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Sri Lanka has to keep policy tight for exchange rate stability: fuss-budget
15 Feb, 2012 07:05:14
By Fuss-Budget
Feb 15, 2012 (LBO) - Sri Lanka is now taking action to fix the balance of payments crisis triggered by a failure to raise interest rates in time and generate savings to finance the heavy borrowings by the state and business.
The peg is well and truly broken and we are now in the midst of a currency crisis as forecast in Thirft Column - BOP 101 and Thrift Column - BOP 102.The rupee is now trying to find its own level, as dictated by market sentiment as well as underlying monetary policy.

Exporter sentiment has been wait-and-see in the first three days of the float.

Fuel prices have been adjusted upwards which will reduce some of the borrowings by state enterprises. Some private banks have raised interest rates more steeply than others to raise fresh deposits. All these are good signs.

But it will take some time for these developments to hit the forex markets. Power prices for example have not yet been raised so the Ceylon Electricity Board will continue to borrow and put pressure on the rupee through state banks.

Why credit?

Interest rates as predicted, has also risen. This columnist would have been more comfortable had interest rates gone higher.

The problem with the peg is one of credit and monetary policy. It is not imports or the trade deficit. Nor is it oil except in so far as oil import costs are not passed on to the economy and losses are covered by credit.

In the second half of 2011, the problem was compounded by sterilization of interventions. Up to June 2011 for example, the interventions were unsterilized.

From July 27, the banking system was again pumped to the gills with liquidity from the dollar bond.

From September, forex interventions were sterilized giving more rupee reserves to banks triggering a steady loss of forex reserves.

The float will take away some of the new reserves added as liquidity injections. That will reduce future loans, and pressure on the peg.

In the past the exchange rate has quickly bounced back after a float. This was because credit growth was not just low, but negative.

The 2008/9 balance of payments crisis was one of state deficit spending and bond buyers selling out. By mid 2008, private sector credit was low and even in negative territory.

When interventions were sterilized and bond buyers were selling out from August onwards, private sector credit picked up briefly and then died again (see green curve) as interest rates rose very steeply. Finance companies also collapsed and were no longer giving credit.

The steep rise in credit to government before April 2009 (red curve) is mainly due to ballooning central bank credit to sterilize interventions in an expansionary fashion.

By April 2009 when the rupee was floated, private sector credit was negative. It was an open and shut case that the rupee had to bounce back after the float.

After the float, central bank credit contracted when excess liquidity from inflows (in a low or negative private credit growth background) were sterilized in a contractionary fashion by a sell down of bills. The brown bars are net dollar purchases by the Central Bank.

In December 2004, when a tsunami hit, a similar situation arose. The pressure on the rupee came largely because money was printed by the Treasury to pay for fuel subsidies. Private credit which was between 11-20 billion rupees a month before the tsunami just came to a standstill as a shell-shocked nation stood by.

The rupee appreciated.

The basic lesson is this: inflows are irrelevant to the exchange rate if proceeds are going to be spent immediately, through the credit system.

Tighter Policy

In 2012 however private sector credit is strong. The problem arose - as pointed out in BOP 101 - not in the capital account but in the current account.

So the current account problem must be solved.

As the column BOP 102 pointed out, state enterprise credit coming from CEB thermal generation was a key trigger. That has been partly solved.

But private sector credit is still high this time around.

The active reverse repo rate rose as high as 18.00 percent in the 2008/2009 crisis and was later cut to 14.75 percent in March as credit contracted. This year it is only 9.00 percent.

The behavior in forex markets therefore is different this time. There is more pressure on the peg in 2012 than in 2009.

That is why the rupee is falling harder this time.

In 2009 the bond buyers were all gone by the time the currency was floated and they were not a factor. This time they are still here, but bond markets are illiquid, so to some extent they are locked in. Hopefully they will stay until the exchange rate stabilizes.

The fall of the currency will send a shock to the system and make people have second thoughts about taking fresh loans and making other consumption decisions. The margin calls on stocks also shows that some credit is unwinding.

If the 18 percent credit ceiling can be strictly implemented for the next few weeks it may help, but admin measures to curb credit are notoriously messy and not as successful as rate hikes.

Higher interest rates curb consumption, promote savings and make it easier to roll over government debt without repaying them with printed money.

Because the Central Bank is not intervening all the time in forex markets, liquidity shortages will not occur as much as they did earlier. Because liquidity injections would be reduced, credit will now start to come down from the highs seen during sterilized interventions.

Amber Lights

But some pressure will still come to the forex markets, if dollars are supplied by the Central Bank to settle oil bills and liquidity is injected to money markets to sterilize them.

While it is not necessary to push private credit to negative territory like in 2009, policy has to be tight enough to ensure that credit is slowed and banks - especially state banks - are generating a little more deposits than they are loaning out.

The problem with state banks is that they lend to the state, which is a net dis-saver and is the key driver of consumption and imports. The private sector only borrows a part of the savings of other private citizens and firms.

Further monetary tightening therefore should be considered.

But the biggest danger to the currency is the Treasury bill auctions. Even if overnight policy rates are not hiked Treasury bill yields must be allowed to be market determined with no interventions at Treasury auctions with Central Bank liquidity injections to repay maturing bills or to raise fresh money.

Maturing bills must be rolled over at whatever price, so that market rates are ratcheted up rapidly until the float takes hold. The quicker the rates rise, the quicker the float takes hold, the sooner the rates will start to fall.

The sooner the rates fall, the lesser than damage to borrowers and banks. If bond holders try to rush out the door, there may be prolonged pressure on both rates and the exchange rate.

But make no mistake, if the rupee was not floated, eventually Sri Lanka would have lost all the reserves at the rate of 400 to 500 million dollars a month. There was a strong possibility of a sovereign default if the float had been left too late.

Sterilized interventions, which are expansionary, amplify and accelerate small imbalances in the economy at a frightening pace making currency crises fast, vicious, and destructive.

Fortunately for Sri Lanka, rating agencies, rupee bond buyers and foreign banks are clueless about the deadly nature of soft-pegs and sterilized intervention and were pussy footing around sublimely ignorant of what is really going on in the monetary system.

This gave policy makers several months to take action. It is better to float before downgrades come and avoid the need of a downgrade, than float after downgrades, as soft pegged countries usually do.

Fiscal Sales

Authorities should also sell dollar inflows to the government in the market, instead of selling dollars to the central bank and generating liquidity.

A monetary authority can only strengthen a currency by engaging in non-sterilized interventions, which tightens monetary policy, like a currency board.

A monetary authority will weaken a currency by engaging in sterilized interventions, which pumps liquidity and undermines existing monetary policy by quantity easing, resulting in fresh reserve losses.

Other than countries like Hong Kong where the monetary authority engages in non-sterilized interventions, no real central bank in the world can strengthen the exchange rate by long term interventions which are sterilized.

US authorities for example have a mechanism to intervene which is effective in some ways. The Treasury has an Exchange Stabilization Fund, which can intervene in co-ordination with the Fed.

While Fed interventions are sterilized, ESF interventions are not, and can therefore have a short term positive effect with no undermining of monetary policy.

Soft Pegs

Soft pegs which were foisted on to the rest of the world by US authorities after the World War II were scams from the beginning. Harry Dexter White, a US Treasury official was the main architect of the Bretton Woods system of unstable soft pegs.

White was a 'New Dealer' interventionist who was later found to be a secret communist.

By persuading other countries that interest rates and exchange rates could both be controlled at the same time (which was not possible in practice) he managed to create a global system of foreign exchange where all other currencies were guaranteed to be weaker than the US dollar.

Because elected rulers are greedy and they want to deficit spend and keep interest rates too low, it has always worked. But the US fell into its own trap in 1971 and countries with greater monetary knowledge either went to floating rates or currency boards.

The IMF was created to help countries that inevitably got into trouble with soft-pegs by keeping interest rates too low and running deficits.

The British currency board system where the interest rate automatically moved in line with credit demand did not need an IMF to keep the exchange rate fixed.

This column has ad nauseum pointed out that if authorities want to keep the exchange rate fixed, they must establish a currency board. At the very least the Central Bank must behave in ways that are consistent with a currency board.

One Virtue

Admittedly a currency peg, even a soft one, has some value if it succeeds in keeping inflation under check, as happened in 2001 and 2009 in Sri Lanka, because reserve losses prompt tighter policy.

A depreciating currency allows the state to continue their profligate ways and steadily impoverish the population.

"One virtue of fixed rates, especially under gold but even to some extent under paper, is that they keep a check on national inflation by central banks," wrote US economist Murray Rothbard in the aftermath of the oil shocks and 'Great Inflation' debacle of the 1970s.

"The virtue of fluctuating rates-that they prevent sudden monetary crises due to arbitrarily valued currencies-is a mixed blessing, because at least those crises provided a much needed restraint on domestic inflation."

"Freely fluctuating rates mean that the only damper on domestic inflation is that the currency might depreciate.

"Yet countries often want their money to depreciate, as we have seen in the recent agitation to soften the dollar and thereby subsidize exports and restrict imports-a back door protectionism."

Currency depreciation only helps exports by making the salaries of toiling workers valueless and pushing them into poverty along with every other worker in the economy as well. It also destroys lifetime savings, including pension funds and bank deposits.

The only real beneficiaries of currency depreciation are highly leveraged entities - the state and geared big business.

The 2009 BOP crisis, where policy was tighter, ended with low inflation. In 2009, policy was so tight that defined reserve money contracted. Defined reserve money, which was 280 billion rupees in August 2008 around the start of the crisis, was down to 260 billion rupees in April, when the rupee was eventually floated.

During this crisis, reserve money which was 410 billion rupees in August has jumped to 448 billion rupees by February 08. That is also indicative of comparatively looser policy. The danger is that Sri Lanka may be left with high inflation and a weak currency and not low inflation and a more stable currency.

In the final analysis, inflation and exchange rates are determined by monetary policy, not trade as Mercantilists believe. Or vice versa.

Trade cycles are Austrian (or Ricardian if you will), not Keynesian. The difference between Germany and England after World War II was this simple (mis)understanding.

"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," to quote Austrian economist Ludwig von Mises.

"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."

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17. fuss Feb 21
@Sompala. Thanks for the ad hominem attack on my character/supposed biases, based on your assumed knowledge of my educational funding.

As regards to the second part of your comment, any country's debt is whatever percentage of GDP based on its history of deficit spending. If it deficit spends less it will have less debt and the economy will grow faster due to lower crowding out.

Unlike mainly Anglo-saxon countries which had good policy until the WWI some countries with German speaking people (presumably policy makers and academics who were familiar with the Austrian critique of Keynesianism) did better in the 20th century after WWII. This includes Austria itself, Switzerland and Germany.

Germany's debt was however much lower upto re-unification.

As regards to Germans being employed in Switzerland, I can only say they will help keep labour costs down for firms in Switzerland, helping them serve their customers at home and in export markets better and increase market market share. They may also increase firm level profits, increasing taxes, pay income and other taxes boosting state revenues etc allowing the government to run a budget surplus. If Switzerland is freely giving jobs to 'foreigners' as Liechtenstein does I can only laud their non-nationalist attitudes towards labour.

In a liberal world people shift from one geographical location to another based on employment availability.

Working it in reverse, a cut in German wages - which should be a natural result of a higher supply of labour - should also allow employment to rise in that country. It is not necessary to print money or depreciate the currency (and impose a real wage cut and destroy life-time financial savings) to do so.

16. Somapala Feb 17
@fuzz. There you go again about mighty Germany etc…
I suspect in your days, you might have given a scholarship by the German Govt. Body or similar

Pls explain why the mighty Germany‘s Debt to GDP is above 80% and half of the German working population is seeking employment in Switzerland.

15. AT Feb 16
Thanks for the reply. I meant to say the “currency appreciation” to imply the CB’s intervention because it distorts the equilibrium exchange rate at the cost of country’s reserve, export competitiveness and creation of jobs etc.

I too agreed that protectionism from currency depreciation is not sustained and it will marginalize quickly due to strong labor union and political reasons in a county like SL (and may take longer time to adjust in US – give some breathing time for businesses)

I really like your articles and this time I had a practical reason to participate for the discussion. Recently, I helped one of my friends in printing business in SL to get some work from USA. He was able to get 1st business to produce 50000 pieces of XYZs. The buyer is already doing business with Chinese companies and we got the same rate as them. First, my friend surprised that how the Chinese are offering that cheap. Based on the offering rate we received, my friend cannot earn more than $0.03-0.04 of profit per piece (true something is better than nothing). So, we had a casual discussion on this and we THOUGHT that followings are the barriers to Sri Lanka.

1. A weak Chinese currency (reduce real labor cost) (see the trade deficit between China and USA:

2. Chinese Labor productivity is high

3. Sri Lankan labor laws – Bad for employees

4. CB’s intervention to exchange rate (lack of long-term policy)

5. Political interfering on salaries for private sector etc.

14. fuss Feb 16
There is no need to 'appreciate' a currency. You only need to keep it stable and allow interest rates to float as economic developments demand, whether through private or state credit demand.

The danger of steeply appreciating currency is that it pushes up the real value of wages, leading to bankruptcies, forcing capital to develop businesses or production processes which are more labour productive. This is what another reader has called productivity. A union that demands higher wages can also bankrupt a company.

In any case now that exporters have been allowed to borrow in dollars, they also feel the pinch when currency falls and experience a massive hit on foreign loan exposure.

Exporting is not superior to any other type of harmless business operating without protection. A business can serve customers in a country within its borders or outside. Unless you are a nationalist, all customers are the same type of human beings.

Serving customers beyond borders simply increases your market share.

Successful exporters however are the most cost efficient producers on earth and are exponents of liberty and human freedoms. They contrast sharply with nationalist import substitution businesses which fleece citizens within a set of borders under draconian protectionist taxes. Nationalism de-humanizes people.

Protectionism from currency depreciation is only temporary, since workers' wages eventually catch up unless the currency is depreciated continuously.

13. fuss Feb 16
Hi Shan. Questions and comments are welcome. They will be answered if they are within the capacity of the columnist to answer :).
12. fuss Feb 16
Hi scrap metal@
Yes fiscal adjustments will help in so far as it helps monetary policy become tighter.

Government spending is connected to the country's money (rupee exchange rate and inflation), via the Treasury bill market.

When the government spends and borrows from Treasury bill auctions and the central bank does not allow interest rates to rise and prints money to buy Treasury bills to keep interest rates down it creates additional demand, resulting in inflation and imports.

In the same way money value is weakened when loans are taken by state enterprises or the Treasury from banks and money is printed through the reverse repo window to keep interest rates down.

A currency board for example separates the deficit spending from the rupee, as it is illegal for the central bank to print money to cover deficit spending and it has no mechanism to influence domestic interest rates. The currency is therefore protected but unless fiscal deficits are kept under check, the state has to face sovereign default. That is why the exchange rate was fixed until 1950 (from the previous century) and after 1951 it started to collapse.

You can get the same effect by 'dollarizing' the country. i.e run the economy with dollars or sterling or Chinese yuan.

Until the gold standard collapsed in and around the first World War all countries had a fixed exchange rates - gold.

Each country was anchored to gold. Despite it being a 'domestic anchor' since gold is a traded good it kept all exchange rates fixed as internationally also it became the same anchor through trade.

Exchange rates now move or float because 'domestic anchors' or the inflation index that is targeted is different and also central banks have different levels of successes in achieving those targets.

11. AT Feb 15
I agreed that devaluation have a negative impact to the savings, purchasing power of salaries and pension and increase the inflation. Appreciation of currency positive impact to them but negatively affect to the industries of export and import substitution and creation of employment. Therefore, I believe depreciation brings more economic benefits to a county. Which way is better “subsidize exports” via devaluation or “subsidize imports” via appreciation?
10. scrap_metal Feb 15
Thanx for the lovely paper sir. But wouldn't the fiscal policy adjustments help the current unstable situation rather than only concentrating on monitory policy?
9. shan Feb 15
Thanks for the response. I didn't mean to condescend when i asked that question, it was a genuine inquiry.
8. fuss Feb 15
@Shan That China is depreciating the currency or that it is 'undervalued' is just propaganda from Mercantilist US economists.

In the 1980s China had high inflation and currency collapse. But in 1987 it reformed the central bank.

From mid 1990s the currency has strengthened. For example in 2000 the Renminbi was 8.2 yuan to the US dollar. Now it is 6.2.

The economists in the US who are blaming China are re-incarnations of Dexter White. The semi-Nazi administration of FDR played a dirty trick on China during the depression, by cornering the silver market. But no wonder, they did worse to US citizens. They depreciated the dollar, banned gold holdings and intervened in multiple ways to prolong the depression.

Wild currency fluctuations are also not so good. US Mercantilists said the same thing to Japan in the 1980s.

7. shan Feb 15
If currency depreciation only creates poverty, why is china doing so well?
6. fuss Feb 15
@Asa thank you. A currency board is simply another name for complementary and monetary and exchange rate policy.

It takes the arbitrariness out of interest rate decisions and operates as a rule of law to protect you and me and take away the discretion of rulers.

Productivity has nothing to do with exchange rates. Productivity will give you higher wages. A strong exchange rate will force owners of capital to run highly productive businesses. They can do it also because inflation and interest rates will also be low.

Take post war Germany for example. Germany followed Austrian style liberal economics. An economist called Ludwig Erhard, who was involved in currency reform did the unthinkable and became economic minister and later Chancellor. His tight money and liberal economics led to the so-called German economic miracle. This was the same country that had 'self-sufficient' autarky under Hitler and hyperinflation under socialists.

5. fuss Feb 15
@Jaya It is very simple. Imagine you had a billion dollars from a sovereign bond say - like in July 2011. If you were a dealer at a commercial bank, you can hit the living daylights out of the market with that money. Instead what happens is the money is sold to the central bank and liquidity is generated to fire credit. Government inflows are negative to the exchange rate when it is done that way. On the other hand the way foreign loans are repaid in Sri Lanka, it is actually creates positive pressure on the currency. So that is good. But we need to reform the central bank, so that these things do not happen in the future and we can have low inflation and a strong exchange rate.
4. jaya Feb 15
Fuss what is the difference between Treasury and central bank interventions? I did not get that
3. Asa Feb 15
I liked the article very much. However it addressed the monetary side only. It would have been more comprehensive if the writer had addressed the productivity and the output side as well. It simply argues that Keynesians are not equipped to counter this type of BOP crisis. In actual terms, if the country does not increase its output further, it cannot sustain in the long run by controlling the paper money only.

One can argue that the best solution would be going back to "monetary board system", however in my opinion this type of system is more suitable for services oriented economy such as Hong Kong or Singapore. Sri Lankan economy has manufacturing and agricultural sector which are contributing about 30~35% of GDP, hence it is more prudent to have a strong "independent" Central Bank which supports in production output and money.

2. Siripala Feb 15
Well said - Excellent commentary based on those pillars of wisdom, common sense and professional experience. Sadly the self-appointed experts in Govt. and the Central Bank seem to have but one reference point - EGO.
1. An Economist Feb 15
Excellent piece on the current crisis. Macro imbalances lead to greater crises of economic body just like the overall health issues of a man leads to his disease levels.