ECONOMYNEXT – Sri Lanka’s central bank has allowed the rupee to generally appreciate amid broadly deflationary policy since 2022, allowing the economic activity to recover quickly, but the rupee has tended to be unstable, amid wide fluctuations in overnight liquidity.
Due to lack of credibility and deliberately fired uncertainty and fear mongering (the exchange rate is ‘flexible’, it is ‘market’ determined), the rupee wobbles at the slightest confidence shock, even if money is not printed to actually push the rupee down.
All of these have costs to the economy. The bigger the hit to confidence the bigger the costs. In the past exchange rate instability has led to downgrades.
In countries with exchange rate instability – an evil that spread like wildfire after the IMF’s second amendment to its Articles in 1978 – there is an unwillingness to defend currency with unsterilized interventions to match the outflow of dollars with an outflow of rupees from the banking system.
Before the collapse of the Bretton Woods itself, exchange depreciation took off in the 1930s among more developed nations as the policy rate and open market operations invented in the Fed spread like a cancer and developing countries which had no OMO largely escaped.
In fact in the 1960s when full employment policies took off in advanced nations, inflation in other countries which did not have aggressive macro-economic policy were lower.
The policy rate and full employment policies were the core reason for Sterling crises, the eventual collapse of the dollar which took the Bretton Woods along with it, and the reason that IMF-backed countries collapsed repeatedly and Argentina collapsed repeatedly despite almost German level fiscal metrics the year before the crisis.
To the extent of the unwillingness to defend the exchange rate with unsterilized interventions – which makes the overnight rate move up (and down) quickly in tandem with outflows (and inflows) – the exchange rate instability will worsen.
The more narrowly interbank rates are targeted, for the single policy rate or mid-corridor rate undermining a corridor system, especially with injections, the more foreign reserves will be lost and the exchange rate will also weaken.
Such flexible exchange rate regimes have weak credibility, and any confidence shock can destabilize it.
Nothing in this column is intended to imply that the central bank’s observed policy of keeping the exchange rate at around 300 to the US dollar is a wrong policy. Far from it.
It is a correct policy and the gains that the economy has made so far – including keeping inflation in check at very low levels since 2022 and the ability to repay debt and contain social unrest so far has been a consequence of it.
The problem is that the operating framework of the central bank, especially the declared one, involving a 5 percent inflation target and the single policy rate, as well as allowing large volumes of excess liquidity has loaded the dice against monetary and currency stability.
The Case of Hong Kong
The movement of the rupee when a Trump tariff of 44 percent was announced is a case in point.
The Hong Kong exchange rate did not move despite a 145 percent tax. The difference is a flawed operating framework and fear mongering that the exchange rate is flexible and the value of money is ‘market determined’.
Shortly before 1981, when interest rates were targeted and there were sterilized interventions – Hong Kong changed the monetary regime in the wake of the collapse of the Bretton Woods and 1960s Sterling crises – the HK dollar went into a free fall when a handover to China was announced.
That was also the time that Paul Volker hiked rates and Latin America collapsed.
In Hong Kong this led to the setting up (or re-establishment we can say) of a formal currency board arrangement in 1981 after John Greenwood, an investment banker explained why.
The one thing in a free market economy that should not be ‘market determined’ is the value of money. At a basic level, inflation targeting (as long inflation is close to or zero) is also a method of not market determining money, but setting a rule for it.
Money is like a weight and measure, like a kilogram or a litre.
In the classical period of low inflation and the industrial revolution, money was protected with a milled edge.
But now with macroeconomists deploying discretionary policy (read flexible) to meet their insatiable desire for inflation, using paper money, central banks themselves are engaging in ‘coin-clipping’ with positive inflation targeting, triggering currency collapses, starvation of people in lower income brackets, and defaults.
Even a king can rule for a long period with stable money – as now happens with the Kings and Emirs of currency-board-like regimes in the Middle East. Jordan has no oil by the way. But bad money led to the ouster of Iran’s Shah.
This should be a lesson to the government of Sri Lanka as initial signs are emerging that the same errors that led to currency collapses, and default of a country without war, are going to be repeated.
Maintaining and Exchange Rate is the Most Simple Policy
Maintaining a fixed exchange rate and giving long term stability for exporters and investors is the most simple of operating frameworks.
However, to do that the legal powers given to central bankers to print money through open market operations (adding fictitious reserves or deposits into banks), and the power given to monetary bureaucrats to general high level of inflation (and punish thrift) through a policy rate have to be taken away.
Sri Lanka’s central bank lost its foreign reserves and also lost borrowed dollar reserves including through swaps by trying to target its policy rate up to April 2022, as the US Fed did in the 1960s in the run up to the collapse of the US dollar.
Because India allowed the central bank to run arrears on Asian Clearing Union balances, the correction in the balance of payments was further delayed and its reserves moved further into negative territory of 4.6 billion dollars.
The US issued Roosa bonds to repay the Fed swap debt taken during the 1960s rate cuts. Sri Lanka’s central bank ran deflationary policy in 2023 and 2024 to repay its dollar debt (bought dollars by selling down its Treasury bill portfolio).
READ MORE ABOUT ROOSA BONDS HERE
https://home.treasury.gov/policy-issues/international/exchange-stabilization-fund/exchange-stabilization-fund-history
The central bank therefore has to operate an interest rate regime that allows it to curb domestic credit sterilize inflows (mop up liquidity from dollars to build up reserves to a positive balance).
The interest rate has to be such that it allows the central bank to absorb some of the savings of the public which it will export and buy foreign assets to build reserves, reducing domestic investments.
To understand recent movements in the rupee, it is necessary to understand the role excess liquidity plays in the banking system.
If monetary policy deteriorates, as it has done in the past, car imports will be blamed for currency crises by macro-economists using Mercantilist doctrine.
They will conveniently forget that car imports were banned from 2020 to 2022 when the worst crisis in history took place and that the 2018 currency collapse took place after gold imports were banned and restrictions were also placed on vehicle LCs.
The Role of Interbank Excess Liquidity
To understand why exchange rates are unstable, it is necessary to understand the role played by interbank excess liquidity and of a reserve collecting central bank to defend the rupee against the liquidity and drive short term rates up.
The ability of the banking system to create excess dollar outflows out of line with imports, rests on the availability of excess liquidity in the interbank market, to give loans with.
When interest rates are higher than is required to keep savings and investments in balance or banks are unwilling to give investment credit and businesses are unwilling to borrow and invest anyway after a currency collapse destroys consumer demand, outflows of dollars are less than inflows and the exchange rate comes under strengthening pressure.
That is why rates are hiked to kill domestic credit and restore confidence in the currency under an International Monetary Fund program after a credit bubble is fired.
Money is printed money (rate cuts are enforced) under the very same operating framework prescribed by the agency for 5 percent inflation or to target potential output.
Remember macro-economists – especially from the 1960s to 1970 and – do not believe stability drives growth or investment but that inflation or ‘price pressure’ does.
This belief was revived by the Fed in 2000 in the process of creating the housing bubble and later in the ‘normalizing’ the abundant reserve regime instead of ‘normalizing’ monetary policy (i.e a return to a scarce reserve regime) with devastating consequences on budgets of many countries including the US.
Rates are raised in countries like Sri Lanka to save the ‘economy’ after a currency crisis, but to save the rupee and the central bank from earlier rate cuts.
After credit contracts (one may call that debt deflation) the central bank is able to buy dollars with newly created money, to re-build reserves, which then builds up as ‘excess liquidity’ in money markets.
Liquidity Trap
If there is unwillingness by banks to lend due to fears of bad loans, there is private sector sterilization or a liquidity trap. After Sri Lanka’s last crisis many banks – especially foreign ones – did not lend. As a result, there was around 130 billion rupees of permanent excess liquidity which was not going out as loans.
The central bank bought several billion dollars and the liquidity was mopped up with Treasury bill sales – banks bought securities previously held by the central bank instead of giving loans to customers to generate imports and a current account deficit.
In a floating exchange rate, there are no dollar purchases or sales and no exchange rate to anchor money growth to. So the inflation target serves at the anchor.
The purchase of dollars by Sri Lanka’s central bank, as well as the sale of dollars to stop a fall in the currency from a spike in credit, shows that there is no floating exchange rate and that the currency is pegged in one form or the other.
The IMF has called it an ‘other managed’ regime.
IMF classifies Sri Lanka’s exchange regime as ‘other managed’
IMF classifies Sri Lanka’s exchange regime as ‘other managed’
Without some kind of pegged regime, it is utterly impossible for the central bank to build reserves – it is possible for the Treasury to do so – and meet IMF targets.
This build-up of liquidity (basically newly created rupee positive balances in the accounts of exporters or remittance families or tourism operations which are gradually transferred to other customers as they purchase goods and services) tends to reduce short term rates.
Interest rates will therefore move towards the lower floor of the policy corridor.
The excess liquidity eventually turns into imports, either through the recipients of dollars buying imported goods like fuel or foods, or the money being loaned for investment projects (since the country has a net savings rate) which will generate imports like building materials or machinery.
The central bank will then have to sell the dollars to stop the currency from falling, unless the liquidity is mopped up to prevent the loan being made in the first place.
Until private credit picks up, the liquidity from savings of the people bought by the central bank may not be used up very fast. That is why, under flexible inflation targeting, the currency starts to collapse again about 18 to 24 months after the end of the previous currency collapse.
When credit or imports come, if the central bank then sells the dollars to maintain a fixed exchange rate, the liquidity will be extinguished just as if they were extinguished by a sale of its securities portfolio.
Interest rates will also go up and banks will curtail credit and the system will come back into balance with hardly any disturbance to the system and minor changes to interest rates.
If the central bank sells its Treasuries stock into this liquidity there will be a steady surplus in the balance of payments and the exchange rate will not come under upward pressure.
What if the central bank does not fully defend the exchange rate at a fixed rate when the rupee comes under upward pressure?
Let’s say when credit slowed, and let’s say in January or February and the rupee came under upward pressure, if the central bank did not fully defend rupee and buy dollars, the rupee would appreciate.
Then importers will at first delay paying off import bills and try to sell their goods and get some money and also repay their import credits, comfortable in the knowledge that there would be no immediate fall of the rupee and it is better to wait for some more appreciation before buying dollars.
This will create further upward pressure on the rupee and result in more dollars being bought by the central bank.
Banks may also run negative open positions, further sell dollars in their open positioning and worsening the strengthening forces. Macroeconomists may call it ‘speculative behaviour’, but it is a normal reaction to the flexible exchange rate that the IMF, the they themselves promote.
If banks did not sell down their open positions, they stand to make losses as the rupee strengthens. It is a normal consequence of the ‘flexible’ exchange or to give it the correct name. non-credible peg.
There is a roughly inverse relationship between foreign assets of banks and the exchange rate.
Exporters will eventually delay selling dollars and start to take packing credit to fund exports with interest rates also falling.
When there is sufficient domestic credit to use up the liquidity, the exchange rate will turn.
What happens if the central bank does not fully defend the exchange rate when it comes under downward pressure?
If the central bank does not fully defend the exchange rate, when excess liquidity is used up in credit, importers will start to cover quickly, exporters will hold back a little more hoping for a better rate, and the exchange rate will swing in the opposite direction.
Banks will also cover their negative NOP positions in a bid to make some profits as the rupee falls under the flexible exchange rate.
To the extent that the central bank intervenes and sells dollars, liquidity will reduce and interest rates will go up. If the central bank injects money to keep rates from hitting the ceiling rates quickly, the whole drama will continue for a longer period.
The correction may eventually come from rising 3 or 12-month Treasuries yields which are high enough to delay private credit. Due to the so-called ‘transmission mechanism’, there may be increases in long term rates as well.
As can be seen there was absolutely no reason for longer term rates to go up, which are determined by different factors. However under a bureaucratic ‘transmission mechanism’ the entire yield curve will move.
However, all that is necessary for a correction if there was a fixed exchange rate, is for short term rates to increase and liquidity to fall.
Who benefits from the lack of a credible exchange rate regime?
With the flexible exchange rate, ‘age-of-inflation’ macroeconomists and the International Monetary Fund can satisfy their doctrinal or ideological desires which are in vogue at the present moment.
Remember, the IMF was created for the exact opposite purpose.
Other than satisfying the doctrinal itch, banks will benefit from the volatile exchange rate.
The volatility makes banks quote big spreads for importers and exporters. They cannot be blamed for asking for big spreads since nobody can predict whether the central bank will intervene or not as liquidity is used up in credit.
Banks also profit by changing their net open positions and financing their position with open market operations or the excess liquidity.
When the currency is allowed to weaken, they can use open market operations and run positive open positions for example even if they did not have some excess liquidity themselves as the central bank tries to operate a single policy rate with liquidity injections.
Banks also profit from selling hedging instruments to importers and also exporters due to the non – credible ‘other managed’ regime.
Banks can also profit by giving credit to exporters who want to delay conversions.
The central bank can also make ‘profits’ if the exchange rate appreciates when foreign assets are negative, just as banks with negative NOPs can make money by covering at the strongest position.
Once foreign assets are positive, depreciation brings profits and appreciation brings losses.
Who loses from the volatile exchange rate?
While exporters and importers can to some extent play a waiting game, remittance families usually cannot. They get slammed if the exchange rate appreciates only for a short time and then weakens again.
If the father’s or mother’s remitted salary is converted when the central bank’s flexible exchange rate is strong, they get less dollars. But two weeks later, when they try to buy fuel, the petrol or diesel may have gone up.
While most businesses are quick to raise prices to maintain margins, prices come back down only due to competition over a longer period.
In addition, the general public may lose because importers have to keep wider margins to cover themselves against exchange rate swings. Exporters who depend on imported inputs from others may also suffer the same fate.
Up and down movements in the exchange rate, however wide, is better than permanent depreciation, it must be made clear.
Exporters can also lose out because there is a timing difference between the time a price is agreed upon and delivered. Sometimes exporters also give credit to win business.
Operating Costs in International Trade
If the exchange appreciates when dollars are converted, and part of the expenses are in rupees (wages, utilities, and transport costs), exporter margins can get hammered. It must be noted that in these days of global supply chains margins are thin.
When the exchange rate is stable, importers do not have to use domestic credit to finance their stocks. They can use supplier’s credit and delay payment until the stock is sold and save money and sell their products at a lower price to consumers, reducing cost of doing business.
However, if the exchange rate is volatile, they will have to borrow and pay off the import bills as early as possible.
This is why the industrial revolution thrived in fixed exchange rates. This is why East Asian fixed exchange rates provided the backdrop for an export boom and supply chains.
While a flexible exchange rate satisfies the latest ideology of the IMF and brings profits to banks, it adds costs to international trade and harms consumers.
Countries that fix exchange rates for long periods – by restraining monetary policy or running deflationary policy – on the other hand experience high levels of domestic stability, capital inflows and permanently low interest rates, as well as in-migration.
In a democratic nation, where the sovereignty of the people is expressed through parliament, the central bank’s ability to create monetary and economic instability must be restrained by the parliament.
Lies and Deception
That Sri Lanka’s central bank is not allowed to print money through its new monetary law is an outright and silly lie, spread by macro-economists.
It was definitively proved in the last quarter of 2024 that the central bank can print as much money as it likes, and keep them sloshing around the banking system.
The central bank is allowed to conduct open market operations and buy bonds from banks and print money. It matters little whether the central banks buy securities outright, or they are renewed term or overnight.
It is through this mechanism that the central bank prevented rates from hitting the ceiling and weakened the currency in the last quarter of 2024 and triggered reserve losses.
As long as parliament does not constrain its ability to engage in inflationary open market operations, under a credible low inflation anchor – or an external anchor which is easy for the parliament to monitor as was in the classical period – the central bank can print as much money as it likes and create x percent inflation and external trouble.
Unless the central bank reduces its domestic assets portfolio, its ability to collect reserves will be limited to interest coupons it gets for its bond portfolio, and any inflation it creates by expanding reserve money.
As had been mentioned earlier, investors are now jumpy after one default. Sovereign bond yield jumped after the Trump tariffs. This shows how easy it is to lose market access for a country that has illiquid bonds even if Sri Lanka gets it.
There has been no fundamental change in the monetary framework since aggressive macro-economic policy led to a peacetime default in Sri Lanka when external conditions were relatively benign.
In fact, what has happened is that the post-war policy errors, revolving the mid-corridor rate and rejecting a bills-only policy to engage in yield curve targeting going beyond overnight mis-targeting of rates have been legislated.
The mid corridor rate which was informal in the past, has been published in a gazette and the 5 percent annual rise in cost of living has also been given legal effect.
It is unfortunate, not to mention silly for a country with a 30 percent savings rate (even if that is not strictly correct) to default externally due to mistargeting rates by embracing statistics and rejecting economics and laws of nature. (Colombo/June15/2025)
