ECONOMYNEXT – Now that Sri Lanka’s central bank has made a pro-cyclical rate cut as private credit is recovering reminiscent of its actions in 2015, 2018 and second half of 2019, the time has come for the government to start taking counter action to reduce the risk of the next default.
The single policy rate and the de facto abandoning of the scarce regime is a key risk to debt repayment or expecting the central bank to provide dollars for debt repayment. Unlike in the past, the IMF loan is now also the responsibility of the Treasury.
Several measures can be taken to easily de-risk the country and elected governments from flexible inflation targeting and potential output targeting.
One is setting up a dollar trading or purchasing mechanism at the Treasury. Others include dropping domestic ‘buffers’, transferring central bank profits to the Treasury in dollar and not through the creation of new rupees.
An important point to keep in mind is that Sri Lanka defaulted due to extreme macro-economic policy involving severe rate cuts and tax cuts not to mention car import bans which slashed tax revenues and triggered more money printing to maintain the reduced policy rates.
All these policies were cooked up either at the central bank during the Yahapalana and Gotabaya Rajapaksa administrations by the Monetary Board itself or Treasury officials or Secretaries who were former central bank staff and therefore had no fear of open market operations or rate cuts.
After the crisis macroeconomists will fly under radar and they will shift the blame to imports, the current account deficit (essentially the public) and budget deficits (politicians).
But the Finance Minister, the President and the entire225 member Parliament will be held accountable by the voting public for both depreciation and default, as well as the subsequent hikes in taxes and rates, and they will get kicked out.
This is also the case in Argentina.
Military juntas and nationalists will rule after high inflation or stabilization crises.
In this age-of-inflation, any direct move to counter inflationism itself is likely to be opposed by macro-economists on the grounds that it undermines central bank independence.
But setting up a dollar purchasing desk, (it can be done through a commercial bank or banks) is not a challenge to the central bank or its inflationism.
All SoEs have that freedom. There is no reason for the Treasury not to have that too.
Monetary Defaults with German style Debt
While Sri Lanka defaulted amid a combination of rate and tax cuts, (most East Asian nations also cut taxes including VAT and borrowed more during Covid but nothing happened) Latin American countries defaults simply from the shattering impact of open market operations and not tax cuts.
Latin America central banks are most exposed to spurious monetary doctrines coming from Saltwater universities, by their proximity to the United States. Constitutions of several Latin American countries were made more discretionary and flexible due to Saltwater money doctoring missions from the US in any case.
Argentina has defaults with relatively low debt in the region of 40 to 60 percent of GDP and deficits or 5 percent of GDP or less, just before rate cuts and episodes of sterilized interventions began.
While tax hikes are important to reduce debt and fix budgets, they will not stop external default if the central bank runs inflationary policy.
The availability of swaps has now led to the ability to print more money and sterilize interventions using reserves a central bank does not own.
In effect policy rate central banks engage in what Adam Smith once referred to as “the web of Penelope; the work that was done in the day was undone in the night.”
All this shows how dangerous it is to reject economics and embrace statistics or econometrics.
The serial defaults in Latin America started after the IMF’s Second Amendment which led to un-anchored monetary policy and the explosion in central bank domestic assets, just like in Sri Lanka with forex shortages, currency collapses coming in the year before the actual default.
The debt to GDP ratio then explodes like central bank assets does, with foreign debt ballooning due to the currency collapse, interest rates rocketing to save the peso and the central bank, and tax revenues collapsing in real terms as the economy contracts.
After most of the post IMF Second Amendment defaults, Argentina’s debt to GDP ratios fall to around the same as Germany’s according to IMF’s own data, just before massive money printing begins again.
So, what the IMF and macro-economists say about GFN, tax to GDP ratios have to be taken with a pinch of salt. These are just statistics, not economics.
The problem is monetary instability. Before every default, BCRA’s assets explode as macro-economists follow Saltwater monetary ideology propagated by the IMF itself with policy rates and ‘monetary policy modernization’.
That is why in Argentina, defaults are serial. IMF programs do not help because they try fiscal fixes but the flawed operating system of trigger-happy central banking continues to de-stabilizes the economy and fiscal metrics.
In a pegged exchange rate regime, it happens very fast because forex shortages emerge. It is more difficult for a central bank to bankrupt a country in a floating regime.
But the Federal Reserve is having a jolly good try and others with ample reserve regimes are also having a go at it.
Banks of Issue before the Policy Rate
When central banks were set up in Europe about two hundred years ago, they acted as bankers to the government or the king.
They sold debt as an agent of the Treasury and also provided gold (or foreign currency in some countries) to settle debt.
Reserves were usually not appropriated at first, as they were private banks with shareholders, but some were set up to take-over debt.
Later in different countries there were different ways reserves were appropriated but since most of these banks were private there were mechanisms to do it usually in exchange for domestic debt.
Because these central banks did not have policy rates, and had no belief that they could run a get-rich-quick scheme to push up employment, growth or inflation, there was no real problem in giving reserves or managing reserves for the government.
Without a policy rate, any reserves sold for cash (bank notes) automatically reduced reserve money and credit and pushed up interest rates which led to a recouping of foreign reserves.
Any reserves given in exchange for domestic debt could be recouped by deflationary policy – under a corridor system of scarce reserves and a willingness to allow short term rates to go up to some level at least.
Without a policy rate there is no question of having foreign exchange shortages in the first place.
In that case the government could also go to the market and buy gold – or foreign exchange in the market with its tax revenues or the money raised from Treasury bills or bonds.
This is the crux of the matter.
Buying dollars for old money vs New
The difference between the government and central bank is that the government can buy dollars in the market without expanding reserve money (printing money), but the central bank cannot.
Any dollar purchases by the central bank (from an earlier deflationary policy) leads to an expansion in reserve money and a fall in rates.
As a result, the government’s ability to raise dollars is dependent on the willingness of the central bank to run deflationary policy.
Once the IMF’s falling ceiling on domestic assets of the central bank is removed, there is no tool to force the central bank to run deflationary policy (other than coupon payments on its debt portfolio). Even that can be offset by inflationary open market operations.
As an independent agency obsessed with a 5 percent inflation target, it is bound to run inflationary policy and put the government in difficulties.
The money printing in the last quarter of 2024 and the latest pro-cyclical rate cut makes it urgent that the Treasury goes about raising its own dollars independent of the central bank.
The mid-corridor rate (called the single policy fate), and the 5 percent inflation will have exactly the same outcome as it did during the Yahapalana administration.
Public finances will be endangered, but the parliament will be helpless – unless it passes a bill requiring the Treasury to buy its own dollars in the market.
Ceylon Government Deposits in the Currency Board
Before the creation of the central bank with a policy rate, there was no such problem.
When the Ceylon government deposited cash in the Currency Board, it automatically led to a contraction in reserve money and credit and a rise in foreign reserves of the currency board.
If the Ceylon Government gave cash and asked for dollars from the currency board, exactly the same thing would happen. Dollars would go out but it would be replenished when reserve money and credit contracted, due to government tax or loan proceeds disappearing into the currency board.
In Singapore, the Monetary Authority, which does not have a policy rate, engages in some complex operations. All cash operations of the Singapore government passes through MAS as does the CPF which tends to influence reserve money and interest rates.
As there is no policy rate Singapore can build reserves easily.
Outside of Singapore, especially former cabinet ministers and prime ministers who directly worked under Goh Keng Swee, officials of a few other countries and a few living classical economists, this knowledge no longer exists.
In a central bank with a policy rate it is not easy to build reserves, maintain monetary stability or repay debt.
The mechanism set by John Exter to give reserves from the central bank – which had a fixed exchange rate – was to issue a new Treasury bill and buy reserves from the central bank.
This does not lead to a change in reserve money – any money created and deposited in the Bank of Ceylon is returned to the central bank immediately to buy reserves – and at a net level is the purchase of a Treasury bill by the central bank in return for foreign reserves.
Unlike a currency board, this transaction does not lead to a tightening in the credit system (a rise in interest rates or a contraction in reserve money) and an automatic rise in foreign reserves.
To re-build the reserves, the central bank has to sell down the Treasury bills, which will lead to a contraction in credit and rise in the interest rates.
In the new monetary law the central bank is not expected to buy Treasury bills directly. If existing rupees are given to buy dollars, and the interest rate rises, the central bank will print money to push down the Overnight Policy Rate.
Interest on the Bond Portfolio
A further complication has arisen. In the past, the central bank had Treasury bills, which were zero coupon instruments.
The bond portfolio held by the central bank now has coupons. When a coupon is paid by the government, reserve money will contract. In other words, coupon payments on the CBSL bills lead to deflationary policy.
However, as private credit picks up, and excess liquidity falls from coupon payments, under the single policy rate, money will be printed to maintain the OPR and offset the disappearing cash from the coupon payment into the central bank.
That is to say the deflationary policy will be reversed.
That will lead to more domestic credit, lower interest rates than is required to repay debt, forex shortages, and reserve losses.
All of this makes it very dangerous for the Treasury or the Finance Minister to depend on the central bank for dollars to repay foreign loans and parliament’s control of public finances.
Yahapalana Foreign Borrowings
That is partly why Sri Lanka defaulted. Flexible inflation targeting – or operational frameworks with different labels but with the same flaws and same rejection of economic principles are also responsible for peacetime defaults in Latin America and some African countries.
During the Yahapalana period, flexible inflation targeting and a low policy rate led to reduced reserve collections, but it was covered by extensive foreign borrowings, undermining public finances.
Extensive foreign borrowings themselves led to artificially lower interest rates, excessive investments and bigger savings and investment gaps (current account deficits).
That is why cement imports were higher during the Yahapalana administration than during the Rajapaksa administration when all those investments were supposed to have been done with Chinese loans.
The 10 billion ISB’s and the syndicated loans – including from China – to offset artificially low interest rates from flexible inflation targeting and potential output targeting dwarfed the belt and road loans from China.
After the default and after being kicked out of financial markets, the Treasury can no longer depend on new external borrowings to cover up for rate cut errors coming from targeting high levels of statistical inflation, rejecting economic principles and laws of nature.
Buy the dollars from Treasury bill proceeds
To head off another default, the Treasury then will have to buy its own dollars from money raised from markets and taxes.
It should set up its own fx dealing desk to do that. It can also give the money to a commercial bank and instruct them to buy dollars as importers or the Ceylon Petroleum Corporation does.
The additional funds raised from Treasury bonds will lead to a rise in interest rates and crowding out of private credit. The idea is to switch the dollar settlements with rupee loans.
Since the government is running an overall deficit in the budget, it is not possible to repay all debt on a net basis. But it is possible to switch dollar debt to rupee debt, as long as the central bank does not run deflationary policy.
If the central bank runs neutral policy influencing only short-term rates and not transmitting the rate along the yield curve the Treasury will be free to raise rupees and buy dollars at other rates.
That is why the central bank should be barred from yield curve targeting and confined to a ‘bills only’ policy.
Then the agency will not be able to influence longer term rates as it did in the ‘operation twist’ style action through which the Yahapalana economic policy was discredited and ultimately brought down.
If the central bank prints money through open market operations and triggers forex shortages as it did in 2015 and 2018 and 2020, the government will not be able to buy dollars in the market either, just as CPC was not able to in 2018.
The central bank itself will not be able to buy them either and that is why reserve targets are missed.
At the time the government also resorted to heavy borrowings through the Active Liability Management Law, again under-stating the actual interest rate required to generate dollars to repay maturing instalments.
As the central bank ran inflationary policy to cut rates the CPC which had the facilities to buy its own dollars, was also told to get suppliers credit which were turned into state bank loans.
The foregoing shows that while a dollar trading desk reduces the risk of Treasury ending up with no foreign exchange if the central bank refuses to run deflationary policy using its ‘independence’, and continues to cut rates.
However, it is also no guarantee to avoid default if the central bank insists on running inflationary policy. In that case all bets are off.
No Domestic Buffers Can Bring Down Rupee Rates
The foregoing also sheds light on another policy error during the Yahapalana regime.
The foregoing also shows why the government cannot build a domestic ‘buffer’ by overborrowing from Treasury bills as it recently.
Before the central bank, without a policy rate, any extra borrowing or cash reserves deposited in the currency board automatically turned the cash into foreign reserves which were invested in third countries.
However, under the current framework any excess cash raised is deposited in state bank accounts.
If the state bank deposits the money in the central bank standing deposit facility it will lead to an accumulation of foreign reserves if private credit is weak though what is called private sector sterilization or more commonly a ‘liquidity trap’. Some of the money deposited in the central bank window by the risk averse foreign banks is in a liquidity trap.
However, if the bank itself uses the money to give loans or lends them in the interbank market, they will get used up and generate imports. No foreign reserves will be built.
If bids to a Treasuries auction is rejected, and the Treasury asks to withdraw the state bank deposit, the state banks will not have cash to give if they were already loaned to customers or to other banks when private credit is strong.
If they cut the interbank loan, the other bank will have to get cash from yet another bank and give to the Treasury crowding out other credits and pushing up interest rates.
If interbank loans cannot be cut or if the funds are already in securities or other loans, the state bank will be forced to borrow from the central bank through the reverse repo window.
If that money is used bond rates will be kept down in the short term. However, there will be currency pressure and foreign reserve losses when the new liquidity is spent.
That is why the buffer strategy of the Yahapalana era failed and it led to more external instability.
Buffers have to be invested abroad
If the Treasury or central bank bureaucrats want to keep down interest rates by not accepting all offered bids at a particular auction the ‘buffer’ will have to be invested abroad as a foreign reserve or a sovereign wealth fund.
This is why Singapore’s GIC funds are invested abroad. Other foreign reserves are similarly invested.
Money to do that comes from the MAS where Central Provident Fund cash is invested leading to a reduction in reserve money and a build-up of foreign reserves as happened in the Ceylon Currency Board.
Monetary Authority of Singapore profits are also similarly invested.
The Treasury will be able to buy dollars from the market, if money is not printed but policy rates are too low for the central bank to collect foreign reserves as rates are signaled down.
When the Treasury raises money from bill or bond sales to buy dollars rates will go up.
If the buffer strategy is used to dampen rates by drawing on state bank deposits, and they are covered by central bank re-finance for the single policy rate, forex shortages will emerge.
That means the Treasury should not only have a trading desk but should also convert its excess cash balance into a foreign reserve.
That is why Singapore has foreign invested reserves. Using those reserves Singapore can ‘stimulate’ the economy without creating forex shortages, inflation or instability unlike in the case of a ‘monetary easing’ of a conventional central bank.
The ‘independent’ central bank however has powers to go against the move, create forex shortages and make it impossible to build a sovereign wealth fund or a sinking fund, with rate cuts that ignore domestic credit.
Transferring central bank profits in new rupees to the Treasury, instead of dollars to a sovereign wealth fund, is another risk to the external sector.
In the words of Donald Trump, a central bank that is sufficiently obsessed with the policy rate and a high inflation target can ‘screw’ the government, whatever the evasive actions it takes and push the country into a second default like Argentina’s central bank does.
There are other strategies to de-risk the economy from a second default which require bolder actions by parliament to directly tackle inflationism which will be harder to implement as there will be resistance as in Argentina. (Colombo/June30/2025)
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