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.
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.
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.
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.
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 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.
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."