreciate after depreciating – inflationary pressure is likely to be less, analysts say.
In 2019 inflation was also kept in check with an economic and demand slowdown after the 2018 bout of money printing.
However bad loans would continue to rise after the latest round of monetary instability, tax revenues would be weak and it would be also more difficult to access international markets after the latest bout of money printing and rating downgrade.
How import controls would hit big and small businesses which are already hurt by Coronavirus and would hit banks in turn is not yet known.
Standard and Poor’s which downgraded Sri Lanka to ‘B-‘ after Fitch said import controls would hit government revenues.
“With COVID-19 dampening domestic economic activity and lower excise duty earnings due to broad import restrictions, we now expect that government revenues will decline to below 10 percent of GDP in 2020,” the rating agency said.
External meltdowns and hyper-inflation happens when the central bank runs out dollars to defend the peg and repay foreign loans after injecting liquidity usually to pay state salaries as tax revenues fall. In wartime it is usually salaries of soldiers and military hardware that trigger meltdowns.
The fall of the currency also pushes up non-salary costs of supplies, triggering more money printing to purchases goods and services.
Private credit can also spike not for expansion but for working capital as prices of goods and services move up, triggering more money printings as attempts are made to keep rates down. Bank bailouts can also inject more excess liquidity, creating more forex shortages.
Such effects can be avoided by avoiding reckless excess liquidity levels and allowing short term rates to fluctuate, keeping the exchange rate stable, analysts say. (Colombo/May24/2020 – Updated with Banking School/Real Bills Doctrine)