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Mon, 17 December 2018 04:22:51
Sri Lanka's monetary crowding out and Bretton Woods: fuss-budget
19 Jun, 2008 20:02:35
By Fuss-Budget
June 19, 2008 (LBO) – One of the interesting questions that can be raised about the current monetary policy regime is to ask whether Sri Lanka's high interest rates are caused by the budget deficit here or in the United States.
In the first quarter of 2008, interest rates went up to very high levels. Yet fiscal policy appeared to have improved. This may be hard to believe, but that is what it looks like.

The recent increases in energy and transport fares also show a partial abandonment of deadly anti-poor Rata Perata type of policies that sent a low inflation, high growth country spiraling into one crisis after another, and the highest inflation in its history.


In the first quarter, state commercial bank overdraft levels have been low compared to previous years.

They were hovering around 10 billion rupees for a few months. That shows fiscal policy was better, at least cash flow-wise. Then why were interest rates so high in the first quarter?

To understand why, one must go deep into how a pegged-exchange central bank works.

In the first quarter the central bank sold its Treasury bills stock down on a net basis. A central bank like that in Sri Lanka gets hold of treasury bills originally by printing money for the Treasury and getting bills in its place or through foreign reserve appropriations.

When the central bank sells treasury bills, it 'sterilizes' or takes the money back from the economy.

Ever since the Sovereign bond dollars came last October, the Central Bank has been selling down its T-bills stock to 'sterilize' the rupees that were generated not only from its friendly neighborhood inflationary press, but from intervening in the foreign exchange market as well.

The central bank also sterilized a printed money 'provisional advance' it has to give to the government at the start of each year, due to a flaw in Sri Lanka's monetary law. (See postscript below for more)

The sterilization strategy however is only partially successful from an inflation point of view, because like any discount window (reverse repo) money and open market operations, the damage is done when the money is first advanced.

Transactions that could not be completed in the real world are completed with the magic money created through T-bill purchases or discount window activity.

The Central Bank's Treasury bills stock, which went up to 95 billion on October 01, 2007 and helped create massive inflation, came down to almost zero by March 2008.

At the time there was even talk of issuing central bank securities to mop up liquidity from foreign inflows. But later domestic assets rose again as printing activities picked up.

In the first quarter the Central Bank collected more than 300 million dollars in foreign reserves. Reserves can be collected when dollar-generated liquidity in the banking system is sterilized or taken away from the economy.

From the end December figure of about 40 billion rupees, the Central Bank's T-bills stock came to almost zero. Hey presto, more than 300 million dollars is collected.

Foreign flows and bank reserves

A long standing monetary myth that has been perpetuated by central bankers and other economists in Sri Lanka is that foreign reserves go up (or that there is a balance of payments surplus) because of capital inflows.

If this were true all capital inflows must push up foreign reserves. But it does not happen like that.

A pegged exchange rate central bank creates domestic money in two ways.

It will intervene in the forex market and buy dollars to defend a particular exchange rate and prevent the currency appreciating. This year Sri Lanka's central bank has been defending a rate of around 107.50/80 in the forex market.

In the process it will accumulate dollars (called net foreign assets or NFA) and generate rupees which will drive the monetary base or reserve money on the other side of the central bank balance sheet.

The money generated from forex interventions become loanable reserves in the domestic banking system.

Foreign reserves (dollar holdings) will grow also. These will be invested in, say, US treasury bills and earn interest, essentially seigniorage. In a currency board or hard-peg this is all that happens.

But a soft-pegged central bank can also drive up the monetary base by intervening in the Treasury bill market and buying up T-bills and adding cash to reserve money.

It will also add money through the reverse repo (discount) window or open market operations. This portion, which Sri Lanka's central bank likes to call net domestic assets (NDA), is inflationary.

This is because NFA or the balance of payments is the country's money supply when a peg with another currency or external anchor, is maintained.

The ability to print money (acquire domestic assets) is what distinguishes a soft-pegged central bank from a hard-peg/currency board and which causes extra inflation over the anchor currency country and also contributes to currency weakness.

Currency Board

A currency board has no discount window or reverse repo window or even statutory reserves. A commercial bank will maintain its own liquidity under a currency board system.

The cycle of foreign asset driven money supply goes like this.

Dollars come in, the monetary authority buys it and domestic money supply expands and commercial bank loanable reserves increase. When this money is given as overdrafts it will drive up demand for goods. Most of the demand may be met by imports.

The dollars the monetary authority collected earlier will be sold in the forex market to meet imports demand. Foreign reserves would fall. The monetary base will also contract. The pressure for the currency to appreciate will reduce. Depending on the growth of the economy and its own ability to supply the goods and services, reserve money may even grow a little.

The system remains in balance. No currency crisis or high inflation is possible under this scenario, provided the anchor currency inflation is low.

Under a currency board system there are no capital controls. Banks will lend abroad if there is no absorption capacity domestically. If there is domestic loan demand, banks will liquidate foreign assets and lend, depending on interest rate differentials.

Foreign inflows, therefore, will not cause domestic inflation to rise under normal circumstances in a currency board or a monetary system without capital controls.

A soft-pegged central bank, unlike a currency board, would have a stock of Treasury bills. These are usually a legacy of previous monetary mayhem, either of deficit financing or the relics of a currency crisis/sterilized intervention fiasco.

When money that comes to the country from abroad (net foreign assets or NFA) is sterilized (sterilization is achieved by selling central bank held Treasury bills or newly created central bank securities if there are no T-bills lying around), the central bank takes the money away from commercial banks.

If NFA money is sterilized, bank reserves will contract and commercial banks can no longer use the money to give loans. Reserve money will contract. Foreign reserves on the other hand will have already increased by an equal amount.

If done continuously, foreign reserves will rapidly outpace the growth of the monetary base. This is how reserves are collected. The country will be starved of capital. Interest rates will rise. That money will go to bridge the budget deficit of the United States in a dollar peg.

Essentially this is monetary crowding out.

Monetary Crowding Out

In the first quarter the central bank collected more than 300 million dollars and gave it to America.

That is a lot of money for a country like Sri Lanka to lose. Here we are scrambling all over trying to raise syndicated loans, sell bonds, treasury bills and bank deposits to foreigners and we are giving Uncle Sam 300 million dollars.

All this is happening because we have a flawed monetary system (Read Thrift Column - Regime Conflict)

Rapidly rising reserves can create other problems. The cost of sterilization (by issuing central bank securities) can be higher than the earnings of foreign reserves. This can eventually bankrupt a soft-pegged central bank.

China for example is desperately investing its foreign reserves in Blackstone capital in a bid to increase returns as the costs of sterilization go up. This is soft-pegged central banking gone stark raving bonkers. Capital that could have been used by Chinese people is appropriated and given to private enterprises in the USA.

Such countries can run current account surpluses easily. This is because the central bank takes away money that should have been used by the population and gives it to America.

If the central bank did not take away the money and park it in the US budget deficit, capital inflows could even create a trade deficit or a current account deficit.

There is nothing wrong with it. If capital is utilized domestically, people's living standards are likely to be higher. Another longstanding monetary myth perpetuated by central bankers and others in Sri Lanka is that the 'trade deficit is financed' by remittances.

Wrong. The trade deficit is driven by remittances. If remittances were not there, people would not have money to buy goods. It is goods that cannot be supplied domestically that are imported. If remittances fell some imports will also disappear.

If remittances from foreign workers and exports are not there economic activity and peoples' living standards will fall. They are simply extra-national markets for labour and goods. It has nothing to do with the exchange rate.

Remittances that are in the foreign currency banking units of course will not cause a trade deficit if lent abroad. But they will if they are loaned to government through Sri Lanka Development Bonds or to other domestic players.

It is no accident that the most developed countries in Asia-Pacific (Japan, Australia, New Zealand) have floating exchange rates. The other rich Asian countries like Singapore, Brunei and Hong Kong operate currency boards with other floating currencies.

A floating rate ensures that there is no monetary crowding out and makes capital plentiful to ordinary people. A floating exchange rate central bank - usually a reserve currency central bank - will not intervene in the forex market.

When a soft-pegged country runs into a currency crisis (See postscript for more) the IMF advises the country to float. But soft-pegged central bankers who are obsessed with collecting reserves cannot help intervening. IMF also eggs them along.

As a result a country that has recently experienced capital flight is starved of capital again. This delays recovery. But capital controls also starve countries of capital and limits growth. Either way such monetary systems deprive countries of vital capital, keeps nominal interest rates high and perpetuate poverty – the exact opposite aims of having 'independent monetary policy'.

Soft-pegged Instability

A soft-pegged central bank can also cause currency crises, like in East Asia.

You can also see it happening in Vietnam now and it happened in Sri Lanka many times. (Read Thrift Column - Currency Crisis)

Policy makers and politicians usually blame oil when this happens, though the culprit is actually rising domestic assets of the monetary system.

In Sri Lanka currency pressure is usually triggered by the April spike in reserve money, where the central bank accommodates a seasonal cash demand with a massive increase in domestic assets.

Up to March 2008 the central bank collected 349.50 million dollars.

The T-bill stock which fell to 4.6 billion rupees at the end of March, then went up to 21 billion by April 22.

In April and May the central bank sold 121 million dollars. By end May the T-bill stock had fallen to 3.4 billion rupees. This is perfectly fine. By June 16 the T-bills stock had again gone to 15 billion rupees.

It is too early to say whether this is a currency problem or a reserve appropriation to pay off a foreign loan.

Double Discount

Another problem with soft-pegs is high inflation. When a country maintains a peg like Sri Lanka does, it imports the inflation of the anchor currency. In Sri Lanka or China it is the US dollar inflation.

The anchor currency – in this case the US dollar – already has its own discount window or reverse repo facility through the Federal Reserve. A soft-pegged central bank maintains its own reverse repo system. This means the inflation will be amplified.

In general a dollarized country or a fixed exchange rate/currency board country will have virtually the same inflation as the anchor currency. (The difference is explained - partially- through the Balassa-Samuelson effect.)

Currency boards do not have discount windows. The only discount window is in the anchor currency central bank. Interest rates therefore will be market determined.

Countries that run currency boards or have dollarized also have fewer bank failures. Because banks know there is no easy lender of last resort facility they engage in prudent banking.

In Sri Lanka the discount window has been restricted, which is good. But the reverse repo rate is artificially low at 12.0 percent.

Basically the central bank is fighting inflation with its hands tied behind its back because for whatever infantile reason, policy rates are kept frozen.

Bretton Woods

Someone who had read the column this far would now get a pretty good idea why the Bretton Woods system failed. The Bretton Woods system was not a system of 'fixed exchange rates' as we were taught in first-year economics.

Bretton Woods was a system of 'soft-pegs'. A fixed exchange rate is a currency board with no discount window. Such a system is credible for reasons given so far, and can be maintained indefinitely. Sri Lanka had such system until 1950 and it only broke down after John Exter created the Central Bank of Ceylon, with a responsibility to finance government and buy T-bills.

The 'Sterling area' of the British Empire was mostly a 'fixed exchange rate' system. Falklands Islands has operated a currency board with a one-to-one parity to the Sterling since 1899. How is that for a credible fixed exchange rate?

Before the Bretton Woods system, countries kept to the gold standard. In effect an internal anchor. Each country had a discount window. But if too much money was printed, the central bank lost gold reserves. To stop gold flowing out monetary policy had to be tightened.

This kept the system in balance. Because all countries had essentially the same anchor – gold- it created a long term balance with everyone else as well.

Under the Bretton Woods system, only the US dollar was expected to keep its link with gold. Other countries were supposed to keep a peg to the US dollar and have its own discount window. US anyway could not keep its link.

This was destined to fail. With two discount windows in two countries and an external anchor, it was a no brainer that it had to fail. But when geo-politics override good sense, and people started to believe that Keynesianism could be made to work, with capital controls if necessary, politics overshadowed common sense.

This shows the relative ignorance in United States about currency boards. If they understood the Sterling area, Bretton Woods may not have happened. The Euro however shows a learning process.

In hindsight we can now infer why John Exter created Sri Lanka's central bank the way he did. He converted the currency board into a soft-peg. It operated like the Bretton Woods system. Just like the architects of Bretton Woods, he probably thought it would work.

Britain at the time had not liked the break-up of currency boards and the sterling area. This is probably why J R Jayewardene had to seek US expertise to set up a central bank.

That Exter had clearly changed his mind and became staunch gold standard supporter later shows the subsequent learning process after the break-up of the Bretton Woods system in 1973 and the emergence of floating rates. (Read this interview with John Exter)

The Bretton Woods system worked for a while and collapsed in the years following the Vietnam War (especially 1967 onwards) and President Nixon's deficit spending in the early 1970s.

If anchor currency monetary policy is benign, it is easier to keep a soft-peg going. The Balassa-Samuelson effect also probably explains why. But when the anchor currency starts to print money willy-nilly like the US is doing now soft-pegs have high inflation.

This is why China and the Middle East are now having 8 to 15 percent inflation. The system in the Middle East and China and Sri Lanka is like a new Bretton Woods.

Singapore and Hong Kong can maintain the hard peg/currency board with comparatively lower inflation because they do not have domestic discount windows and do not manipulate domestic interest rates artificially. Singapore however has a complicated system which probably over-performs a currency board.

Kuwait has already broken its soft-peg with the US dollar. Most Middle East countries are debating whether to break the soft-peg or not. The US is trying hard to persuade them not to.

Monetary Puzzle?

If all these problems are known, how come soft-pegged central banking is maintained? For one thing not all these problems are 'known'.

This is because economists connected to government will always try to give complex 'explanations', cover their culpability, hoodwink the public and continue to print money so that a large government can be kept going.

'Independent monetary policy' is a euphemism for manipulating rates, or printing.

For example the purchasing power parity theory of exchange rates does not seem to stand the test of the real world. If it were true Singapore-style monetary systems could not exist. But over-valuation is a very real problem.

Why is the Euro stronger than the US dollar? That is because its internal anchor is better. Its inflation index either better reflects inflation or its actual inflation target achievement is better or a combination of both.

Either way less Euros will be printed compared to output. It is not a matter of trade.

All this has serious implications for Sri Lanka's current monetary policy stance. This column has supported all attempts by the central bank to tighten policy including discount window restrictions, freeing market rates and staying out of the T-bill market, all of which brings the system closer to a currency board.

It has even been supportive of quantity targeting, in the absence of a better alternative.

However, the foregoing shows that quantity targeting may have outlived its usefulness, especially in the context of maintaining an external anchor. This is also the point that Steve Hanke made. It is not practical to run two anchors.

What now?

An external anchor will create some domestic inflation even if domestic asset growth is negative. That is what Singapore found out. That is why after 1980 it broke the peg with the US dollar and appreciated the Singapore dollar.

Marshall Islands, which is a dollarized country, is reporting close to 6 to 10 percent inflation in the first quarter of 2008. That shows US is printing heavily.

Quantity targeting was successful in reserve currency countries. In a pegged system where the balance of payments or NFA is the money supply it makes no sense to target a monetary base though it can help in the presence of exchange controls which is a self created problem.

The time has come to seriously re-think the monetary system. If oil is discovered Sri Lanka will turn into another high inflation Iran under the current system.

There are, however, things that can be done, in the meantime. When large foreign inflows come, the government should keep them in foreign currency banking units and convert them gradually, instead of repaying commercial bank overdrafts overnight and creating a 'soda bottle' effect like it did after the sovereign bond.

Treasury overdrafts should be limited to say less than 5 percent of reserve money especially in March and April. Ultimately, as can be seen everything boils down to fiscal policy.

The extra dollars collected by the central bank in the first quarter may come in useful if there are net debt repayments - especially if foreign investors want to cut their holdings in government dollar or rupee bonds.

Experienced central bankers probably know this and may well have been deliberately collecting reserves.

Essentially the foreign reserves act like a sinking fund for the government at the expense of private enterprise and ordinary peoples' living standards and the future of the country.

Dipping into foreign reserves to repay government debt shows that even the 'monetary crowding out' in this country is eventually caused by the domestic budget deficit.

Also exporters are now clearly suffering from overvaluation. While it is perfectly possible to maintain any exchange rate by restricting the domestic money supply, it may lead to export sector bankruptcies. To keep them in business and preserve economic activity, a devaluation may be needed.

All this point to the crying need for monetary reform, so that inflation would not be created in the first place. The most effective solution is to go for a currency board, probably with the Singapore dollar like Brunei has done.

At a bare minimum, a separate public debt office, ending central bank obligations to cover foreign obligations of the government without approval of parliament, and the immediate halt of provisional advances and independence for the central bank to raise policy rates, is needed.


Provisional Advance - Due to a serious shortcoming in Sri Lanka's monetary law, the central bank is forced to print money and give to the Treasury (usually in the first quarter) up to 10 percent of its expected revenue for the year.

This is called a 'provisional advance'. This provision must be removed from Sri Lanka's monetary law as soon as possible, if the country is serious about fighting inflation.

Each year a new 'advance' of about 10 – 12 billion rupees is given. The previous year's lending is never paid back despite there being a legal requirement to do so. Auditors or the parliament have so far not taken either the Treasury or the Central Bank to task over this 'default'.

Currency Crisis - A currency crisis is created when a soft-pegged central bank creates too much money through the acquisition of domestic assets, in an effort to keep down interest rates or defend the currency a process known as sterilized intervention.

When a currency crisis hits a country IMF tells the country to float the currency and allow rates to go up. If a currency is floated, central banks will no longer buy dollars. It can run the money supply out of T-bills.

Vietnam which tried to push up its currency in the got into a currency problem and had to push up policy rates from around 8 to 14 percent in the past month.

To get out of a currency crises, the exchange rate has to be floated and domestic asset growth in the monetary system has to be halted. This pushes rates up.

But in a serious crisis, when rates rise and bad loans ratchet up, central banks will bail out failing banks with printed money. This will worsen the currency crisis. That is why IMF advised countries like Indonesia to close banks that failed during the East Asian currency crises.

It is perfectly possible to run the money supply out of domestic assets. This is what a reserve currency countries like the US or Japan does.

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8. Anura Nov 03
Can't believe how they manage the economy. If they do not reverse these bad policies we would be worser than Zimbabwe. I think, officers cannot do anything over the political influence. We should pressure the govt to leave Central Bank to be independent. Monetary Broad has Secretary to the Finance Ministry. So, how would the Monetary broad would be independent. What a poor country....
7. Deane Jul 11
Thanks fuss,
I think both you and Harsha should start a SL econ/development blog. Seriously.


6. nihal Jul 09
Hi Harsha
This has nothing to do with your BW article. Now that, at the EForum, Kabral has provided details of how the CB is attempting to do the balancing act, may be a report card on how well they do it would be a good subject to examine. Just a thought.
5. fuss-budget Jul 06
Keynes was acting for the British government. He was very knowledgeable about currency boards according to researchers. But hey, he had a brand new theory.

By the way Ajay Shah from India has started a blog on inflation/RBI and has observations about Sri Lanka in response to a question from Deane.

Deane, frequent participant on these colums also has a blog on petroleum powered inflation among other hang-ups about inflation. Nice going Deane.

4. dilan Jun 26
Why did Britain agree to Bretton Woods? They must have known about currency boards better than the US.
3. fuss-budget Jun 20
Hi Harsha,
Thanks. I was partial to currency boards but was perfectly happy to see inflation targeting earlier. But you can see that running internal anchors is a deadly business - see the pressure that ECB is under not to raise rates - and by manipulating the index you can undermine the process also.

The point is even though we have had a 'central bank' since 1950 all this time we have been running a type of currency board variation. It had all the disadvantages of a currency board with non of the advantages. Capital convertibility and low inflation are key advantages.

The transition from the existing system to a currency board is a hop step and a jump away. A floating exchange rate cum inflation targeting is a big transition and as a small island we will have lots of problems too.

The other point is running domestic monetary policy needs knowledge and skills - at best a basic understanding that that inflation is monetary. When some of the official statements say that the central bank cannot fight 'cost-push' inflation it is enough to scare the living daylights out of anybody who is willing to trust the central bank engage in inflation targeting.

China has thousands of central bankers, yet it has higher inflation than Hong Kong, which has none.

I guess it is ok to lie - if you are not scared of going to hell. Reserve currency central bankers fudge, hum and haw and 'lie'. But they do not really believe the rubbish that they tell, though the media and everyone else lap it up.

The current monetary strategy is probably giving some results. But definitely there is a lot of imported inflation now. In the past 12 months may be even 8 percent or more was imported, compared to about may be 3-4 percent in normal years.

Most of it must have come this year also. US started printing heavily from August onwards so it would take a few months to hit us.

Also we are now at a time when inflation targeting is itself questioned. Bernanke was instrumental in cutting rates in 2003 raising non existent panics about 'deflation'.

Manufacturing sector-productivity-growth driven lowering of inflation indices, such as the China factor is not an excuse to print more money. Yet this is what happened.

That means inflation indices should be reformed to reflect commodity prices and asset prices.

The US depression was caused by the collapse of a bubble which developed following the mass-production-driven productivity growth in the early part of the last century.

The China factor was a repeat. The problem is that central bankers are looking to print - always and everywhere - and hoodwink the people that they are 'fighting' inflation.

The lesson here is this. The monetary world described by classical economists like Ricardo and later the Austrian school still remains.

Now is a good time to debate these issues because when people are starving due to US money printing, it is difficult to give excuses for central banking.


2. Harsha de Silva Jun 20
Fuss, as usual an extremely comprehensive theoretical piece, with empirical support bringing further credibility for your call to get rid of the CBSL in favour of a currency board. Your reasoning is valid and would put a broad smile on the face of Hanke and other proponents of the cause!

I hope Mr Cabraal and his team would pay serious attention to what you have laid out so beautifully and be convinced that its soft peg strategy is not working. You and I have argued over the years that the CBSL can’t have the cake and eat it too; re exchange rates and interest rates.

The practical reality however Fuss, is that no Sri Lankan government would ever want to let go of the power to print money especially not when the CBSL press is the only angel financier for wasteful projects which are just fronts for massive corruption. Of course it is so much easier if and when you have a hard-core politician running the institution! We don’t have politicians of the caliber of LKY or others who’ve had the neither the knowledge nor the courage to take the bull by the horn and deal with issues. Plus, the so-called advisors [dozens of them on monetary policy alone] don’t seem to yet have comprehended the problem in the first place. Or maybe, they just keep quiet in order to enjoy all the perks?

So, in this background, what are the options? I totally support your recommendations of de-linking the public debt office from the CBSL and halting of the ‘provisional advance’ scheme. Recently I pointed out in public what a huge volume is printed in terms of these ‘loans to GOSL’ which in turn attracted a bout of personal attacks from certain quarters in government. [Upload if you can, I am sending it as an attachment].

To get any of this done we need political will. Already there is provision in the 17th amendment to the Sri Lanka constitution for a Constitutional Council which HAS to give its concurrence to the appointment of the majority [3 of 5] of members to the Monetary Board. I believe if we can at least get that done some level of independence can be brought in to the CBSL to do what is right in the interim.

1. Shiraz Jun 19
It is interesting to see how all our economies are wired to one another. Certainly we need to be cognizant of the fact that we cannot be immune to changes in larger economies.

But we do need a balanced and proactive approach to managing our economy so that we get the better of the two worlds. I do not think that is happening in any aspect of our economy and its management.