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Tue, 22 August 2017 18:09:36
Sri Lanka's pegged currency and freewheeling interest rates: fuss-budget
19 Feb, 2008 23:14:06
By Fuss-Budget
Feb 19, 2008 (LBO) -- The big question in almost everybody's minds now is how Sri Lanka's so-called floating rupee is going to behave now that the Central Bank seems to have resigned itself to inflating the economy by double digits this year.
However, let us hope that the Central Bank is actually too cautious in the light of determined efforts it has made in the last two months not to print money.

The next challenge for the Central Bank is in March and April when reserve money peaks, eventually tripping up monetary policy. That is also the time that the currency regime veers in a different direction.

This is what undermined the quantity targeting framework last year. While it is good that the central bank is under some self-restraint, given that no go-ahead is given for either inflation targeting or a currency board, the current system is extremely tricky to operate practically.

Let's get a handle on the overall interest and exchange rate policy we seem to be running now, and see how different policy conflicts are pulling the monetary system in different directions.

G-sec market

In December, the Central Bank raised large volumes of money for the Treasury, printing hardly any money. Rates went up, and rates came down in January with lower credit demand.

The secondary government securities market suddenly came alive as soon as interest rates were freed.

In fact, secondary market rates started to move below auction rates and there was very active trading as money poured into the g-sec markets as financial repression ended. It was beautiful to watch.

In January the rates came down. Ideally the government should have used this opportunity to raise more money but partly due to the availability of central bank credit in the form of provisional advances as well as other reasons, borrowing requirements in the first quarter are lower.

Short term high volatility in rates and yield curve can have odd effects, but it is good news for bond traders who can make quick profits. But provided the market is freed, arbitrage may gradually close this gap in several ways and smoothen the yield curve over time.

Private borrowers may get used to raising more money for longer during this time as there is less crowding out. Also a new dimension has come in.

There is evidence that some hedge funds sold bonds during the period, betting that rates will jump again later. Volumes were small but this is arbitrage in a hurry. Aren't markets beautiful?

Monetary Framework - Guess the regime

The discussion above shows that the Central Bank has no control over the yield curve, whether overnight or longer. It is no longer conducting 'monetary policy' in the way it is normally meant in other central banking regimes.

A central bank is set up to control interest rates and to manipulate the price of credit. In a market economy a central bank is an anachronism that controls the price of credit artificially and usually gets into trouble.

When central banks make credit too cheap for too long, economic turmoil follows. It creates property and stock market bubbles and loan defaults that we are seeing in the US and Sri Lanka.

With the reverse repo window also closed in Sri Lanka, a situation very close to a currency board is found except that interest rates are higher than it would have ever been under a currency board regime because the capital account is only partially open.

People who believe in central banking and its supposed ability to keep full employment lay much emphasis on 'monetary policy independence'. Well, we don't have it. We have free-for-all-interest rates even in the overnight market subject to the 12.00 percent floor, while usually exceeding the 19.00 percent ceiling.

(And isn't our banking sector resilient? Aren’t our long-suffering borrowers and corporates resilient in the face of 20 percent plus interest rates? In the US, when rates go to five percent the so-called Wall Street giants go whining to the Fed for rate cuts like a bunch of namby-pamby cry babies.)

However, a policy rate environment and open market operations are needed to operate a floating currency regime.

Exchange framework - Guess the regime

Despite the rhetoric spewed out by the Central Bank, Sri Lanka does not have a floating exchange rate. Sri Lanka has a soft-pegged exchange rate with some flexibility. This can be easily shown by the extent of sterilized intervention.

In fact Sri Lanka's foreign reserves now exceed reserve money making it possible to have a currency board, and even dollarize the country and eliminate inflation overnight.

It was amusing to see the Central Bank making completely contradictory statements in the 2008 Monetary Policy Roadmap.

"Sri Lanka continues to follow a floating exchange rate regime, where the market forces of supply and demand largely determine the exchange rate," it said in once place.

Amazingly elsewhere the Central Bank said:

"It would also be useful for us to note that the reserve money growth would be facilitated by the growth in Net Foreign Assets (NFA) and Net Domestic Assets (NDA) of the Central Bank.

"Further, any change in reserve money due to a change in expected growth in NFA would necessarily have to be offset by a corresponding change in NDA."

These are polar opposites. By sterilizing Sri Lanka is running a pegged exchange rate by definition.

The fact that Sri Lanka now has a fully foreign reserve backed currency also shows that the country does not have a floating rate. In a floating rate environment the monetary authority runs reserve money out of domestic assets (CB credit or gold earlier) not foreign reserves, because it does not intervene in the forex market.

Policy Implications

This is the problem with monetary policy here. We are confused. We have multiple anchors as Steve Hanke said (Read Dragging Anchor), which is another way of saying the same thing.

We have an exchange rate anchor with the US dollar, with a very soft peg, where the central bank is not only prepared to sterilize foreign flows but is also willing to do the opposite and cause a currency crisis as seen repeatedly.

A country with a peg (hard or soft) will import inflation. That is the anchor currency inflation, in Sri Lanka's case US inflation. With US inflation rising even hard peg countries like Hong Kong are having problems.

When the central bank maintains a fairly hard peg, net foreign assets or the balance of payments fulfills all the money needs (reserve money requirements) of a country.

That is why any debt monetization and discount window activity tends to be inflationary in a pegged environment. This is the problem facing Gulf countries and driving them to break the peg with the US dollar.

That is why there is a close co-relation between central bank credit and inflation in this country. This columnist has previously explained why. It essentially captures the difference between a currency board and a central bank (soft-pegged).

Also the outstanding T-bills or CB credit behaves like a flow because it is tied to annual budget cycles. Read Money Money. However one can just as well compare growth rates.

It won't happen like this in the US or Australia which run reserve money out of central bank credit and have a floating exchange rate. In other words this is a classic soft-peg problem. Inflation jumps when central bank credit jumps because the real money demand is already completely satisfied through the peg. The country also does not have a floating rate to balance domestic asset movements.

There is another complication. Because the capital account is not free, foreign capital flows cannot easily leave the country here.

Therefore the problem becomes more acute than Hong Kong which is running an orthodox currency board and all kinds of capital comes in and goes out without causing a problem.

Singapore is operating a very complicated system which will take pages to analyze so we will leave it aside for the moment.

But our system is very complex and has built in multiple policy contradictions. We have multiple anchors like Steve Hanke said. The central bank is targeting the exchange rate and money supply at the same time. It can be done as long as the balance of payments is in surplus.

As of February 2008, the Central Bank is now running a system that is very close to a currency board, with freely fluctuating interest rates, a partially closed discount window, and active intervention to prevent the rupee going up. The rupee will be rock steady under these conditions.

But because we have capital controls, the Central Bank has to deal with excess liquidity from capital flows also.

All this is very interesting academically, but practically our monetary regime is loaded with basic theoretical policy conflicts which are nightmarish.

Precariously Balanced

These policy conflicts cause the system to unravel from April onwards.

Since fuss-budget started to analyze this economy one fact has stood out like a sore thumb. Somewhere in May-June the country is shunted into a currency crisis with clockwork regularity.

This happened in 2004, 2006 and 2007. Read The Thrift Column - On the brink and The Thrift Column - Currency Crisis for more details.

One of the triggers is the sharp increase in reserve money in April. Look at the Policy Logjam graph. Plotted in the graph is reserve money, reserve-money-with-excess liquidity and the exchange rate. The exchange rate is in fractions of dollars for a rupee.

The April peak is caused by several factors. There is a large festival related drawdown of cash from the system.

Last year in April reserve money went up to 277 billion rupees, which was higher than the end-of-the-year money target.

A part of this cash need is satisfied by foreign flows. The entire export sector gives festival advances by selling dollars. In the first and second quarters of 2007 foreigners were also buying bonds. Ideally a hard peg should satisfy the entire cash requirement out of the balance of payments.

However in April the government also gives festival advances to state workers. This is usually printed. This is the root cause of the problem.

When the behaviour of the rupee is plotted against reported reserve money and reserve-money-with-excess-liquidity, some trends can be seen.

The rupee was weakening only a little in the first quarter after recovering from a bout of money printing the previous year. The blue area is reserve money and the orange is excess liquidity.

With the central bank pussyfooting around excess liquidity the rupee started to crash last year after May. By late July/August there was full scale sterilized intervention to defend the currency and the rupee was going down like a stone as reserve money was kept within targets.

Consider this. Before April the central bank was sterilizing dollar flows. In April the rupee is floating and appreciating.

Then the rupee comes under pressure from May onwards. The central bank then abandons all pretences of floating and tries to intervene.

The central bank is essentially switching between different exchange rate regimes.

When the exchange rate is targeted, the balance of payments supplies all the money needs, so there is no room to add domestic assets. When it happens, inflation and currency pressure is the result.

The problem with excess liquidity is that it is not only available for lending the next day but more importantly it is available for payment settlements.

The ability of commercial banks to 'reserve short' and go excess reserves are extensions of the same problem. A bank could reserve short up to 10 percent in this country.

In other words it is like a backdoor reverse repo window. For all these reasons (and a closed capital account) the reported reserve money does not really reflect the ability of the financial system to generate inflation.

What's to be done?

Last year in the midst of all this promises were made that rates would fall. That way lies madness.

The central bank should make all efforts to persuade the government to collect some cash ahead of time or raise it abroad, and like in December 2007, stay away from the primary bill market and stop funding state worker salary advances which is the core problem.

Then if the central bank wants to defend the currency after April, it should engage in non-sterilized intervention until post-festival excess liquidity is exhausted and not try to control the rates or keep to reserve money targets. If reserve money has to shrink, let it shrink.

Without a policy rate regime, a floating rate also cannot function effectively.

The 'problem' with capital flows and excess liquidity is caused by exchange controls. But by sterilizing capital flows the central bank is also denying the economy of the benefit of external capital and keeps rates unnecessarily high.

Here is another policy contradiction. There is no point in the Treasury telling private firms to borrow abroad if the central bank is going to sterilize and appropriate the money.

The 500 million dollars ended up pushing up foreign reserves because of sterilization and it was used to repay banking system overdrafts without causing real economic transactions. Otherwise all capital flows should increase reserves. It does not happen like that.

Foreign Borrowing

Technically there is no harm in opening the capital account for foreigners to buy bonds, if there was an institutional framework to support it, like a credible peg -- in other words a currency board. Or a floating exchange rate. We have neither.

A currency board will impose a hard budget constraint. Even then, if a government continues to borrow abroad irresponsibly, there could be sovereign default.

But there need be no currency collapse and economic collapse and bank collapse in a currency board environment. A simple sovereign default will be enough.

But in a pegged exchange rate regime, a country can have a currency+economic+banking crisis to the extent that bond maturities are financed with central bank liquidity (printed money) initially and the currency is defended and then finally let go, followed by eventual sovereign default as well.

A currency board in Sri Lanka will probably hurt the exporters less than a floating rate because there will be more time for adjustment.

Remember the bi-polar view? It says that only currency boards and floating rates will work and 'non-credible' pegs do not work and are disappearing into currency unions/dollarization or currency boards or to full floats.

Former IMF first managing director Stanley Fischer who saw the East Asian crisis at first hand paid a back-handed compliment to Steve Hanke and Kurt Schuler for their "tireless proselytizing" of hard pegs in a landmark address where he basically wrote off soft pegged exchange rates (read Is the bi-polar view correct? )

Pegged exchange rates seem to be relics of colonial era currency boards that have failed to grow up in to full functioning floating rate central banks.

That is essentially what the bi-polar view means. Soft pegged exchange rates/central banks are an immature system which can be very costly to the poor as has been proved in Sri Lanka.

Next year, around this time, hedge fund-held rupee bonds will mature.

Before that happens get the fiscal house in order, re-think our monetary regime and start dismantling the policy conflicts that are pulling an inherently unstable system in different directions.

If the war intensifies and credit quality is called into question by rating agencies, the authorities would not be able to play the same games with hedge funds that it is now playing with the EPF and cancel bond auctions.

Aren’t markets beautiful?

_____________________________

Bouquets and brickbats to fuss-budget@vanguardlk.com. You may also click the response tab to write comments.

Postscript

Error corrected. Last year promises were made after April that rates would not rise. Not fall.

Financial repression or the way interest are manipulated downwards by the central bank is also part of the monetary problem in Sri Lanka.

The discussion below relates to recent development in government securities markets.

Defenders of the powerless

One of the problems in the market is that the employee's provident fund (EPF) is mis-used by the authorities to repress rates. However, now there are some large bond buyers and dealers who can challenge the anti-market practices of the EPF managers.

The problem is that the EPF does not act in the best interest of its beneficiaries as a genuine market participant would.

In fact the big private bond players must realize that they are the last hope that the little people have, such as EPF beneficiaries who are slaving away in the hill country tea estates or garment factories.

Fuss-budget could say that big bond players have a bounden duty to protect the little people from the authorities and the Central Bank. But no such altruism is needed.

Bond market players should use their expertise and market power wisely for their maximum profit and automatically the man on the street, including small savers, will be protected from the draconian 'business' of government.

Even borrowing short in the overnight market and running a 3-month bill portfolio and bringing down rates is perfectly ok, because the government must get that benefit also.

The crazy 12.00 percent reverse repo rate must be used in some way, otherwise short term lenders will lose heavily. However structural rigidities prevent the discontinuous rate structure between the overnight and one month term money being arbitraged away more efficiently. No matter.

Authorities must also realize that primary dealers do not want rates to go up. Rates go up because the government is borrowing too much and ultimately bond holders who hold to maturity (the savers and the insurance companies which represent little people again) push dealers to bid higher.

When dealers advise clients to bid higher, even at the cost of their own portfolio, they are displaying a remarkable professional integrity which is sadly lacking in this country elsewhere, especially in the EPF.

It was really funny to see some dealers getting upset when auction rates went up and the value of their portfolios fell a few weeks back. That is also ok. The market needs different views to work. Aren't markets beautiful?

Remember the forex market last July? (See The Thrift Column – Currency Crisis). The problem of exchange rate depreciation or rate rises is not the fault of the dealers. Heavy handed actions on the part of the authorities will not work if their policies (sterilized intervention, budget deficits) push dealers to act in the opposite way.

It is perfectly legitimate to try to sell bonds outside the auctions on other days especially because money comes looking for homes all the time and not just on the auction date. If the government does not grab it, it goes elsewhere.

But this also shows why bond auction cancellations have proved counter productive in the past. Money not taken is money lost and tied up in a fixed deposit somewhere.

Auction prices go above the secondary market because the Treasury comes into a market between private players. The auction rate also gives early signals to draw new money in.

This is the way markets are expected to work.

Updated

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READER COMMENT(S)
19. mike.mags May 21
With civil war ended there maybe influx of overseas funds causing the rupee to strenghten.As a foreigner I can bring in funds ,convert them to rupees,earn high interest rate,pay no taxes as these are special accounts.

Incredible isn't it.Even if you allow 10% depreciation pa,one is still a winner and still make close to 6- 8%.Am i Correct?

18. Carlos Jul 30
I am interested in investing in SL T-Bills converting Us dollars, swiss francs and UK Pounds. How can I hedge against the devaluation of the SL Rs.
Should I buy futures in these currencies?
17. fuss-budget Apr 14
There are no supply shocks. At least not in tradable goods. Commodities, metals, minerals are rising due to loose monetary policy in the US. This is the same thing that happened in 1970s.

If you are interested go read Paul Volcker's speech to the Economic Club of New York last week. It can be downloaded readily. US banned the export of soybeans then. India is stopping rice exports this time.

There is a complex process of arbitrage going on in the world which is pushing prices up to a new level to account for years of money printing by the Fed. That is not to say that the current levels are correct however.

They are most certainly too high. Commodities are the last market that is giving profits to excess liquidity that is floating around the world.

If the bubble breaks, prices will slump. The extent of the slump depends on the how much the Fed will print. If Fed prints a lot it will 'validate' these prices to some extent.

Volcker brought them down by refusing to validate 25 years ago. But gold never went back to 35 dollars. Though it was 35 dollars for more than a century until the second world war.

Our inflation is 'imported' only to the extent that we cannot effectively counter US/global inflation. Countries with independently floating exchange rates (usually with inflation targeting regimes) can do that. We do not have a system to do that. That is why we need monetary reform.

Countries that are hard-pegged are a bit helpless and they will have anchor currency inflation almost. But of course this is not a lot if you consider US dollar and Euro inflation. Countries that are soft-pegged like us, the Middle East, China etc, will create inflation on top of peg-imported inflation. That also answers your question about food.

The Philips curve has been disputed by practically all modern central bankers, including the most senior people here, so I need not get involved in it. At the risk of sounding facetious I might point out that Zimbabwe has 100,000 inflation and 80% unemployment. Many countries with low inflation also import labour on a net basis, like the Middle East did when US policy was benign.

Reserve money is demanded everyday. The requirement changes everyday. In a pegged environment reserve money is satisfied by the balance of payments. Any deviation will either starve the economy of money and push rates up or create inflation. That is what happens to us most of the time.

That is why currency boards (hard pegs) are not allowed to buy treasury bills or have a discount window.

Floating rates also provide required money everyday. Floating currencies are fully backed by central bank credit, because floating central banks do not intervene in the forex market usually.

Though I guess you can do a bit if there is a policy rate structure in operation, and there are no capital controls. Central Banks like to have foreign money also to settle payments if necessary.

In the gold standards days most central banks had requirements for a ratio of foreign hard currency. But essentially these were also 'gold', because other hard currencies were also linked to gold. You can work it out for yourself. That is why you could have a fixed/pegged exchange rate in a gold standard with policy rates, discount windows, fractional reserve banking and what not, which was the pre-Bretton Woods scenario.

But you cannot do that when the other currencies are fiat. That is the fundamental mistake behind Bretton Woods, the Middle Eastern pegs and Sri Lanka's peg. Reserve money targeting is a bureaucratic exercise. Our reserve money went out of line with economic activity after April 2007. Before also it was out of line but in the other direction. But let's say that is ok.

A currency crises happens when the monetary base goes out of line with economic activity.

I don't want to get into an argument about economic growth numbers, but they are highly suspect, though useful if calculated on the same basis every year.

The people who are running monetary policy in the central bank almost certainly know the limitations of reserve money targeting, and are doing it because they have no other alternative.

16. abesinghe Apr 09
I should be thankful for your explanation. I think I have not understood what is in the report correctly. However, the explanation from the central bank (even in the box article of the annual report 2007) says that the inflation is due to the ‘supply shocks’- which is the commodities.

The relationship that you are ( or Dr Harsha) going to show by printflation graph is spurious. But, cant it be other ways – relationship shows with FAO price index and local inflation is spurious.

Another, thing that our unemployment rate has come down while we are dealing with high level of inflation. This is ‘’typical Phillip’s curve” relationship. Can this relationship also be false.

But, what Anil ( Or CBSL by Anil’s name) is saying that they have printed only less amount of money (10.2% growth) than required (20.8% growth) by the economy which is basically contractionary. In 2003 and 2004 we have exactly match these two. When overall reserve money is not match with required how do we ended up with such a high demand inflation.

Shall we clarify this before going into next step.

Your quick response is highly appreciated.

15. fuss Apr 09
The CB fired at the graph a long time ago. This is nothing new. The reason the graph was constructed in the particular way was explained twice earlier. This column also explains the same thing (see above).

First of all fuss-budget is very happy that the Central Bank is responding. This is what this columnist said when the graph was first criticized. However when trying to find statistical co-relations you cannot compare a stock and a flow.

This particular column has a graphic which compares growth rates.

From time to time both net credit to government and treasury bills had been used in the printflation graph. T-bills represents the most volatile part.

Nobody however claimed there was a one-to-one relationship with govt credit and inflation with no lags. Depending on how the index is constructed different lags would happen.

In non-tradable goods like food, inflation would show up pretty fast, in a matter of weeks. Remember the graph was constructed to show the effects of sterilized intervention to wit: a hard peg vs soft peg.

Sterilized intervention is why a currency crisis rapidly develops. It does not take years to do that. Just weeks. US Fed research has shown that a rate cut translates into exchange rates fully within six weeks. Exchange rates and inflation are like two sides of the coin.

Index behaviour (remember index growth is just one of the effects of money printing) depends on the components of the index. Some indices with a heavy bias towards non-tradable goods like the old CCPI will spike faster.

Other non-tradables like services - say doctor's fees, land prices - will respond slowly, maybe even a year or so or more.

If you over-generalize: inflation will first hit non tradable goods, then other things like land, which will then feed into wages and manufactured traded goods/exports. This is what we call 'overvaluation' of the exchange rate.

Imported inflation will be, in general, limited to the inflation of the anchor currency. The rest of the inflation would be created by discount window activity or any increases in domestic assets/ govt credit.

However a dollarized or hard pegged country will not have the exact same inflation as the anchor currency country though it is similar. This is generally explained by what is called the Balassa-Samuelson effect.

The Euro area has different indices for example.However it is almost the same.

Differences in index construction can also lead to lags in the way inflation shows up. Also currency board countries can get hit when there are rate cuts in the anchor currency and the domestic financial sector is strong and continues to lend to property etc.

But the bottomline is this. Sterilized intervention has huge costs. If you print and sterilize or even the other way - like what we are doing now - has costs, because we end up exporting capital.

In any case a peg with a discount window /government financing is not possible to maintain over long periods.

That is the lesson that Gulf countries are learning. That is what happened to the Bretton Woods system.

Sri Lanka is unlikely to be very different. As pointed out in the column above, Sri Lanka's exchange controls are another source of inflation. Last year's inflation remember was caused partly by the bond issue. Replacing printed money with foreign dollars doesn't solve the problem, therefore inflation continued to be high even if there was a switch in assets from domestic to foreign through sterilization.

So we need monetary reform. To the credit of the Central Bank it is trying hard. But it is running a pegged system which unfortunately is very tough just now because of the loose monetary policy by Fed.

However CB is trying hard so that should be appreciated. Also this debate is very necessary. This should have happened years ago, perhaps decades ago. People like Harsha and Anil are fulfilling a very valuable function from which future generations would benefit.

However at that time there was not enough information to write off soft-pegged central banks. Now we have enough examples.

It is no wonder there is confusion here. If countries like China and the entire Middle East and even the Bank of England got it wrong it is should not surprise anyone that we get it wrong too. Let's face it, just a few years after Bretton Woods collapsed, Bank of England was trying to shadow the Deutsch Mark. One would have though the Old Lady would have learnt a lesson.

You don't find the Bank of England saying Oops? Sorry I forgot. Look at the Fed. You don't find the Fed saying Oops sorry either. This is the biggest central banking debacle since the great depression.

14. RIP Apr 09
Hello fuss,
Do you think CBSL is following the FED in printing or is it the other way around?

RIP

13. Abesinghe Apr 07
Hi Fuss,
Your Prinflation gragh (which used by Dr. Harsha De Silva) has been fired by Anil Perera, Economist of CBSL on this sunday.

I even confused by now what's really going on.That explaination is quite reasonable. Let' s forget that these arguments are pureley not from mr perera, but has been wrutten by somebody else at CBSL, what is your explaination to Printflation. As he pointed out, can't we explain these complex economic relationships so easily??

What have you been wrttting all these times? Hope you would be able to quickly reply
Thanks

12. Nava Mar 01
Fuss,
Do you have a recommendation for a seasoned analyst or, do you know which brokerage house provides great research reports? I thought it wouldn't hurt to ask as you very knowledgeable and might be able to recommend an analyst.

I guess the situation in Sri Lanka is the reverse of the US where over the long run equities have outperformed fixed income substantially. You have provided the ratings agency view of the country as 'junk status' but do you think Sri Lanka might default on its debt.

When the Sri Lankan government faced two severe disaster events (terrorist attack on the Central Bank of Sri Lanka and Tsunami of 2004) the government still managed not to default. Do you think this is a strong indication of the resiliency of the government not to default? I am inclined to believe the chances of default are quite slim, but this is just based on historical track record and not much more.

Your response to why investors to put more money in treasuries vs f/d is interesting. I guess at the end of the day this is poor marketing by the government. One cannot fault the banks for asking investors to place money with them as they need these deposits to fuel growth. I just wanted to make sure I was not missing something more serious. You’ve convinced me to buy my first Sri Lankan treasury note!

Cheers!
Nava

11. fuss-budget Feb 28
Hi Nava
Sorry for the delay. Yes the parallels are the same. Securitzation is just a side issue actually. The problem is that the underlying assets - home loans - went bad. Actually it helped US by passing some of the pain to overseas banks.

I don't go around giving investment advice but if you decide to invest , right now you may be better off being overweight fixed income rather than equities. When you go into equities also better pick some defensive ones and get advice on timing to enter markets based on your view of where it is going.

The best time to enter equities is when rate are falling obviously but no harm in getting in early if you know can gauge where the bottom is going to be. The shorter the time to bottom the better off you will be. So talk to a seasoned analyst.

There is also evidence to show that T-bills have outperformed equities in the past couple of decades. That is because our government is too big.

Regarding the fixed deposit issue it is partly convenience, partly branding. T-bills are a mystery to most people and fixed deposits are familiar. Bank branches are nearby. Banks actively discourage people from going into T-bills and bank managers are the only investment advisers that ordinary people have.

Cheers

10. Nava Feb 25
Hi Fuss,
Thank you for your feedback. I like how you parallel the subprime mess in the US, however those are for securies that were tranched and securitized. Though I did not have the foresight to short (I was not invested) the CDO market, it is obvious that if you lend someone with poor credit to buy a bigger house than his/her means, then s/he will likely default as interest rates on their adjustable rate mortgages.

At any rate, I am inclined to invest in SL govt secuties. Thought there might be potential capital loss if rates rise to 22 or 25%, I can't complain if I can still get a 19% return if I hold onto a 1 year bond. My concern is the chance of default and I guess you answered that by sharing the Fitch and S&P soverign rating on Sri Lanka.

As someone that lives and breaths this on a day to day basis what is your personal assessment on my financial decision? Additionally, I was looking at this as a diversification strategy to investing in the Colombo Stock exchange.

Rather than placing 100% of my funds that I want to invest in Sri Lanka in the equity market, wouldn't it make sense to put say 70% in the equity market and 30% in the fixed income market? Lastly, is there any reason why an investor would put money in a fixed deposit account with a lower yield than purchasing a government treasury?

On a separate note, it might be nice if the webmaster might consider redesigning this website. The only way I knew to get back to this page is because I bookmarked it. I find the navigation to be challenging and this is a shame given the amount of interesting material on the site. For example, I am uncertain how to view all the Thrift columns or LBO >>Equity.

9. fuss Feb 23
Hi Nava
You want to do the same thing that a lot of foreign hedge funds are doing. They pumping hundreds of millions of dollars into SL government bonds.

It is a matter of risk and reward as usual. Higher the risk, higher the reward. You must understand that all Sri Lankan residents think that government treasury bills are 'credit risk free' or AAA rated.

In that context, you are obviously onto a good thing. If you open a Tierra account and buy bonds through that you could also pull it out if things do not look good. However if rates increase say from the current 19 percent to 22 percent or 25 percent you will make a capital loss of 3-7 percent because when you sell at higher interest rates the value/price of your bond falls.

In Sri Lanka savers have no alternatives because exchange controls prevent people from investing outside the country. It is a form of economic dictatorship and appropriating the assets of ordinary people by the state. You can clearly see it happening to the EPF.

Externally however the risk is not triple A, with the ever present threat of exchange controls. The risk measured by S&P is B+ and by Fitch BB-. Essentially these are speculative or 'junk' ratings. But then look at the sub-prime/cdo mess in the US!

If you do what you said, you are doing what a lot of hedge funds are doing voluntarily and what 20 million Sri Lankans are doing semi-voluntarily.

fuss

8. Nava Feb 21
As a Sri Lankan graduate student living in the US, I want to see if it makes sense for me to capitalize on the high treasury yields currently available in Sri Lanka. It seems I can get 19% returns and was curious about your take?

I don't think I have to face the traditionally inflationary pressures of someone living in the country for who the price of bread, milk, etc are rising. However, I know that the high inflation should effect the weakness of the rupee vs the US dollar. However I have not noticed this occurrence in the last several months which might be offset by the dollar weakening against other major currencies.

Therefore, I was curious whether I need to be concerned with default risk of the Govt Treasury which I feel is somewhat unlikely. Therefore, should I go ahead purchasing these treasuries, open a Sri Lankan bank f/d account, invest in the local stock market or keep my savings in the US or pursue another option? I look forward to you weighing in on my dilemma.

7. fuss-budget Feb 20
Hi Javed
The column has been cleaned up a bit and more subheads put in. See whether it is any better.

a) The first part relates to interest rates. It shows how the Central Bank no longer controls rates. Which of course is not a bad thing. It is rate manipulation that lands us in bubbles and inflation.

b) Then the column tries to find out the type of monetary regime we are in. At the moment it is more towards a harder peg to the dollar. But the column shows that in the past the peg loosens somewhat from April onwards and eventually backfires on us.

c) The final part relates to foreign borrowing. Is foreign borrowing good bad or ugly? We have now gone beyond the original sin. We can borrow abroad in our own currency. Actually this is a big thing.

There is no special value attached to 'foreign exchange'. That 'foreign exchange' is more valuable than rupees is a bit of a false concept born out of living with loose monetary policy - that means money printing- for six decades.

However we do not have the institutional make-up to escape the dangers of foreign borrowings. A foreign borrowing is foreign whether it is rupee or dollar denominated. Currencies are simply rules that people accept.

Assuming that a currency is a simply a set of rules in the international payments system - our rules are a bit wobbly due to fiscal dominance of monetary policy - that is Treasury interference in deciding the level of money supply -in particular; but also because we have a central bank. A currency board/hard peg has some very firm rules which give credibility and makes the system work.

A central bank is discretionary therefore the 'rules' can be changed at will.

The East Asian crisis showed this very well. Wherever there was more discretionary power, (the so called East Asia 5) the currency collapsed and took the country and the banking system with it. But wherever the rules were strong (East Asia 3) the country withstood the shock.

Hope this helps.
fuss

6. fuss-budget Feb 20
Harsha
I am afraid you are suffering an occupational hazard of all messengers in this country. However you must take heart in that you are not doing this for yourself but to protect people who have less financial clout from poverty.

If you help the poor you will be rewarded in non-financial ways. Who knows maybe even in another life, if your life ends prematurely as has happened to other messengers, not only here but elsewhere as well.

Regarding the currency board, it may be argued that a floating rate (and inflation targeting as a necessary condition) may be better. I would bet that Sri Lanka's currency would then appreciate very quickly.

To what extend I do not know. If we appreciate above OECD countries our exporters will be subjected to a very steep correction within a very short time and there would be structural unemployment. However we are already running short of workers, so maybe the time has come.

A currency board will keep us in parity with OECD countries. Say if we peg with the EURO we will not appreciate against EU. If we peg with dollar, we may be even better off, exporter wise.

You see due to the long-running peg our industries have got used to the dollar, and all their supplies and even sales is dollar denominated. Therefore a dollar currency board is an easier transition than a float.

But fed policy has been looser than the Euro since its creation, therefore our peoples living standards will rise faster if we hardpeg with Eruo.

Singapore broke its hard peg with the US dollar the last time the Fed went on a binge in the early eighties, and all hell broke loose just like this with gold hitting 850 dollars an ounce and oil going to record highs.

A float will be even more advantageous.

But the adjustment costs on the export industry will be severe in the short term. But the housemaids will come home quicker if we float. Either that or they will have to be paid double or treble, maybe more than Filipino maids even.

Either way I can hardly object to a float provided we are willing to sit out the short term fallout and are prepared to change educational policies etc so that we can really make use of intellectual services and get high returns for workers instead of doing brute work.

You see what has happened in India. India rupee is going up. Indian consumption will increase, eventually it will reach equilibrium somewhere once the 'rupee convertibility' process ends.

The productive sectors here work harder and longer hours than in OECD countries. It is just a large government that is keeping people poor.

A hard peg or a float will reduce this. A hard peg more than a float because the government will lose the exchange rate as a tool to force adjustment on the people. Therefore the burden of correction may be higher on the government than productive sectors in a pegged/currency board environment.

This is the same as California govt. vs the Federal government. That is the difference between hard peg/dollarization vs float, subject to the seigniorage issue.

fuss

5. Javed Feb 19
I agree with Sudarshana.
Half way down the road it gets a bit too complicated to understand with too many issues being mixed up. Maybe it's not explained well or maybe Sri Lanka is in a HUGE mess that its becoming increasing difficult to understand!
4. fuss-budget Feb 19
Sorry Sudarshana

Well this is the problem. When a writer gets too technical he loses the audience. On the other hand if he writes monetary policy like a cricket match he is accused of being political or extremist.

Having said that if there is anything that you particularly did not understand please feel free to ask.

If I know the answer I will explain in greater detail. Where exactly is the problem area?

fuss

3. Harsha de Silva Feb 19
Fuss
Thank you for that comprehensive analysis. You have explained in a very technical way the outcome of the problem of the CBSL attempting to sustain a polygamous relationship.

You very nicely show how in the attempt to please both at the same time [pegging the currency and holding interest rates] CBSL has lost control of its primary objective; low inflation. [To say it is doing a great job by saying it won some obscure international award when inflation is over 20% does not count, sorry.]

All this time I believed that the CBSL was able to understand the problem and act accordingly. But more and more it seems like CBSL is actually unaware of the problem.

This is seen by the kinds of statements and press releases that come out regularly now. Recent comments dismissing the analysis presented here, which I too have been articulating in a simpler fashion, as ‘hazardous, biased and unrealistic’ that ‘mislead’ the people and ‘generate negative sentiments’, I think goes to strengthen that suspicion.

In the past I disagreed with you on the need for a Currency Board which would have made the CBSL completely powerless; nothing but a passive observer. But now it seems like the CBSL must be disciplined one way or the other. Does it mean a Currency Board?

Well, I am still not advocating such a [drastic] move in the hope that the many top economists there, whom we all respect greatly, will be able to explain to the top, the theory behind the problem and therefore the need to take necessary steps to bring down inflation in Sri Lanka. A Currency Board in my view should be the last resort.

I think these issues should be discussed among professionals; in and out of CBSL and in academic circles; rather than calling the few us names for pointing out flaws in the system. Fuss, you are protected, but as for me… that’s another story. Lets hope something positive comes out of the hard work you have consistently put in to this most important topic.

Thanks again
Harsha

2. Sudarshana Edirisinghe Feb 19
Real interesting stuff from you. But the articles before this was more digestible. I was really getting the hang of this economic stuff but I am somewhat clueless about this article.

Maybe you are trying to say too much in one go, really would have been better if u could have explained with examples as previous articles.

Anyway, keep the good work going.. Really understood why my wife is complaining she needs more money every month.

1. option Feb 19
So is the syndicated loan good?