By Bellwether
ECONOMYNEXT – Sri Lanka’s central bank has been playing with swaps for some time and the agency’s 778 billion rupee forex loss in 2022 was directly related to swaps and other borrowings, which allows it to maintain an artificial policy rate.
Central bank swaps along with other doctrines like portfolio balance channels, are the foundation of modern age-of-inflation forex crises, default, outmigration and sudden soaring poverty.
As part of steps to prevent the next sovereign default by macro-economic policy, outlawing forex swaps will be a key measure that legislators can take.
The Nick Leeson style losses came not only from swaps but also IMF borrowings taken during an earlier flexible inflation targeting crisis and borrowings from India through the Asian Clearing Union, which have since been converted to a term facility.
A central bank is supposed to have foreign reserves, but with the invention of the policy rate, modern central banks engage in ‘macroeconomic policy’ or try to boost growth through money printing to suppress the policy rate and run out of reserves.
At least before swaps, macroeconomists were forced to allow market rates to go up to stop the currency from depreciating further after a central bank ran out of reserves.
But after the invention of the swaps by the Federal Reserve when it started aggressive macroeconomic policy in the 1960s, a modern central bank can continue to print money by sterilizing non-existent reserves and promote investment and imports essentially re-financing private sector activity.
The People’s Bank of China, bless its communist heart, at least stopped the macroeconomists in Sri Lanka from busting the proceeds after gross foreign reserves fell below three months of imports.
Otherwise, the central bank would have used the swap, printed more money to suppress rates, private imports would have gone up some more and instability would have continued and people would have suffered more, like they did due to the misguided ACU loans India gave.
The entire doctrine of ‘reserve adequacy metric’ of the IMF’s statistics is completely flawed as central bank reserves cannot be used to make private sector imports, which is enabled by liquidity injections made to sterilize outflows.
Any use of central bank reserves must result in a rise in market rates and a fall in rupee reserves in banks (a real outflow of funds) to maintain external stability.
Where and when did this perfidy start?
The Federal Reserve was the culprit behind the swaps which allowed macro-economists to suppress rates on borrowed money.
The Fed during the Bretton Woods had a lot of gold reserves, but it did not have a lot of foreign exchange, unlike other central banks which did not have much gold.
When the fed printed money for ‘macroeconomic policy’ (boost employment/lean against the wind) and continued artificially low interest rates, it had to get foreign exchange from somewhere to redeem the dollars that boomeranged on itself. The Fed then went shopping in Europe, from Swiss National Bank, the Bank of International Settlement, France and Germany.
The initial ad hoc swaps started with Swiss National Bank in 1960.
Charles Coombs, head of the foreign exchange desk at the New York Fed was the perpetrator who built swap facilities with counterparty central banks on a standing basis and eventually helped in the collapse of the Bretton Woods.
Swaps also helped worsen currency crisis in Sri Lanka and also does in countries by giving another tool to policy rate-obsessed macroeconomists to delay rate corrections and end up with a 700 billion rupee loss in 2022.
When Fed printed money in excess of its gold holdings it was obliged to exchange them for gold (as were free banks in the old days through the clearing system) under the Bretton Woods agreement. To prevent the dollar boomeranging on itself, the Fed hit upon the idea of the swaps.
The fx taken from the swaps could be used to buy back the excess dollars from Germany or France or Belgium or whatever bank that did not print money.
Governor Brunet of Banque de France cottoned onto the trick and reportedly Bank of England the “thought that the American idea of organizing swap facilities around Europe for large sums indefinite
in time was wrong in principle” because it allowed the United States to avoid going to the IMF to resolve “deep seated difficulties” with the dollar.
The ‘deep seated’ difficulty was of course the bureaucratic policy rate which had done so much harm to Sri Lanka in the recent past.
France had greater monetary knowledge unlike the Anglophone macro-economists with the French Franc recently being fixed by Jacque Reuff into the New France, who had argued with Keynes as far back as the 1920s on current account deficits, and failed to convince him.
France was right since the dollar and the Bretton Woods eventually collapsed against gold like the rupee collapsed against the dollar in 2022.
Swaps were wrong in principle in 1960s and they are wrong in principle now.
Assuming Risk.
One of the reasons that European banks agreed to swaps was that it acted as a forex hedge. When the Fed got Deutsche Marks and exchanged them for excess US dollars instead of giving gold, the Deutsche Bank was left with exactly the same volume of dollars as before.
However, this was under the swap and any dollar devaluation (against gold) will not affect the more prudent French, Swiss or German counterparty central bank.
The Fed eventually browbeat Deutsche Bank into accepting part of the forex loss.
In 2022 when the rupee collapsed steeply Sri Lanka’s central bank made a 720 billion rupee loss on its forex operations and it was deeply in debt.
Fast forward to 2024.
What did the IMF say in support of the swaps?
This is what an IMF official told reporters in Colombo in response to a question about the central bank’s predilection for swaps.
“Rebuilding reserves is a very important component of the IMF supported programs.“One, is what we call organic purchases by the central bank in the foreign exchange market. The other one is rebuilding reserves for engaging with swaps. This can either be swaps with domestic banks, but also swaps with other central banks. The latter is a very important part of both global and regional financial safety nets.”
RELATED IMF sees no problem in Sri Lanka central bank building reserves with fx swaps
To be fair to the lady, Fed swaps of recent origin, including during the collapse of the housing bubble it fired, were aimed at giving dollars to other central banks as markets froze and everyone held on to cash of all kinds.
But what the Sri Lanka’s central bank did and is doing by engaging im buy/sell swaps are the 1960s style transactions, assuming enormous forex risks which eventually end up as losses like in 2022 when the currency eventually collapse from the impact of reverse repo injections or standing facilities.
Swaps with domestic banks simply allows them to convert dollar deposits (or foreign credit lines), lend them as rupee loans and the central bank will end up holding the baby when the ‘flexible exchange rate’ rears its ugly head.
What can be done?
From the foregoing it can be seen that swaps are deadly in multiple ways.
One: Central bank swaps allow macroeconomists in Sri Lanka to cut rates through open market operations and liquidity facilities and keep them down, making the eventual crisis worse.
Two: It creates a forex risk and losses to the central bank and the people since it is a state agency
Three: It creates a moral hazard for private banks as it allows them to dump the forex risk on the central bank and lend in rupees to customers or the government.
Four: In the language that modern isolationist macro-economists understand – or should understand – swaps are a threat to the credibility to its monetary policy.
As banks are sitting on large dollar balances at the moment, the temptation for Sri Lanka’s central bank must be irresistible to either swap them or borrow them and show dollars as ‘reserves’ to all and sundry and the IMF. And that has happened to some degree already.
Sri Lanka’s politicians can move and amendment to the central bank’s new inflationist and output targeting monetary law to ban forex swaps, as part of measures to prevent a second default.
Or legislators can draw up an outside law like the classicals did with the Bank Charter Act of the UK, and impose restrictions on the central bank through a second law notwithstanding its inflationist output targeting IMF-backed monetary law.
That will make it less easy for macro-economists to drive the country into a default in the future.
Support for swaps shows why countries with bad central banks keep returning to the IMF as bad habits are encouraged.
Once a country has defaulted, defaults tend to follow swiftly unless the central bank is restrained through tight laws on its ability to mis-target rates.
Through swaps, a central bank can mis-target rates without buying Treasury bills. In fact the central bank can print money and destabilize the country without contravening the ceiling on domestic assets in the IMF program, just like the Fed did in the 1960s as it went about busting the Bretton Woods.
Argentina’s central bank also ended up with negative foreign assets due to its dollar borrowings. It also issued dollar securities.
Same Story – All geographies, all centuries
For several years this columnist had warned that swaps would result in enormous losses for the central bank when the currency collapsed.
Though examples abound, the IMF dependent central banks continue to use swaps and get into trouble again and again.
The Central bank of the Philippines had to be recapitalized.
The Bank of Thailand got dollars from speculators and hit an own goal. .
So did the Bank of England in the ERM crisis. Fed minutes show it drew on swaplines in the run up to the late 60s Sterling crisis as well.
More recently Lebanon’s central bank borrowed dollars (took deposits) and eventually collapsed itself.
Argentina’s BCRA also does the same.
All this happens due to the policy rate. The swaps simply allow artificially low rates to be continued until the swap proceeds are lost.
Sri Lanka also has a history of this type of forex risk going back to a note issue bank before the current central bank.
The Eastern and Oriental Bank, one of two note issue (Chartered) banks that issued rupees in Ceylon closed its silver door in 1884 just like the Fed closed its ‘gold window’ and floated in 1971.
The Oriental Bank rupee collapsed 50 percent overnight but the Madras Bank’s rupee held according to surviving accounts of what happened in 1884.
The problem with the Oriental Bank was the same as Sri Lanka’s central bank.
Modern Saltwater/Cambridge central banks, borrow dollars, sell them in the forex market, and then prints large volumes of money to sterilize the intervention by repurchasing Treasury bills from banks to maintain its policy rate, worsening the credit cycle, leading to an eventual collapse of the currency.
The Eastern and Oriental Bank borrowed in Sterling and loaned in Silver. The rupee was Silver backed or silver denominated.
In fact, researchers who went into 19th century ledgers of the Bank of England found that Oriental Bank was a top borrower at its sterling discount window.
That is why this column advised that removing counterparty limits for borrowing through the standing facility or reverse repo auctions was a mistake.
The imposition of the counterparty limit was a key prudential move by the current management of the central bank.
The Oriental Bank closed its doors not only due to a parity problem between Silver and Gold.
It is unfortunate that in almost 150 years we have learned absolutely nothing.
Plus ça change, plus c’est la même chose
The Eastern and Oriental Bank did not just collapse due to exchange risk, but also because of its clients, the plantation companies were hit by falling prices (as a commodity bubble deflated) and could not repay loans.
The central bank which used Sri Lanka Government paper as collateral to print money into the banking system also ended up with a ‘bad loan’.
The restructure of Sri Lanka government debt had left it with hefty losses.
It must be noted that except when foreign debt is repaid with a reserve appropriation, or some deficit is being monetized through provisional advances (which was supposed to conform to the bills only policy), most of the money printed by a central bank targeting the potential output gap or policy rate has nothing to do with the government.
Government securities already in the balance sheets of commercial banks (from previous deficits) are taken to the central bank to conduct overnight term or outright reverse repo injections.
Before the Fed, central banks did not discount government paper but discounted actual trade bills (banker’s acceptances) from various fairly good companies.
The BoE researchers found that in the past, when some of the bill brokers or banks went down, the Bank of England did not actually have much losses, as the paper it took was from strong companies.
Violating bills only Policy
Either way the large mark-to-market losses of Sri Lanka’s central bank is from violating another classical central banking principle, the bills only policy.
This prudential practice was also violated in Sri Lanka in the general deterioration of policy after the end of the war, eventually ending in sovereign default.
Violating the bills only policy which was seen during the Yahapalana regime which was ousted amid currency collapses and low growth from stabilization program, allows inflationists to mis-target rates deeply into the yield curve, create forex shortages and bust the rupee.
In defence of the central bank it must be said that it took a hit on its balance sheet in 2023, so as to protect the government securities market and the move has helped bring down rates faster.
There are banking practices that must be observed in running banks.
There are even more stringent prudent rules to be observed when running a note-issue bank or a bank that can create its own reserve money or circulating medium as the classical greats used to say.
IMF has weak knowledge of operational frameworks of note-issue banks, in keeping with general saltwater doctrine, that is why its patients keep going back with increasingly worse symptoms and diseases.
The doctrine of the ‘portfolio-balance channel’ is laughable at best.
If the central bank is mis-used to target potential output, or if the domestic 5-7 inflation anchor rears its ugly head, a second default is not too far away.
A peaceful country, which overcame a civil war, was driven to a default with flexible inflation targeting/potential output targeting, the latest spurious monetary doctrine of the Saltwater/Cambridge inflationists.
Sovereign defaults hit the world like a Coronavirus pandemic after the IMF’s Second Amendment to its articles in 1978 led to severe monetary instability as the restraint from external anchoring was taken away from reserve collecting central banks.
Nothing of the ideology has changed, as can be seen with IMF endorsement of central bank swaps. That is why IMF-dependent central banks keep going back to the agency, again and again and the country sovereign-defaults within 10 years of getting market access.
If legislators and the public want to end a second sovereign default, outlawing swaps should be a key rule in a law that should be brought to restrain the central bank or revise the current law into a true central bank constitution and not a law that gives it discretion to create 5 percent inflation and run exchange rate policy on top.