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Fri, 20 October 2017 04:56:36
A Sri Lanka fiscal bomb explodes with little fanfare: fuss-budget
06 Aug, 2007 20:40:49
By Fuss-Budget
August 6, 2007 (LBO) – The fiscal bomb went off soundlessly, somewhere around Janadhipathi Mawatha and Lotus road in Colombo, leaving little outward signs of destruction.
There was debris of course; two 'cancelled' Treasury bill auctions of more than 10 billion rupees each; a Central Bank held treasury bill stock that shot up from 30 to over 50 billion rupees in a matter of days.

Then there are the imploding foreign reserves.

It was only in early June that Peter Sinclair, Professor of Economics at the Birmingham University said at a Central Bank public lecture that, chronic budget deficits were a "time bomb" that cannot be contained with monetary policy alone.

"Sooner or later it is going to blow up," he said.

Let's try and trace how the Central Bank's widely acclaimed 'Monetary Policy Roadmap', which drew praise from this column also, finally ended up in the boondocks.

Post Mortem

The balance of payments surplus which was 250 million dollars in May is now down to 160 million dollars, according to officially admitted data, indicating that we have lost about 90 million dollars in the last two months on a net basis.

On June 21 reserve money was 248 billion rupees. Domestic assets, in the form of central bank held Treasury bills (money printed and given to the treasury to bridge the budget deficit in earlier times), was 32 billion rupees.

By deducting T-bills from reserve money, a proxy value of for international reserves can be obtained, though it has other components as well. On June 28 our proxy for Net Foreign Assets (NFA) was 213 million rupees. On June 29 it plummeted to 204 million dollars. Since then it has continued to fall.

The June 29 foreign payment must have been by government because no one else is big enough. Government makes loan repayments at mid-year. But no information is available on military procurements.

The following week reserve money went up by another 5 billion rupees as the Central Bank tried to keep 3-month treasury yields from rising above 17.40 by printing money. Fiscal dominance was back at work.

By July 26 net foreign reserves had fallen by the equivalent of 17 billion rupees, which is about 154 million dollars according to the calculations in the table 'Reserve Outflow'. This is higher than the official number. At a guess, the difference is probably made up of accrued interest abroad on international reserves or some other unpublished number.

Boiling Pot

Central Bank officials are putting on a brave face saying reserve money is on target and inflationary pressure is contained.

Let's say, for the sake of the argument, that the late June dollar payment was a short circuit and the money went straight out of Sri Lanka's monetary system as a book entry between the treasury and the central bank.

But it was not just the fiscal bomb in June, and the two cancelled T-bill auctions, that upset the monetary program. The roots of the problem dates back to April.

In both May and June inflation went up by a massive 3 and 3.2 percent, despite point-to-point inflation coming down. In both those months Central Bank had to sell dollars to intervene.

The deterioration of international reserves coupled with the rising CCPI index are clear indications that demand pressure is boiling.

Now annual inflation is up to 17.6 percent. Though Central Bank says it is within the targeted range, the targeted path was about 3 percent below that. The yearly number may moderate next month, but that does not really mean anything.

Excess Liquidity

So how did all this happen – if, as Central Bank says – reserve money targets were met?

In April, reserve money went to very high levels, to 277 billion in fact. This was even higher that the year-end target of 260 billion rupees and the June target of 250 billion.

Reserve money went up by more than ten percent in a matter of days when the entire year it was supposed to go up by only 11 percent. How can you run a monetary system like this? And this happens every year, twice a year in this paradise isle.

The excuse given for this is that there is a seasonal draw down of cash for the festivals.

Some analysts argue that the problem in April is partly caused by money printed to give festival advances to government workers. Even export firms convert dollars to pay advances to staff at this time.

The banknotes come back to the system shortly after the Sinhala and Tamil New Year. Here the central bank made another major blunder.

Instead of permanently sterilizing the excess liquidity, the bank started sterilizing overnight at low rates.

It played games with the banking system and rejected several short term auctions to push rates down. Overnight sterilizations do not really take money 'out of the hands' of market participants because it is available the next business day.

There is also a structural problem with rates. The repo rate at which the central bank sterilized overnight was 10.50 percent when market rates were 16.00 -18.00 percent. At best the repo auctions paid just below the 12.00 percent reverse repo rate, say around 11.8 percent.

Who would want to keep money at Central Bank when market rates were much higher? Nobody really knows why the policy rates are kept at 12.00 percent but it is believed to be a sop to foreign bond buyers who were promised no policy rate increases.

By doing this, the central bank created parallel markets and also undermined spot and forward forex markets which operate on interest differentials.

The short-term auction rejections had another unfortunate outcome. Banks who were liquid must have either raised deposits at high rates or put the brakes on credit growth to get the money, even if they were partly rights issue proceeds.

By rejecting the short term auctions, the central bank penalized the banks for doing exactly what they were told to do earlier.

Dog owners are told never to hit a runaway dog when it finally answers to its name and comes back. The dog thinks it is getting beaten for coming back and will not answer next time.

The central bank did the same thing and punished the best responding banks for being liquid and forced them to lend again.

Monetary Loosening

Official reserve money numbers are reported net of overnight sterilizations indicated by the blue area in the 'Liquid Problem' graph.

The actual cash available to the financial system in the next business day was the orange area which includes excess liquidity.

One may say that 15 billion rupees or 10 billion rupees of excess liquidity is not much compared to an annual GDP of 27,000 billion rupees.

But in the interbank market, which is the primary market for paper money, daily dollar trading is about three billion rupees including forwards. Excess liquidity was 5 or 7 times that much. The central bank later did sterilize permanently at lower rates, but it was too late.

Overnight rates plummeted from 35-40 percent in March to around 12 to 18 percent post-April. This was perhaps the biggest 'rate cut' ever, in central banking history in Asia.

Monetary policy must be loosened very slowly, when improvements in the budget are clearly seen in order to maintain economic stability. This was much too soon and much too fast with little improvements on the fiscal side.

That is not to say that the Central Bank's efforts were in vain. The picture would have been much worse if policy was loose in the first half of the year as well.

Magic Targets

This solves another puzzle. The June and July reserve money numbers were met, almost effortlessly.

What happened was that foreign reserves were going out, because demand pressure was back in the system. In May net Central Bank dollar sales were 50 million. In June it was 30 million dollars. In July it was 59.9 million dollars.

In Thrift Column – Rate Signals, this column showed why interest rates should not be brought down if the central bank wanted to keep inflation down. Though the fundamental problem is fiscal in nature, monetary policy is also looser now.

There is also no point in authorities claiming that money printing has stopped, simply because central bank credit levels are still below the beginning of the year level. There is no point in saying that inflation is caused by 'administered prices' going up either.

If the central bank is buying treasury bills (domestic assets), it is printing money. It does not matter if the total is below the beginning of the year or not.

One can say "in my grandmother's time central bank credit levels were higher. Though it went up 50 percent in the last six months, it is still below grandmother's time, therefore we have not printed money".

Going by the same argument we can say there was no money printing in 2006 because central bank credit levels were higher in the 24 month from January 2004. Obviously this is male bovine excrement.

This is the same as saying that 'inflation' is a change in price levels over 12 months. While this is the standard definition, it has no basis in the real economy. The economy doesn't read text books and doesn't know the definitions put by homo sapiens economists.

Central bank disease

There is also no point in blaming forex traders when the rupee falls or putting shopkeepers in jail like Zimbabwe does. Monetary or fiscal policy is at fault.

If the Central Bank tries to defend the rupee and keep interest rates down by maintaining base money which is also called 'sterilized intervention', the country moves into a vicious downward spiral.

This column has warned of the deadly effects of sterilized intervention before, when the same trick was pulled in September 2006 as well as in earlier crises.

Under a 'currency board', which we had before independence, local money -- what we call reserve money -- was only created by dollar inflows. Dollars and rupees were matched.

A 'dollarised' economy does almost the same thing conceptually, though dollars are allowed to circulate instead of local paper.

But a central bank can print money at will.

If the central bank issues domestic money against T-bills or other domestic financial asset, (which we call money printing) especially a big volume in a short period, there are too many rupees chasing too few dollars and the mismatch causes a balance of payments problem.

This is the same as 'too many rupees chasing too few goods' that causes inflation. Exchange rate depreciation and inflation are two sides of the same coin.

This is why a Keynesian stimulus or deficit spending causes BOP problems and inflation. Such a stimulus implies an increase in the budget deficit by suppressing interest rates to increase economic activity.

When the Central Bank said recently that interest rates would not go up, it was relaxing monetary policy by increasing domestic assets in the system through central bank credit, to reduce interest costs to the Treasury and other economic players.

This is more of a Friedmanite response, but, as John Exter pointed out ( Read interview) there is not much difference in the end.

He said; "Both believe in government intervention in the economy, although Friedman restricts his intervention to the Federal Reserve, which is the worst intervention of all."

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. There was no effective way of exchange control in an open trading economy like ours to deal with the inevitable balance of payments troubles.

The Keynesian system is a closed one, that is, it takes no account of foreign trade. This is admissible in theory, but in practice, since all modern states engage in foreign trade, a Keynesian stimulus will lead eventually to balance of payments deficits if governments do not exercise restraint in time.

A part of the increased incomes people receive will be spent on imports and when exports do not increase in proportion a trade deficit will occur.

This was not said by fuss-budget or John Exter but by former Singapore finance minister Dr Goh Keng Swee. (Read: Why a currency board?, for more details)

Money printing therefore is suicidal for a trade dependent country like Sri Lanka whose economy is 70 percent exposed to the outside world.

Sterilized Intervention

Some would say that you cannot defend the exchange rate and run domestic monetary policy at the same time.

But if low inflation and exchange rate stability is the same thing, why cannot it be done? The EU is doing it (The Euro is stronger than the dollar because ECB policy is tighter than the Fed). Singapore is doing it despite having an oddity of a monetary authority.

What you cannot do is to defend the currency by intervention and hold interest rates down at the same time. This is an entirely different thing.

When the Central Bank sells dollars to defend the currency, reserve money should shrink and interest rates should rise. To prevent this, the central bank prints money to expand reserve money. This comes back to hit the forex markets again.

This is what is called 'sterilized intervention'. Obviously it does not work. That is why the IMF advises countries that want to defend their exchange rate to increase interest rates.

You can do this either through open market operations (by selling domestic assets) or by directly intervening in the forex market and not sterilizing the liquidity shortage. Open market operations may take longer to influence exchange rates while a direct intervention in the market will have an immediate effect.

In the graph 'Humpty Dumpty' you see what happened. In late August 2006 and early September the central bank intervened heavily. The rupee rose but then fell even faster. It is like a bungee jump in reverse.

Even if Central Bank bought T-bills from a commercial bank to sterilize, and did not give cash to the Treasury, it still creates new bank reserves. Then the banks will lend it in the real economy.

Either way the system is busted. This is what is happening now.

Now what?

Fiscal policy must be tightened as you cannot keep on tightening monetary policy forever.

The fertilizer subsidy is 18 billion rupees. Electricity prices have to be raised quickly. Public sector subsidized loans have to be reduced.

The Treasury is trying to do some of this. Petroleum prices are being raised each month. Until economic stability is restored, even cutting the capital budget is a good move. Value added tax has to be raised, at least later.

The 500 million dollar sovereign bond will also cool the system somewhat. But it will also not last too long with Treasury overdrafts at state banks at around 40 billion rupees.

Half the money will be busted to bring down the overdrafts to manageable levels.

If the central bank wants to keep intervening in the forex markets it must revise reserve money targets down and allow rates to go up. Otherwise it will be taken care of through further domestic inflation. But this will hurt exporters in the long term, and the exchange rate will anyway depreciate later.

If the rupee is allowed to depreciate faster, a part of the problem will be solved. To the extent that depreciation destroys purchasing power, some of the demand pressure will be dissipated and imports will be curtailed.

Sins of fiat money

To stabilize the economy in the medium-term we need to put the brakes on the government, which has been the biggest growth industry since independence, courtesy of the Central Bank.

Legislation must be brought to start inflation targeting in this country and commit the government to low inflation and economic stability. Another option is to reform the central bank to a currency board-like institution.

Hugo Chavez had to pass a special law to loot Venezuela's international reserves and pay for subsidies while the central bank governor retired protesting.

In this country the central bank is obliged by the monetary law act to be the financier of the government. JR was responsible for this by creating the Central Bank in 1951.

This as well as Treasury representation in the monetary board must be abolished if the children of the citizens of the country are to have any sort of future.

Also you cannot relax monetary policy (printing more money) at a time when international commodity prices are rising. The International Monetary Fund last week warned that monetary policy must be tightened to keep inflation down because commodity and food prices were rising.

"In the current context of continued very robust growth and rising prices in energy, commodities and food, to sustain this favorable outlook will require keeping inflation and inflation expectations under control," IMF deputy managing director John Lipsky said at a regional finance ministers' meeting in Australia.

"That may require policy actions."

When central bankers say 'cost push' inflation cannot be fought with tight monetary policy or that 'administered prices' cause inflation, they are lying. It is all part of the monetary policy hocus pocus.

They can lie because ordinary citizens do not understand either the concept or the history behind the transformation of commodity money to fiat money.

When the United States and UK went off gold (from commodity money to fiat or paper money) they made an implicit deal with their citizens. By abandoning the gold standard, Western governments openly admitted that their currency would no longer rise exactly in step with gold.

But the implication was that their money would still keep pace somewhat with commodity money, though not at the rate of gold, as was the case earlier.

The International Monetary Fund was primarily created to ensure that the value of paper money would be preserved as much as possible and linked to the earlier commodity money though not in direct proportion.

If commodity prices - like oil, basic metals and food - are rising, governments must print less money and increase the intrinsic value of their worthless paper money.

The poor people of countries like Sri Lanka are hardly asking for a gold standard. But they deserve better than the 10 to 20 percent inflation which has been keeping them in poverty all these years.

The British parliament has given the UK government the right to rob the people by two to three percent a year, through an inflation targeting law. New Zealand, Australia and Sweden also have inflation targeting laws putting a limit of around two percent a year.

Indians have given the government the right to rob them by 5 percent a year, not through law, but by general agreement that inflation should be below 5 percent. Even if Sri Lankans are poorer than Britons, they will happily allow the government to rob them by 5 percent, just as Indians have done.

But do not create 10 or 20 percent inflation in this country just to keep a bloated government going. It is a great wrong and a sin.

Postcript____________________________________

A hotlink to a digital copy of Fiat Money Inflation in France by Andrew Dickson White has been added to the bottom of the The Thrift Column - Rate Signals. Bouquets and brickbats to fuss-budget (at) vanguardlk.com. You may also use the response tab below to respond.

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READER COMMENT(S)
11. Das Samuel Aug 10
Rajive de Silva says it all.
Unless qualified managers are put in charge of state institutions the nation's future is bleak.

This game of political appointments to positions needing expertise has gone too far.

This is the difference between us and countries like Singapore.

10. fuss-budget Aug 09
A
If you want to stop feeding the reserve outflow you have to stop printing. This can be done by raising rates or fixing the budget.

To repeat what was said in the column; "you cannot keep on tightening monetary policy forever."

What we need is fiscal tightening. What the column said was that the Central Bank should allow reserve money to contract (and rates to rise) if it wanted to defend the rupee.

This is non-sterilized intervention. The column never suggested that the rupee should be defended.

The better option is to allow the rupee to go a little and not defend it. The rupee will settle at a place where the demand pressure is dissipated.

When you engage in sterilized intervention the supply of rupees grows faster than the supply of dollars. So you have a BOP crisis.

No one is in favour of raising rates further. But inflation is high you should raise it. If you want to cut it and loosen monetary policy, you have to tighten fiscal policy. Since fixing the budget is more difficult than raising rates people eventually do a little of everything.

Getting the dollar bond is important now to fix the monetary system. But if we get it we must do a better budget and stop wasting money on ideological subsidies and getting into another mess six months after the next budget.

9. a Aug 08
Are you suggesting that interest rates should be raised further?
8. Aug 08
Thanks fuss,
I just took the three wheeler guys for example what would be the effect on the monthly salaried people? Prices going up,

Thanks

Ps; You mean the three wheeler guys who went to lunch?

7. fuss-budget Aug 08
Hi anonymous,
What it means to the three wheeler driver is that his cost of living will be limited to the target specified in the inflation targeting law. If we specify 2-3% it will be 2-3%. If we specify 4-5% it will be 4-5%.

However petrol prices will still go up. But that does not mean everything else will also go up.

The three wheeler driver may find that he is not be able to fully pass on his costs to his customers. This happens when there is monetary tightening.

As a result he may not be able to wait around in a corner for half a day and earn his money from a few customers. He may have to change his business model and carry more passengers.

Cab services for example operate their vehicles for longer hours and are equal to or cheaper than 3-wheelers despite having an engine a few times bigger than a three-wheeler.

On the other hand the cost of new three-wheelers for example will stay largely static.

His lease rentals will plummet to maybe half or quarter of what he is paying now as lease interest fall from 20 percent to around 7-10 percent.

The you come back to the problem of the budget. If the deficit is not fixed rates would not come down.
fuss

6. harsha de silva Aug 07
Fuss
rajive says that cabraal has done more damage to our country than prabha.

this is a very interesting comment given cabraal's recent comment that people like fuss and i [and everyone else who criticise his money printing people robbing activity] are terrorists and terror sympathisers.

fuss, i also feel that a start MUST be to get the governor answerable to parliament after having given him the opportunity to set his own inflation target and let him acheive it...

5. Aug 07
Fuss,
can you explain the same in what it means to the three wheel driver on the road? said what's goin to happen to our day to day life?
4. fuss Aug 07
Hi Harsha,
The thing is, a currency board is not a cure all as you know. Take a country like Bhutan.

Bhutan monetary authority has a strong no nonsense anti-inflation anti money printing focus. They seem to be quite open about it.

Pegged directly to the Indian rupee. Basically greater India.

Though you can call it a currency board, it has lender of last resort facilities etc.

However you also need other policies to drive the country forward. You have to liberalize, build infrastructure and so on.

The problem is we have liberalized and done a lot of right things and we are busy bees with 6 percent unemployed. But we are poor.

Of course with India taking off Bhutan may also take off. When India printed money like mad before Rajiv Bhutan also must have got hit.

The fact that you and I are discussing this over the internet shows we have done some things right.

Our problem is that despite doing a lot of things right, we are still held back by severe economic instability due to fiscal and monetary policy errors.

Also people would have to want to do things right. Even countries with central banks do well, because they operate within certain self imposed constraints.

Technically under our monetary law act, the central bank is not supposed to de-stabilize the economy. But it happens. Nobody is held accountable.

The law is there, but it does not work. One approach could be to bring in inflation targeting with tough provisions and make the central bank answerable to parliament like in Britain. Even Fed is answerable to congress.

That may be a more practical approach to the problem as a first step.

Fuss

3. Rajive de Silva Aug 07
The CB governor is not a central banker. He is a politician, with accounting qualifications. Can you expect a political accountant to govern the CB like a banking professional ?

This is the problem with our country. The rulers cannot understand that by appointing politicians to run important state institutions the country is being pushed to the brink of destruction.

What CB is doing now is worse than the destruction unleashed by the LTTE in 20+ history of war. When LTTE destroy economic assets you can re build them.

When CB destructs fundamentals of the economy that spells the doom for the country. It's irrecoverable in the medium term.

2. harsha de silva Aug 07
Fuss
Yet another classic!

Only problem is the complex arguments will be lost in the governor who still thinks 'money printing' is printing currency notes. what a predicament for us to be in!? god help us citizens of this country.

So finally you've gone the whole hog; asking for the scrapping of the central bank and replacing it with a currency board! Interesting position to take. Let us see who would support such a move...

Keep up the good work.

1. aj Aug 07
Bangladesh inflation was 8 percent in April. Any idea what it is now?