ECONOMYNEXT – Sri Lanka is just emerging from a default after large volumes of money were printed to target a narrow policy rate, in the pursuit of instant growth (potential output) and denying monetary stability to the people.
From 2015 in particular Sri Lanka very narrowly targeted a policy rate despite being a reserve collecting central bank.
Targeting a mid-corridor rate is the same as printing money to maintain a single policy rate. The label is different but the required inflationism is the same.
The same consequences of targeting a mid-corridor rate in 2015 and especially 2018 when the budget deficit was brought down.
If the call money rate is so dysfunctional as claimed in a recent defence of money printing through OMO, it should obviously not be used as the operating target for monetary policy at all.
Can Sri Lanka cut rates?
Since the end of the war the central bank has cut rates around 18 to 20 months after a currency crisis, just as private credit recovered and triggered a currency crisis.
The central bank can cut rates. At the moment, with the currency appreciating amid deflationary policy, private credit is just starting to pick up, state enterprises are making cash profits and the budget deficit is falling.
If it wants it can remove the floor policy rate altogether.
But to maintain monetary stability and the exchange rate, it has to allow short term rates to move when credit picks up. If it prints money claiming inflation was low, BOP troubles will come back.
However, it should not keep the floor policy rate and print money to target a rate below the ceiling rate.
A floor policy rate through a standing facility essentially sterilizes liquidity that is generated from a surplus balance of payments (dollar purchases) at a particular interest rate.
When the central bank prints money on top of that, it rewards overtrading banks, rewards bad behaviour, rewards asset liability mis-matches, encourages moral hazard and prevents a BOP surplus from being developed from banks that deposit money in the window.
In the currency board days, government deposits in the currency board led to BOP surpluses. That is also why fiscal ‘buffers’ cannot be created domestically in a country with a policy rate, but that is another story.
Banks that face a liquidity shortage should slow credit and hoard some cash instead of going to the central bank facilities days on end.
Removing the floor rate does not cause much of a problem. The central bank closed access to its window sometime back in an inconsistent way.
Some East Asian nations do not have a standing facility for floor rate and whenever there is a slowdown in credit, interbank rates fall steeply and credit recovers fast.
Another option is to cut the floor rate steeply and allow a 300 basis point gap within the floor and ceiling rates to develop. Rates will fall without any money being printed.
However, when it does, rates have to move up. Otherwise, the exchange rate will fall and the system will shift violently from being a peg to an inconsistent float like a yo-yo, sending shockwaves across the system.
That way there is no danger of any credit spike from vehicle imports from affecting reserves or the BOP.
Sri Lanka lost market access on such an occasion in 2020. Welcome to the yo-yo regime’s ‘flexible exchange rate’ yet another unstable regime cooked by the IMF and peddled to unfortunate countries.
If the central bank narrowly targets the policy, give up trying to collect reserves. Even the Fed, which it was giving lower inflation in a floating regime, did not so narrowly target rates as now (see below).
If it narrowly targets an interest rate – even in a floating regime, it has to absorb all economic shocks to the credit system by liquidity injections, and encourage banks to lend without deposits.
There was no policy rate before the age of inflation and peacetime instability
Before the age of inflation which began around the 1920s involving peacetime depreciation and inflation, there was no policy rate in the sense that some politburo made a decision on the discount rate of a central bank.
The discount rate was decided by those who discounted bills . Invariably the credit was by discounting 30 or 40 day trade bills/bankers’ acceptances. So, it was relatively easy to restrict reserve money when the specie reserve outflow began.
The discount rate was also two-way – that is partly how profits were made by note issue banks in addition to the interest and not a single policy rate or a mid-corridor rate, which results in wanton printing unrelated to any pressing liquidity need of market participants.
The world started to go downhill after the Fed Open Market Investment Committee was formed in April 1923 where money printing in peacetime became institutionalized, and the age of inflation and regular currency crises was born.
Violent inflation crises and stabilization crises then became common.
Politicians take note – as the central bank prints money to obstinately target the policy rate, the government will get kicked during the initial inflation crisis (Gotabaya Rajapaksa) and also during the stabilization crisis (Ranil Wickremesinghe).
The Yahapalana regime suffered two inflation crises and stabilization crises due to targeting the mid-corridor rate within its 5 year rule.
Fed started to narrowly target rates from the time it started to fire the housing bubble
Before high inflation and high interest rates, in a kinder and more gentle time, the Fed did not target rates so obsessively and commodity prices were not so violent as now.
The reason for the collapse of the Bretton Woods and the high inflation 1960s was due to the policy rate. The bubble that led to the Great Depression was entirely created through OMO under the nose of the Treasury Secretary who was ex-officio chairman of the Fed.
Before the IMF’s second amedment, Sri Lanka’s inflation was also stable despite up to 80 percent of the index being food. The obsession with ‘core inflation’ started with floating exchange rates and activist monetary policy. One bad policy sprouts another bad reaction.
The Fed now issues monetary policy reports to its trading desk to target a ‘fed funds rate’ within 25 basis points.
It was not always so, before the Housing Bubble was fired. During the Great Moderation period the Fed funds rate moved within a wide daily range.
When Paul Volcker stabilized the US (and East Asian countries that pegged closely and imported the stability allowing them to become export powerhouses) the Fed funds rate fluctuated within a wide band.
In fact, it was later revealed that there was an ‘expected’ rate. The Federal Reserve open market desk had been given widely differing instructions to operate at different times including in between FOMC meetings.
Until Bernanke, short term rates and the Fed funds rate itself fluctuated much more than now. As a result, it did not have to print much money and bad banks could not lend money they did not have as much as now and get into trouble.
Under Volcker from around 1979 onwards under the New Operating Framework when money supply was targeted directly, the Fed funds band was as much as 200 basis points.
There was no need for ‘macro-prudential’ regulation at the time and micro-prudential regulation was more than sufficient. Macro-prudential regulation is also a knee jerk reaction to a deteriorating operational framework of central banks.
In the recent past the Feds operating framework deteriorated further, with the concept of ‘excess reserves’ being jettisoned.
After the housing bubble, the operating framework worsened with excess liquidity a permanent feature which was named a ‘ample reserves regime’.
One Fed governor suggested that the concept of voluntary reserves be introduced to promote prudent banking but it got nowhere.
If the call rate is dysfunctional do not use it as the intermediate target
The central bank has defended its recent money printing claiming that the call money rate is dysfunctional.
“Certain commercial banks have faced severe liquidity shortfalls due to stricter exposure limits for interbank transactions following the sovereign credit rating downgrade,” the central bank said as its injections to reward what appeared to be dummy bids of banks was criticized.
“Money market lending by the foreign banks operating in Sri Lanka has remained limited, despite their significant liquidity surplus, due to the strict exposure limits. Hence, the CBSL’s liquidity injections have addressed these shortfalls, ensuring that short-term interest rates, especially the call money rates remain stable.”
Foreign banks have always had limits, and they always had excess liquidity in the past.
However, not only foreign banks but local banks also cut limits to each other during the crisis.
At one time there was zero trading in the call market. There was virtually zero trading in the repo market as well.
It is no longer so. The call market is working – supposedly dysfunctionally – and the repo market as well.
If it is indeed dysfunctional, it raises a very important question. Should a dysfunctional maret rate be used as its main operating target?
Obviously not.
The central banks claim that: “Furthermore, central banks worldwide regularly conduct similar operations to manage liquidity conditions. These are routine and standard actions carried out by central banks in liquidity management under monetary policy implementation,” holds no water.
It is the copying of these bad frameworks that land countries in trouble in peacetime.
The Fed is not a good example to follow. Many non-English speaking countries did very much better after 1960. Germany was the obvious example. So was Japan, Denmark is even now, so is Switzerland. To some extent Canada has a better record but it also messed up during Covid.
Through IMF technical assistance various fads like the single policy rate, or potential output (basically full employment policy) a high inflation target (essentially Phillips Curve belief that there was a trade-off between growth and employment which even the bad boy Fed now says has been thoroughly debunked.)
In better times, before it started busting the Bretton woods, OMO by the Fed was even more limited than the Great Moderation period. Paul Volcker, who was put on the New York Fed trading desk in the early 50s as a junior officer when the world was a more stable place, once said there was nothing much to do there during those days.
“But, day after day, I would sit at the Trading Desk, and the markets were not doing anything,” Volker said in an interview decades later. “It got boring after a while.”
It may have been boring for OMO but it was good for stability and the poor.
The scare stories floated in Sri Lanka about car imports – which is naked mercantilism – is also an indictment on mid-corridor single policy rate targeting of the central bank, as well as lack of knowledge about balance of payments.
In countries with greater stability and domestic savings, intra-day liquidity is also given at a price, not free like in Sri Lanka. The central bank has to seriously re-look at its Operating Framework instead of imposing trade controls on the people.
Now after the latest inflation debacle, the Fed is trying to reform its OF again while Sri Lanka is trying to target a dysfunctional rate with excess money.
“We are open to new ideas and critical feedback and will take onboard lessons from the last five years and adapt our approach where appropriate to best serve the American people, to whom we are accountable,” said Federal Reserve Chair Jerome H. Powell said a few days ago.
Transplanting floating rate OFs to a reserve collecting central bank with IMF targets is counterproductive as Sri Lanka’s post-war experience has shown.
Sri Lanka should take a hard look at its central bank operating framework if it wants to escape IMF programs and a second sovereign default.
Wide Corridors Support Prudence
A wide corridor limits central bank injections and allows the credit system to absorb all kinds of shocks including capital outflows by limiting sterilization or accommodation of capital flight or any other short term credit shock.
Another advantage is that it promotes prudence in banking and avoids greater asset liability mis-matches.
More than a decade ago it was SJB legislator Harsha de Silva who criticized direct market operations and took the problem to the streets, which eventually led to some changes to the monetary law.
Sri Lanka later shifted to open market operations to print money and created serial currency crises and eventually drove the country into default.
Money printed for growth (potential output) achieved something that Prabhakaran could not.
In the third week of October 2018 when the-then ‘Yahapalana’ administration had publicly given ‘central bank independence’, Ministers did not interfere with its operation, but the currency was collapsing as interventions were sterilized with new money.
At the time excess rupee deposits were not as high as in 2015 or 2020.
“As you now see, overnight call money rates have almost hit the ceiling at 8.5 percent,” de Silva said at the time, in a public forum, using mild language.
“If it is hitting the ceiling and you’re not injecting money at below 8.5 percent, then it’s alright and there’s no need currently to increase your policy rates.
“But at least let the overnight rates be within a higher margin of the policy rate. It’s prudent.”
“Of course it’s going to have a negative impact on growth, but that is what we have to give to have some sort of stability on the exchange rate.”
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At the time the central bank was injecting 200 day money outright as well as short term.
The then government’s economic record was already in tatters and President Sirisena executed what was called the ‘coup’ in the same week.
Car import LC margins were raised to 100 and 200 percent.
All of this was done so that the central bank could enforce rate cuts through money printed from open market operations.
A cursory look at recent data shows why the ceiling rate (and abandoning the mid-corridor) promotes prudence, as de Silva said.
De Silva is not just an economist but a former bank treasurer who was on the lending side of probably the highest overnight rate ever seen in Sri Lanka in the mid – 1990s. Those rates kept the IMF away. The budget deficit hit 9.1 percent in 1995 and was 8.7 percent of GDP in 1995. T-bill rates hit 20 percent but there was no monetary meltdown and no IMF program.
Coming back to 2024, the central bank offered 20 billion of printed money to banks on November 04. There were bids for 31.56 billion rupees. Only 20 billion were given at 8.50 percent minimum rate as that was the volume.
But only 0.05 billion rupees were borrowed from the window, indicating that about 10.5 billion rupees were dummy bids tempted by the auction.
A day later, 35 billion rupees were offered and 16.67 billion rupees were bid. In the next two days the lowest rate was 8.26 percent, indicating that dummy bids were filled by OMO.
In 2015 also excess liquidity was pushed up without any dysfunctional call market, triggering the first Yahapalana currency crises and then the 2017 stabilization crisis.
After the recent 9 percent inflation debacle, where the Federal Reserve blamed supply chain shocks and delayed a correction in its policy, the Fed is trying to learn.
“The Federal Reserve will continue to host Fed Listens public events around the country, and discussions among Federal Reserve policymakers will begin with the January 28-29, 2025, FOMC meeting,” the Fed statement said.
It is not just Sri Lanka that lost the fear of excess liquidity after quantitative easing. Bad practice spread worldwide even to Australia and New Zealand which were countries that avoided the housing bubble, got hit by high inflation after the Coronavirus crisis.
Sri Lanka has a further difficulty to contend with. As has been pointed out recently, borrowed reserves seem not to be reflected in reserve money, which will tend to make decisions faulty.
Therefore Sri Lanka should re-examine its operating framework and not go down this single policy path or the mid-corridor rate involving excess liquidity and trigger a second sovereign default when the economy recovers.
As other analysts have also said, the central bank has done a lot of good work in the past two years. And people have paid big price.
All of this will be undone in the next two years if excess liquidity is printed through open market operations to accommodate dummy bids of banks. (Colombo/Nov26/2024)
