ECONOMYNEXT – A guidance rate mandated by Sri Lanka’s central bank is another way of is not found in the real world and the monetary authority has no ability enforce a managed float (soft-peg) a top economist has said.
Sri Lanka’s central bank started quoting a guidance rate for interbank market at around 360 to the US dollar in May, about 20 to 30 rupees below the market rate at the time where a higher level of middle remittances were also starting to come from exchange houses.
Banks are quoting telegraphic transfers around 365 rupees to the dollar.
“I speak to importers everyday and they tell me that when they go to banks to buy dollar at 365 they are told to wait at least one to two months,” W A Wijewardena, Former Deputy Governor, Central Bank of Sri Lankatold a Central bank forum in Sri Lanka’s crisis on Thursday.
“They have to wait in a queue.”
Foreign exchange shortages happens in a non-credible or soft-peg (also called a managed float or flexible exchange rate) which collapses whenever the central bank injects money to mis-target interest rates.
A pegged central bank runs out of reserves when money is injected to enforce the artificial policy rate and dollars are sold to mop up the rupees hold the exchange rate, in self-feeding spiral when domestic credit is strong either due to a deficit or a recovery in private credit.
A central bank then gets into a sterilization trap where liquidity shortages coming from dollars sold to defend the exchange rate (reserves for imports or to provide ‘convertibility’ to the newly created money) are sterilized (offset) with new money, preventing reserve money and credit from slowing.
A central bank which steadily continues to provide reserves for imports then ends up financing the private sector with central bank credit, by injecting money into banks through open market operations to sterilize the interventions.
In a sterilized intervention cycle (reserves for imports) the soft-pegged central bank then loses control of reserve money in the process of trying to enforce a policy rate.
Later the money shows up as deficit finance because Treasury bill or bond (originally issued to cover past deficits) holdings of the central bank go up altering the loans to deposit ratio of banks.
However the private sector finance is eventually classified as deficit finance because the instrument used to inject money is a government security.
In the days of the classical economists of UK for example this error was not made as bankers’ acceptances were used for open market operations and central bankers could not get away blaming the deficit and not their fixation with a policy rate as they do after World War II, analysts say.
Market participants who fear a currency collapse, then hold back dollars and try to take counter measures to protect their savings from the central bank leading to a loss of credibility of the peg.
To restore the credibility of the peg domestic credit and economic activities have to smashed to make outflows fall below inflows. If the deficit is high, private sector credit has to be smashed to a greater degree and high de-leveraging has to take place in a typical IMF style ‘stabilization measure’.
The central bank has raised rates to match domestic conditions and taken the first step towards reducing outflows.
Sri Lanka’s central bank has not only lost its reserves but also lost borrowed money leaving it about 4 billion US dollars in debt by March.
Wijewardene said the central bank’s gross debt was in the region of about 6 billion US dollars while the net debt was over 4.0 billion dollars.
“The central bank debt is 6 billion dollars while the reserves are minu 4.4 billion dollars,” he said. “So putting money in central bank is like sinking well. No matter how much water you put, it won’t fill.”
With no reserves it should not try to hold an exchange rate. At the moment the central bank is accumulating more debt from Asian Clearing Union deferments as busting them on ‘reserves for imports’.
“For a central bank to hold on to an exchange rate at a given level, it should have reserves to do so,” Wijewardena said.
“If we don’t have reserves then we are holding on to a kite that this floating freely without any direction by the person who is holding the thread.”
“So when you have a negative foreign exchange position, central bank cannot fix the rate. We have lost the battle already with the exchange rate.”
“What we have to do now is to allow the exchange rate to fall to whatever the realistic level the rate would take.”
“In my view the present exchange rate policy to fix the exchange rate at middle rate officially (the previous two did it unofficially).”
“You can’t do it without having a sufficient stock of exchange.”
A central bank that runs out of reserves and cannot exchange dollars for rupees (provide convertibility and enforce an external anchor) can then float the currency (suspend convertibility) and shift the regime to a float, where reserve money is no longer altered by forex interventions ending the need to sterilize any interventions.
Reserve money no longer drains from the banking system through dollar sales and the central bank then regains the ability to enforce both a policy rate and the reserve money.
The currency then stabilizes and forex shortages disappear as long as new money is not created to generate excess liquidity in money markets.
The central bank and then peg reserve money to a domestic anchor (inflation target) instead of an external anchor (the convertibility rate) through a policy rate.
Soft-pegs or managed floats collapse when domestic credit picks because the intermediate regime central bank tries to enforce two monetary anchors (domestic and external) simultaneously (anchor conflict), eventually losing control of the policy rate, reserve money, broad money and also inflation.
Under an IMF program the currency is re-pegged and inflows sterilized to re-build reserves.
IMF programs usually advocate structural reforms.
However the IMF does not advocate the ending of the soft-peg or managed floats and the anchor conflict comes up again to trip the managed float when the economy recovers.
Instead IMF gives clues to developing country central bank to ‘modernise monetary policy’ further towards those practiced by clean floating central banks which do not collect forex reserves and do not give any forex reserves for imports.
The intermediate o dual anchor regime, worsened by monetary policy modernization (the latest permutation being flexible inflation targeting/flexible inflation targeting) then almost guarantees that the country will go to the IMF again a phenomenon classical economists call IMF recidivism.
Sri Lanka has gone to the IMF 16 times.
The trips to the IMF ends when either a clean float where reserve money is pegged to an inflation index with suitable accountability imposed on the central bank governor who fails rates on time is set up or a currency board (hard peg) linked to an external anchor is set up, ending dual anchor conflicts.
A currency board blocks both also types of central bank credit: deficit finance (monetization of the deficit) and also private sector finance by re-purchasing bonds from banks after giving reserves for imports.
The decision to end trips to the IMF and move to a single anchor regime can be made by the people who are hurt most by the soft-pegging and also politicians who are kicked out of power when currencies collapse. (Colombo/June03/2022)
