ECONOMYNEXT – Sri Lanka’s controversial ‘single’ policy rate, which came after International Monetary Fund technical advice is undermining the interbank market activity again, but this time in the opposite direction.
Sri Lanka does not actually have a single policy rate like the Bank of England now, with its monetary instability and ‘cost of living crises’ as Western media puts it, but a mid-corridor rate, with a floor rate below the overnight policy rate.
The ‘single’ policy rate which is now being operated in Western floating regimes that resulted in uncontrollable inflation economic downturns public unhappiness with nationalists getting elected far and wide – Germany is on the brink – is actually a floor rate.
After pumping the interbank market up to gills with excess liquidity through the quantitative easing (no borrowed reserves) short term rates are controlled via a floor rate, essentially a passive standard deposit facility.
To recap, key sign of a single policy rate is excess liquidity injected through domestic assets, in a floating exchange rate regime, not a reserve collecting regime, where liquidity can come harmlessly from foreign assets acquisition when a pegged exchange rate is operated.
Let’s see what happened in Sri Lanka.
Last year in April and May there was large dollar purchases amid mostly negative private and SoE credit, leading to a build-up of excess liquidity (from foreign assets) as inflows were not loaned out, leading to a fall in overnight rates towards the floor Standing Deposit Facility Rate (SDF).
In March 2024, for example the central bank bought 715 million dollars amid negative credit. At the time the floor rate was cut. Immediately the minimum interbank rate hit the new floor. That was because the floor rate was higher than credit demand warranted at the time and the central bank was higher than ‘market’.
Credit turned positive around June. In June the central bank also sold some dollars to prevent the exchange rate from depreciating. Government debt repayment for cash may also lead to outflows and falling liquidity as long they are not re-injected to maintain the policy rate. This is perfectly fine.
Liquidity from dollar purchases may also fall due to do being mopped up and foreign reserves being built up, which is the same as debt repayments. But rates then have to be allowed to move up.
Getting Up from the Floor
From around August 2024 short term rates started to move up as liquidity dropped. There may have been some election jitters also involved.
The minimum interbank rates then moved up from the floor.
At this time central bank started to print money like there was no tomorrow through open market operations to push call market rates down down, triggering an abundance reserves regime with large volumes of printed excess liquidity.
When Western central bankers (or at least some of them) try to reverse quantitative easing and try to ‘normalize’ monetary policy, the ultimate objective or the final result, is ‘getting up from the floor’.
Then a scarce reserve regime where liquidity is only given through the ceiling rate for clearing purposes will take place, inflation will go away and people will be content.
READ MORE : Getting up from the floor
German central bankers would give their eye-teeth if the ECB is able to do this.
Abundant Reserve Regime
However, what Sri Lanka’s central bank did was to print money to try and keep the rates down. One can see the minimum interbank rate is persistently above the floor, but it is kept from moving to the ceiling by pushing up excess liquidity 250 billion rupees by early December.
Whatever it is, the central bank cut rates in November after printing vast amounts of money to bring interbank rates down, throwing caution to the winds. The OPR started at the same time. This then led to reserve losses.
This column at the time pointed out that 100 billion rupees was being printed and when private credit really picks up, this will lead to excess credit and reserve losses and get the country closer to a second default.
In January 2025 private credit contracted and the exchange rate stabilized. Higher tax revenues which reduce state borrowings may also help.
One of the reasons for the exchange rate pressure and outflows may also have been early covering of imports fearing that car imports will lead to a depreciation.
Speculation on the exchange rate is one of the confidence busting problems of having an IMF-backed ‘flexible’ exchange rate with zero credibility which tends to magnify effects on interest rates.
Tail Wagging the Dog
As private credit picks up it will be increasingly difficult to recover from liquidity miss-steps. It can be seen from here that it only take a 100 basis points or so, for a few weeks to undermine monetary stability. The opposite is also true.
The three month rate moved up and that helped the correction.
Whatever it is, the interbank market has to work. If not, imbalances will build up, it may amplify the movements in longer term rates. The bigger the loss of confidence, the bigger the corrective rate needed.
After the November rate cut, the minimum interbank rate did not fall to the floor. It was around 8.0 percent overnight policy rate.
When the dollar purchases resumed, the central bank terminated the OMO contracts, taking away the liquidity and re-building some of the lost reserves.
In 2015 and 2018, currency crises – and the stabilization crises that followed – were triggered due to the unwillingness of authorities not to allow rates to go up a couple of hundred basis points.
The 2020-22 crisis was and abundant reserve regime of massive proportions – a floor rate was set on gilt yields.
Signalled Up
To get back, when dollar purchases resumed and liquidity moved up, rates did not fall to the floor in 2025 which is now 7.50 percent. Rates remained around 7.90 to 7.95 percent with interbank dealers not giving money far below the OPR rates, except for one of two occasions.
With 400 million dollar being bought in March and liquidity going up, the minimum rate is still about 7.95 or so.
This is an occasion where the ‘singalled rate’ is above the floor despite excess reserves (from NFA). These reserves are coming from weak credit amid inflows and strong savings.
In the last quarter for 2024, rates were pushed down with large volumes of money being printed, which is sometimes called ‘heavy lifting’.
It is also possible to cut rates by signalling alone as long as the market believes it and bank money dealers and others follow the central bank’s signal.
In fact, the Fed created the Housing Bubble with signalling and some OMO while basically running a scarce reserve system. The OMO was nowhere near the abundant reserve regime being seen now, but it was absorbed into reserve money over time, triggering a commodity bubble.
But what is happening now in Sri Lanka is that the signalled (OPR) rate is higher than the floor rate.
Instead, the 3-month Treasury bill had fallen to the true floor rate. There is active demand for 12-moth bills.
The former Governor of the Bank of England Mervyn King – when he was Chief Economist of the Bank of England – once said it would be great if rates could be changed by signalling alone.
“The ability to send monetary policy signals is inextricably linked to a central bank’s liquidity provision, as I discussed earlier,” King said.
“But the act of monetary policy signalling need not be linked to such liquidity provision. The two are separable functions.
“Indeed, we could easily envisage a world where policy signalling was achieved not through open-market operations, but by hoisting a flag from the top of the Bank, or by speeches by the Governor.”
The signalled rate being higher than the market in Sri Lanka at the moment is not a problem. It can lead to greater monetary stability and reserve collections, and avoiding a second default.
As this column has said earlier, the interest rate is has to be determined by the domestic credit demand and the need to collect reserves and repay debt.
Can interest rates continue to fall?
Interest rates can continue to fall over a longer period if :
a) Short term rate movements are allowed through a corridor system so that banks manage their liquidity prudently
b) This will also allow the exchange rate to be kept stable or fixed, preserving the value of domestic financial capital and savings.
With a 5 percent inflation target, and the instability implied long term rates cannot fall. The parliament will have to do its duty to change the situation and bring back sound money.
It is silly for a country with a 30 percent saving rate to either default, borrow abroad or run an external current account deficit.
It is paradoxical problem of central banking that more a central bank cuts rates by printing money – essentially by expanding its note issue – the more the interest rates rise from the crises that follow and capital that is destroyed through inflation.
It was John Law who suggested the policy rate, but it was opposed by all (classical) economists for many years.
The policy rate came by stealth without public debate in the 1920s after the Fed invented open market operations and led to permanent inflation, social unrest and war.
It comes from a a belief that central banks know better than the market, what the short term rate is and in the case of a ‘transmission mechanism’ long term rates as well.
Why do rates go up when central banks cut them?
In Sri Lanka, whenever central banks cut rates as the economy picks up, using excess liquidity, a currency crisis is triggered because there is no clean float.
This then leads to a currency collapse and very high interest rates which are required to kill credit and restore confidence in the currency again, essentially to revive a dead bank of issue and stop the further destruction of financial savings and capital.
This is also a broader problem related to the ‘transmission mechanism,’ where a bank of issue also tries to influence long term rates.
Fictitious Capital – Reserve money is not capital
John Law believed in rate cuts and what is called monetary accommodation in countries with inflation and instability.
“Indeed, if lowness of Interest were the Consequence of a greater Quantity of Money, the Stock applyed to Trade would be greater, and Merchants would Trade Cheaper, from the easiness of borrowing and the lower Interest of Money, without any Inconveniencies attending it,” he wrote in 1705.
Unlike John Law classical economists on the other hand had pointed out that interest rates of a country are a function of capital not the note issue of a central bank (or a free bank for that matter) which is just circulating medium.
“It is contended, that the rate of interest, and not the price of gold or silver bullion, is the criterion by which we may, that if it were always judge of the abundance of paper-money too abundant, interest would fall, and if not sufficiently so, interest would rise,” explained David Ricardo in 1810.
“It can, I think, be made manifest, that the rate of interest is not regulated by the abundance or scarcity of money, but by the abundance or scarcity of that part of capital, not consisting of money.”
Adam Smith had also pointed it out before. Reserve money created by a bank of issue is not actually capital.
”When we compute the quantity of industry which the circulating capital of any society can employ, we must always have regard to those parts of it only which consist in provisions, materials, and finished work: the other, which consists in money, and which serves only to circulate those three, must always be deducted.
“In order to put industry into motion, three things are requisite: – materials to work upon, tools to work with, and the wages or recompense for the sake of which the work is done.
“Money is neither a material to work upon, nor a tool to work with; and though the wages of the workman are commonly paid to him in money, his real revenue, like that of all other men, consists not in money, but in money’s worth; not in the metal pieces, but what can be got for them.”
When currencies depreciate, financial capital denominated in the money is destroyed.
As a result, countries with depreciating currencies inflationary policy end up with higher interest rates and are also forced to import capital, leading to a ‘current account deficit’.
On the other had countries with strong exchange rates which is a result of deflationary policy have low interest rates. Japan and Singapore are examples after 1970 in particular. Germany was the prime example before the ECB.
Savings Glut
When the Fed cut interest rates recently, 10 year bond yield went up. In the run up to the Housing bubble, when the Fed raised rates, long term bond yields, like the 10-year bond did not move up.
That was because, US securities had a very deep long-term market where Asian central banks for example which were running deflationary policy and collecting reserves (by sterilizing deposits in the domestic banking system, rather than expand the note issue) were buying them.
Interest rates are a function of capital as classicals said decades or centuries earlier, in their wisdom.
US Mercantilists including in the Fed said there was an Asian Savings Glut which was undermining their ‘transmission mechanism’.
They then induced Asian central banks like in China to break the peg, run flexible exchange rates or floats and stop buying US debt. As a result they killed a market for US debt, which the US built with the Bretton Woods I deliberately, and unwittingly in Bretton Woods II.
Now around 20 years later, there is no Asian Savings Glut, and US is on the path to a debt crisis.
Rejecting Economics, Destroying Capital
Modern central bank and English speaking Western academics who propose full employment policies or potential output targeting or rate cuts push central banks to run a political agenda divorced from elected governments using ‘central bank independence’.
In the process they reject classical economics out of hand.
Competitive exchange rates or high inflation targets, and discretionary or flexible policy, which destroy monetary stability and capital go against the very basis of a running a sound monetary system, which is required for a liberal political system and free trade to operate.
In the classical period central banks were not independent to run discretionary policy. They were under the control of specie like gold, and to depreciate they needed parliamentary authority like a Bank Restriction Act in the UK.
Post 1980s IMF programs also fail due to ‘competitive exchange rates’ which were pushed by people including fellows of the Petersen Institute.
Central bank independence is not about allowing a note issue bank to depreciate currencies by cutting rates with an abundance reserve regime or triggering social unrest with a 5 percent inflation target.
Only the parliament can fix this. In the US, the employment mandate comes from a law, which was ignored by both Volker and Greenspan.
The modern ideas about central bank independence come from events in 1951 where the Fed resisted pressure to buy long bonds under a wartime deal, with the intellectual backing for coming from Governor (and former Fed Chair) Marriner Eccles.
The Fed Treasury Accord stopped yield curve targeting, (essentially the transmission mechanism) and returned the Fed to a ‘bills only’ policy. At its core central bank independence meant a return to a ‘bills only’ policy.
All these ideas are corrupted now. In Sri Lanka under the Yahapalana administration the opposite happened.
Passing (Dangerous) Fads
Make no mistake, Sri Lanka’s central bank had done an exceptional job since 2022 and made an IMF program itself respectable, as opposed to programs in other countries.
All these modern central bank gimmicks, whether it is ‘operation twists’ or quantitative easing, or transmission mechanism, goes against everything that ‘economists’ taught and reflect some absurd buraucratism based on the coercive powers wielded by an agency as state monopoly issuer.
They filter to countries like Sri Lanka through the IMF and Western academics.
The abundant reserve regime and single policy rate is the latest in long list of fads that emerged since 1920s and especially after the 1960s.
When these actions are done long enough, countries become ungovernable, cranks are elected and countries default.
Quite apart from capital itself, modern banking systems based on paper money are fragile and hang on a thread of confidence.
It is easier to destroy confidence in countries like Sri Lanka than in the US where there is a past history of confidence. But it can be done in any country.
Central banking and reserve money expansion, and flexible or discretionary policy are key tools to destroy confidence. Discretionary flexible policy is the basis of Trumpism. Sri Lanka should not go down that path, again. One default is more than enough.
It is important for interbank rates to function, so that banking crises are avoided. Sri Lanka has reserve targets and debt repayment problems and no floating exchange rate, even to survive for a few months with an abundant reserve system, let alone years.
That is why Singapore, which Sri Lankans so admire, chose not to have a policy rate or a politically determined transmission mechanism for growth or other objectives.
They have not gone to an abundant reserve regime either which is the latest fad that is generating monetary instability and re-electing Trumps of this world, in other countries.
“..[W]e wanted to indicate to academics, both local and foreign; that what is fashionable in the West is not necessarily good for Singapore,” Singapore’s economic architect and economist in the classical tradition, Goh Keng Swee once said.
“A perceptive mind is needed to distinguish the peripheral form the fundamental, transient fads from permanent values.” (Colombo/Apr30/2025 – Update III)
