ECONOMYNEXT – Sri Lanka’s obsession over reopening car imports, shows a sad and worrying defeat of economics and the iron grip of naked mercantilism among policy makers that led the country to 72 years of exchange and trade controls and eventual external default in 2022.
Sri Lanka’s peacetime default, after a 30-year war, came amid a general deterioration of monetary policy worldwide in the aftermath of the housing bubble fired by the Fed, reviving the false religion of stimulus (potential output) and excess liquidity (quantitative easing), which classicals used to call the super abundance of paper money.
In this journey to default, technical advice from the International Monetary Fund, for monetary policy modernization and justifications to print money and deny monetary stability to the poor (potential output) has played a big part.
The single policy rate and liquidity forecasting, will contribute to the next currency crisis just as rural credit re-financing before 1995, direct market injections to offset interventions and open market operations (since 2015 in particular) for flexible inflation targeting has done after the end of a civil war.
At different times Sri Lanka’s macro-economists have obsessed over different types of goods, falsely believing that they caused forex problems rather than the domestic operations of the central bank whether direct, open market or rural credit re-finance. They had not only controlled imports but also fostered price-gauging import-substitution.
For many years Sri Lanka’s policy makers have obsessed over oil while using bank credit to cover losses and contributing to monetary instability. Oil was not only blamed for forex shortages but also for inflation.
Blaming oil for inflation is partly justified as commodity prices rise due to Federal Reserve money printing, just as non-traded commodities rise due to domestic printing.
The 2015 currency crisis which happened due to money printing mostly via open market operations, while oil prices collapsed, seems to have cured that petroleum obsession to some extent.
Gold is another obsession for control by macro-economists in countries with a bad central bank operating framework. India and Sri Lanka are prime offenders.
Related Sri Lanka rupee collapses as gold imports end
Exchange control is another tool through which the people are oppressed in such countries. All of these controls then lead to smuggling, disrespect for law and corruption of society.
The Bretton Woods and the IMF itself was set up with Article IV, permitting capital controls, in the false belief that this contributed to external instability rather than the policy rate that was invented by the Fed in the 1920s.
Years of currency crises (and IMF programs) in countries with exchange controls like Sri Lanka, have not made macroeconomists any wiser.
In the decades after the roaring 20s bubble, Cambridge University, Harvard destroyed the learning of a century. It was as if the classical greats did not exist. Briefly there was a resurgence of sound money from 1980 to 2000 after the excesses of the 1960s and 1970s.
That Great Moderation ended with the Feds ‘reflation’ under Princetonomics, triggering the housing bubble. The age of excess liquidity (from Fed quantitative easing) has since brought misery to millions and led to elected governments that cannot last a full term rather than two terms.
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Germany, a country with the tightest post war monetary policy and had governments re-elected for four five times in a row under the Bundesbank now cannot last a full term under the European Central Bank.
And Sri Lanka worries about car imports and other IMF countries worry about the current account deficit and not liquidity injections.
Q: Are car imports different to any other imports?
Car imports are no different from any other credit-financed import. In any case imports cannot cause monetary trouble.
Monetary troubles, losses of forex reserves of the central bank which is an asset in its balance sheet can only be lost by direct or open market operations that increase reserve money, a liability in its balance sheet.
It is this liability, that is exchanged for forex reserves when the users make imports with it. If those IOUs are not overproduced against domestic assets, and there is a mechanism (operating framework) to stop it, there is no external trouble.
The central bank does not give dollars against any other instrument (except perhaps against Treasury bills in a roundabout way to settle government debt) other than domestic currency.
Since direct market operations are now opposed by the public, macro-economists shifted to open market operations to cause forex shortage as seen in the 2015 and 2018 crises. The 2020/2022 crisis was caused by direct market, open market operations and liquidity releases from SRR cuts.
OMO has largely been deflationary since September 2022, but concerns have been raised that the inflationary operations are just starting just like in 2015, 2018 and late 2019.
Q: What happens when someone decides to buy a car?
A decision to purchase a car, especially after a sudden opening of the market, impacts the banking system in two ways.
A potential car buyer will withdraw a deposit and they will get a loan to finance the rest. Both actions will lead to a drain of rupee reserves from one bank, which will be exchanged for dollars within the same bank or different bank.
Banks and finance companies will now have to stop other credit to give these loans. In the absence of open market operations there is an opportunity cost to banks and finance companies in financing vehicle import loans, or deposit withdrawals.
Q: What type of other credit will banks reduce (in the absence of OMO)?
One thing that may happen is that banks and finance companies will reduce their holding of Treasury bills. Already the signs are seen in banks.
Finance companies have also invested in Treasury instruments, directly and through repos as car imports and other private credit slowed.
Related Sri Lanka finance companies invest in treasuries, repos amid vehicle import ban
They will now cut the repos and refrain from re-investing in Treasury bills beyond their liquidity requirements when car imports are allowed. Depending on how the budget deficit is managed, this will lead to upward pressure on Treasury bills as long as more money is not injected by open market operations.
This tends to undermine the ‘transmission mechanism’ and macro-economists have tended to print money to maintain rates in the past, reversing the automatic correction and triggering peacetime currency crises.
Banks could also reduce other types of credit private and give car loans with new deposits or loan repayments they get.
This leads to sequencing or prioritizing of car loans over other credit as long as new money is not injected through open market operations to maintain the single policy rate.
Q: Are car credits different from other credits?
Car credits are slightly different from say a credit to build a hotel or factory. A credit to build a hotel will generate imports of building material like steel or cement (or clinker and gypsum) but things like sand or labour will be domestic in nature.
As a result not all the credit will not immediately hit the forex markets.
In a second round, fuel that is used to transport rocks or sand will have to be imported. Then the suppliers will use the money they earn on imported foods or other goods, or save in banks which in turn will be used in imports through new credit.
So there has to be several rounds of cascading credit for all the loans to hit the forex market.
However, cars are a fully imported item. So almost all the money except the margin and taxes will immediately hit the forex market. The distributor margins will hit the forex market when employees and the owners spend the money.
Since taxes are around 200 percent, only a third of the money will hit the forex market.
Some of the worst credit is loans taken by the CPC and CEB to finance losses. That is almost 100 percent spent on imported fuel and there are hardly any taxes. When that happens the exchange rate comes under quick pressure, if the policy rate is maintained with open market operations.
For example in 2004, when the fuel pricing formula was abandoned, macro-economists offset taxes from CPC and printed money to finance the budget instead of allowing T-bill rates to rise with the deficit. As a result, the currency collapsed in 2004 until credit contracted due to the tsunami shock. In 2012 it was done with the policy rate cut and so was 2018. This column called the cut the unkindest cut of all
Q: What if banks use the excess liquidity that now exists in the banking system?
These are customer money or their profits, which banks have deposited in the central bank, which for which the monetary authority has bought dollars, when interest rates were market driven.
There are about 200 billion rupees deposited in this way in the central bank.
Some of the money has been printed recently without reserve backing. The central bank has injected around 80 billion rupees to the system through term and overnight operations.
If these monies are withdrawn and given to customers via car loans, instead of using new deposits and loan repayments to fund them, there will be excess demand for dollars and it can pressure the currency.
If the currency is allowed to fall as the excess liquidity is used up, all traded goods including foods for the hungry and coal for electricity will go up.
If the exchange rate is defended, against the liquidity, foreign reserves backing it, (or not in the case of OMO) will be lost until interest rates rise. If there was a policy corridor (and not a single policy rate) there would be some room for a correction in the credit system.
Q: Can foreign reserves of a pegged central bank be used for private imports?
No. Whenever they are used, there is trouble as the pegged central bank (if it has a policy rate) will print money to replace reserve money lost in interventions (sterilization of outflows). IMF’s reserve adequacy matrix is a false concept in line with the general corruption of economics that has led to external trouble in so many countries since the 1920s and 1960s.
If there is no policy rate, when a small amounts of reserves are used, liquidity in the banking system drops, interest rates go up and total credit is balanced and further loss of foreign reserves stop.
However, since there is a policy rate, the central banks will inject more money to target the average weighted call money rate to artificially depress the interest rates structure against market credit demand.
To the extent that more money is injected to suppress the rates more reserves will be lost.
Let’s assume that one commerical bank will use 30 billion rupees of the excess liquidity they have deposited in the central bank to give some investment credit for imported capital goods. That will lead to a demand for around 100 million dollars in the first month.
If there isn’t enough savings generated in that month from dollars that are coming in, then the central bank will have to lose 100 million dollars from its foreign reserves to stop the rupee from falling.
If the same demand is there in the second month, another 100 million will be lost.
As liquidity drops, rates should go up. However it does not happen when there is a policy rate.
Eventually the central bank will inject new money to maintain its policy rate. People will then blame car imports for the monetary trouble, as happened in 2015.
Q: What if foreign banks buy more Treasury bills now that the external debt restructuring is complete, and domestic risks are reduced?
If foreign banks buy more Treasury bills from the excess liquidity, pressure on government securities will reduce for a time.
But once the suppliers to government suppliers or state workers who got the money start spending, the money will hit the forex markets in the imports consumed or subsequent rounds of cascading credit and reserves will be lost.
Excess liquidity only gives some temporary happiness to macro-economists as they see rates fall, but permanent unhappiness to the public when the currency falls.
If there was a commitment to defend the currency, and not a ‘flexible exchange rate’, then there is no problem in maintaining excess liquidity from balance of payments surpluses.
Q: What are the factors that will determine the interest rates in the first quarter?
Sri Lanka’s central bank – or most central banks under IMF programs using monetary policy consultation clauses or flexible inflation targeting – tend to cut rates just as private credit recovers, which is around 18 to 20 months after the initial float and rate hikes restores monetary stability.
This action of cutting rates claiming inflation is low, tends to plunge the country into a new currency crisis in peacetime if there is a reserve collecting central bank.
This was shown in 2012, 2015 (Sri Lanka knocks hard at BOP crisis door: Bellwether) and 2018 (Sri Lanka is recovering, Central Bank threat looms: Bellwether).
In 2020 rate cuts were compounded by tax cuts, which requires rates to rise to finance the deficit, keep the BOP in balance, and exchange rate stable.
Budget deficit is also credit, car imports are also mostly credit.
There is usually a drought in February and March that drives up coal and fuel use and reduce hydro power. That may also put pressure on interest rates. If the regulator allows the CEB to maintain prices, the pressure will not be as great.
The general economic recovery and adjustments of salaries to pre-crisis levels, will boost power and energy demand in case.
On the positive side, car imports will bring more tax revenues for the budget reducing the deficit. But there may be higher spending on state worker salaries and welfare. There are also value added tax cuts promised.
All this is difficult for bureaucrats of the money monopoly to estimate as the policy rate, but will be reflected through the market credit demand accurately. That is why flexible inflation targeting countries go to the IMF repeatedly.
If there is a wide policy corridor or no ceiling rate, or the ceiling rate is pushed up until credit slows like in Singapore, external stability and the exchange rate will be maintained.
In summary, the private sector are net savers. Even if they take credit, they can only take credit from savings of other people. If the central bank does not obsessively target the average weighted call money rate with open market operations and create fictitious ‘savings’ (bank rupee reserves) to give loans, there will be no external trouble, no currency depreciation or forex reserve losses.
The shock to the credit system from opening vehicle imports, will be dissipated by a temporary rise in interest rates.
Q: If this is so, why don’t central banks allow rates to go up?
Currency crises happen because macro-economists believe the monetary policy board knows the correct interest rates more than the market. From time to time, the belief gets worse and sweeping defaults are the result.
This can be seen now in what the IMF now calls ‘monetary policy modernization’ where floating rate operating frameworks or parts of them, are transplanted to reserve collecting ones.
If the central bank has a wide enough policy corridor, as liquidity drops due to currency defence, rates go up, new credit is limited to deposits and loan repayments, and the balance of payments and reserves are protected.
In a floating exchange rate regime, there is no currency defence, so the problem of sterilizing interventions with new money does not arise.
But if a reserve collecting central bank targets inflation and says inflation is low therefore there is ‘space’ to cut rates, the balance of payments will go haywire if and when the cuts are enforced with open market operations.
This is why flexible inflation targeting countries like Ghana, Zambia and Sri Lanka which receive IMF technical assistance go from one bailout to the other and eventually default.
After the monetary policy consultation clause (MPC) was introduced in 2014, and inflation targeting-with-a-peg generally, the risk of program failure has intensified in Sri Lanka with reserve targets being missed halfway into programs.
In Sri Lanka this was seen in 2012 and 2018. The 2020 crises happened outside an IMF program. This time however there is a ceiling on domestic assets of the central bank, in the IMF program which can limit OMO somewhat.
This may also be why IMF programs build depreciation into their programs. It is childishly simple to maintain an exchange rate peg – as long as money is not printed to suppress rates.
Inflationary domestic operations (direct or open market) results in reserve losses. Deflationary operations result in foreign reserve accumulation.
Q: Why does this happen and why was knowledge that once stopped inflation, economic crises and social unrest lost?
It happens because what we call economics now is not a positivist science based on reason. It is a kind of social ‘science’ where doctrine swings from reason (classical economics) to unreason (Mercantilism) from time to time.
In Sri Lanka, an unusual concept has emerged recently where it is claimed that money printing is refinancing the government and not re-financing private investments.
All this appears to be a result of macro-economists lacking knowledge of history.
They do not seem to know that all these arguments are old hat and had been thoroughly debated and refuted many decades ago, such as during the bullionists debates in the UK and Austrian economics in German speaking countries.
Friedrich Hayek once observed that Keynes appeared to be completely ignorant of his own country’s monetary history debates and only appeared to be familiar with the teachings of Peter Marshall.
These matters were exhaustively debated in the early 1800s in the UK, and then in the 1840s. In each instance parliament brought laws against the Bank of England with legislators who were classical liberals, who were personally involved in developing the theory.
But after the policy rate was invented by the Fed in the 1920s, the knowledge was gradually lost.
In fact when the Gold Standard Bill was debated in 1925, many legislators were speaking second hand, not from personal reasoning, a perusal of UK Hansards show.
In the 1930s as currencies collapsed due to the policy rate and open market operations, capital flows were blamed and the IMF was set up permitting capital controls and only a commitment to Article IV.
What appeared to have been common knowledge till 1914 on the eve of World War I, was no longer known by the end of World War II.
Unlike in the past when central banks were private, state agencies, with a money monopoly are completely unaccountable. They can also make their own laws, despite causing social unrest through inflation, repeatedly.
State owned central banks also have the power to impose controls on citizens instead of correcting their open market operations or other easy money tools.
Because other scapegoats are found, like car imports or oil imports, or the current account deficit, no solution to the monetary problem can be found. Repeated IMF programs and eventual external default is the result.
Silly concepts like ‘exchange rates are market determined’ have been spread by the IMF and Anglophone inflationists.
Anglophone universities like Cambridge, Oxford, Harvard and MIT have done a great deal to revive debunked mercantilism of the 17th century which then led to the collapse of the Bretton Woods and Great Inflation.
University textbooks written by the likes of Paul Samuelson and books and the doctrine spread by John Maynard Keynes can take a lot of credit for the current monetary problems.
The latest debacle relates to the positive inflation ideology of Ben Bernanke, who tried to reverse productivity driven price falls and fired the housing bubble which then led to quantitative easing.
QE did not cause much problem when the banking system was in shambles, but 10 years later it caused the worst inflation since the Great Inflation and also set off a fresh wave of defaults in pegged countries like ours.
QE seems to have eliminated the fear of excess liquidity which the classical greats called super abundance of paper money. The central bank has allowed excess liquidity to build up to 200 billion rupees, like it did during the 2020 crises.
The tyranny of exchange controls and import controls, wherever they are imposed on innocent citizens, are indicative of a deep flaw of the operating framework of the central bank concerned.
Though floating rate central banks do not have currency crises, asset price bubbles and inflation, the most recent of which the media called the ‘cost of living crisis’, in Europe and US, are the consequence.
Yet they send out a great many public communications at taxpayer expense to defend mis-targeted policy rates and the consequences of their errors and the media reproduce them faithfully and people believe them.
This is in sharp contrast to the 19th century when sound money came from law.
Economist Gordon Tullock in comments on Capitalism and Freedom: Problems and Prospects, related something Milton Friedman has told him.
“On several occasions in my hearing (I don’t know whether it is in his writing or not but I have heard him say this a number of times) Milton Friedman has pointed out that one of the basic reasons for the good press the Federal Reserve Board has had for many years has been that the Federal Reserve Board is the source of 98 percent of all writing on the Federal Reserve Board. Most government agencies have this characteristic.”
In Sri Lanka there is a history of over 70 years of exchange control and import controls, as well as 17 IMF programs, to get over, and a well-cemented belief system that imports or the current account deficit cause currency trouble.
But it is not impossible. Many countries have defeated Mercantilism and discretionary (flexible) central banking.
Singapore did it after the Japanese left, Germany did it after World War II, Japan in 1948, Saudi Arabia in the late 1950s, Taiwan did it in 1960, so did France at the same time, UK did it in 1978 (but got into trouble with the ERM), Hong Kong in 1981 (the territory had a pretty ok system until 1971 as well), New Zealand and Australia and UK again in the 1990s after the ERM soft-peg debacle.
Switzerland never got into trouble and Sweden largely escaped. So it can be done and the ideology of exchange and trade controlling central banks can be changed if the people and legislators are willing to take action as economist-legislators did in the 19th century. (Colombo/Dec12/2024 – Update VI)
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