ECONOMYNEXT – A guideline rate mandated by Sri Lanka’s central bank is not found in the real world and the monetary authority lacks the ability to impose a managed float (soft-peg), with negative reserves , a leading economist and former Central Bank Deputy Governor WA Wijewardena said.
Sri Lanka’s central bank began quoting a guide rate for the interbank market at around 360 to the US dollar in May, around 20-30 rupees below the market rate at a time when a higher level of Medium remittances were also beginning to come from exchange houses.
Banks quote wire transfers of around 365 rupees to the dollar.
The guidelines appear to be an attempt to officially do what was done unofficially earlier.
No clean float, no believable peg
“I talk to importers every day and they tell me that when they go to the banks to buy 365 dollars, they are told to wait at least one to two months,” said WA Wijewardena, former Deputy Governor from the Central Bank of Sri Lanka to a central bank. forum in Sri Lanka’s latest currency crisis.
“They have to wait in a queue.”
“In my opinion, the current exchange rate policy is to officially fix the exchange rate at an average rate, which was done unofficially earlier.
“You can’t do that without having sufficient exchange stock.”
Currency shortages occur in an uncredible or loose peg (also called a managed float or flexible exchange rate) that breaks down every time the central bank injects money to mistarget interest rates.
A pegged central bank runs out of reserves when money is injected to apply the artificial policy rate and dollars are sold to mop up the rupees keep the exchange rate up, in a self-reinforcing spiral when domestic credit is strong, either due to a deficit, or a recovery in private credit.
A central bank then falls into a sterilization trap where liquidity shortages from dollars sold to defend the exchange rate (reserves for imports or to ensure the “convertibility” of newly created currency) are sterilized (compensated) with the new currency, preventing reserve currency and credit from slowing down.
Refinancing of imports
A central bank that continues to provide reserves for imports on a regular basis then ends up financing the private sector with central bank credit, pumping money into banks through open market operations to cover the lack of liquidity due to the sale of dollars, preventing a contraction of the reserve currency and credit.
In a sterilized intervention cycle (reserves for imports), the loosely pegged central bank then loses control of the reserve currency by trying to apply a policy rate after the intervention.
Later, the money injected appears as deficit financing because treasury bills or bonds (sometimes issued to cover past deficits) end up on the central bank’s balance sheet, changing the banks’ loan-to-deposit ratio.
Currently, state banks in particular have large volumes of overnight borrowing from the central bank in sterilized dollars granted for imports and debt repayment, creating serious asymmetries between assets and liabilities.
The refinancing of the private sector by bank credit is then qualified as deficit financing because the instrument used to inject money is a government bond.
In the days of classical economists in the UK, for example, this mistake was not made because bankers’ acceptances were used for open market operations and central bankers could not get away with blaming the deficit instead of fixing them on interest rates, as they began to do after World War II, analysts say.
When shortages of dollars appear and exchange and other controls are imposed, market participants who fear a currency collapse then withhold the dollars and attempt to take countermeasures to protect their savings from the central bank. which leads to a loss of credibility of the link.
To restore the credibility of the peg, domestic credit and economic activities must be destroyed so that outflows fall below inflows.
If the deficit is high, private sector credit should be reduced to a greater degree and deleveraging should take place in a typical IMF-style “stabilization measure”.
Sri Lanka’s central bank raised rates and market rates rose in the first step towards reducing private credit and outflows.
The government also announced tax measures.
India provides lines of credit which when extended to the private sector or fuel at market price also generates rupees for the deficit.
However, in this cycle of printing money to fix interest rates, Sri Lanka’s central bank not only lost its reserves but also lost borrowed money, leaving it with a debt of around US$4 billion by March 2022.
Wijewardena said the central bank’s gross debt was around US$6 billion while net debt was over US$4.0 billion.
“Central bank debt is $6 billion while reserves are minus $4.4 billion,” he said.
“So putting money in the central bank is like sinking well. No matter how much water you put in, it won’t fill up.
At present, the central bank is accumulating more debt due to the Asian Clearing Union’s arrears to India.
A central bank that runs out of reserves and cannot exchange dollars for rupees (ensure convertibility and impose an external peg) can then float the currency (suspend convertibility) and shift the regime to floating.
The currency then stabilizes after a fall, and currency shortages disappear until new currency is created to generate excess liquidity in the money markets.
“For a central bank to maintain an exchange rate at a given level, it must have reserves to do so,” Wijewardena said.
“If we have no reserves, we hang on to a free-floating kite without any direction from the person holding the line.”
“So when you have a negative currency position, the central bank cannot fix the rate. We have already lost the battle with the currency rate.
“What we need to do now is allow the exchange rate to fall to whatever realistic level the rate would take.”
In a floating reserve, the currency is no longer altered by foreign exchange interventions, ending the need to sterilize any shortage of liquidity with new printed currency.
The central bank then regains the ability to apply both a key rate and control the reserve currency.
The central bank can then tie the central currency to a single domestic anchor (inflation target) instead of an external anchor (the convertibility rate) via its key rate.
Double-anchored intermediate regimes
However, Sri Lanka’s central bank attempted to float with a buy-back obligation (forced sales of dollars to the central bank for new money), the rupee fell sharply. The buy-back obligation is still in effect.
Soft pegs or managed floats collapse when domestic credit picks up because the intermediate regime central bank tries to enforce two currency pegs (domestic and external) simultaneously (peg conflict), ultimately losing control of the policy rate, reserve money, broad money and also inflation.
Dual-anchor regimes (which violate the concept of the impossible trinity of monetary policy objectives) have been promoted by the United States before, especially after World War II, when the Bretton Woods system was established. faulty flexible anchors.
Among its supporters was US economist John H Williams, analysts said (Sri Lanka’s use of reserves for imports is a deadly false choice: Bellwether).
Under an IMF program, the currency is re-pegged and inflows sterilized to replenish reserves.
IMF programs generally advocate structural reforms.
However, the IMF does not advocate an end to the soft peg or managed floats and the peg conflict returns to trigger the managed float when the economy recovers.
Instead, the IMF gives cues to the central bank of developing countries to “further modernize monetary policy” towards those practiced by clean floating central banks that do not collect foreign exchange reserves and give no foreign exchange reserves. for imports.
The intermediate or double-pegged regime, compounded by the modernization of monetary policy (the last permutation being flexible inflation targeting/flexible inflation targeting) then almost guarantees that the country will return to the IMF, a phenomenon that the classical economists call the IMF backsliding.
Sri Lanka has approached the IMF 16 times.
Trips to the IMF end when either a clean float where the reserve currency is pegged to an inflation index with appropriate accountability imposed on the central bank governor who fails on rates on time is put in place, or a cashbox issue (hard anchor) linked to an external anchor is put in place, putting an end to double anchor conflicts.
A currency board also blocks both types of central bank credit: financing the deficit (monetizing the deficit) and also financing the private sector by buying back bonds from banks after giving reserves for imports.
The decision to end trips to the IMF and move to a single peg can be made by those most affected by soft-pegging as well as politicians who are forced out of power when currencies crash. (Colombo/03 Jun/2022)