ECONOMYNEXT – Sri Lanka’s central bank has injected around 100 billion rupees against domestic assets through multiple liquidity tools by October 25 official data show, driving up excess money in the banking system to over 190 billion rupees.
The central bank injected 36.16 billion rupees through an overnight auction and 70 billion rupees for 7 days through a term auction of printed money.
Monetary Methamphetamine at 8.27-pct
By offering 40 billion rupees to all comers as low as 8.27 percent (just 2 pips above the floor rate) where only 36 billion rupees were bid, the monetary authority prevented overtrading market participants from borrowing at its 9.25 percent standing facility and encouraging them to trade without deposits.
In the run up to the election period – where there could have been a drawdown of cash – the central bank acted less imprudently and some banks went to the window and borrowed at 9.25 percent.
Since the central bank was set up in 1950, the agency has resorted to various means to print money to mis-target rates, triggering forex shortages and monetary instability.
It then either imposed trade and exchange controls, or egged on politicians to do so, crippling economic activities and eventually driving up interests to very high levels, by its inconsistent policies.
The Money Printing Lie
Sri Lanka’s macro-economists have led the public and politicians to believe that a new discretionary monetary law, which cannot be labelled a central bank constitution due its excessive discretion (flexibility), has blocked its ability to print money.
However, through open market operations (essentially instrument independence) the central bank has unlimited powers to print money and inject money into banks to trade without deposits.
It is laughable that the IMF has criticized central bank financing of primary dealers but not banks. Primary dealers get temporary money, but it is liquidity addicted banks that finance investment credit through term, outright and ‘operation twist’ money.
Sri Lanka’s original central bank law, which gave the powers to macroeconomists to control rates buy purchasing Treasury bills, provisional advances for six months to directly finance the budget, or up to 12 months re-finance credit, also put a restraint through a gold and exchange rate peg.
However, no such restraints now exist under a ‘flexible exchange rate’ and the IMF’s second amendment to its articles which Sri Lanka followed after 1978 and ended up with Greater than Great Inflation and IMF programs, but East Asian export power houses did not.
Pushing down gilt yields?
It is not clear why such large volumes of money is being printed through liquidity tools, but it may be to suppress government securities yields, which is an indirect form of monetizing deficits.
In the original central bank law devised by John Exter, the central bank was not expected to buy bonds directly from auctions.
“So long as open market purchases of Government securities are allowed (as, of course, they must be), it is very difficult to prevent these becoming an indirect means of making central bank credit available to finance Government deficits,” an analyst writing in The Banker magazine said in 1950 prophetically describing what happened later.
Modern-day politicians generally do not understand the arcane domestic operations of state-owned central banks unlike the legislators of the 19th century, who brought effective laws against the central banks which were not independent but tightly regulated and prevented the age of inflation (and currency crises) from starting.
Rate cuts through OMO which trigger exchange rate instability (exchange rate as a first line of defence), will drive speculative behavior by exports and importers eventually trigger capital flight, loss of confidence, and even higher interest rates.
Destruction through Instrument Independence
When the central bank was set up in 1950, Treasury bill yields were less than one percent, and age-of-inflation concepts like ‘real’ interest rates were almost unknown.
As the obsessive targeting of short-term rates by printing money fired inflation, concepts like real interest rates came was brought into common use by age-of-inflation macroeconomists who had weak knowledge of monetary operations but were strong on statistics.
“There wasn’t a focus on real interest rates at the time, because there wasn’t an assumption you were going to have much inflation,” Paul Volcker said in a 2008 interview on his decades of experience in the US Treasury and the Fed.
“The term “real interest rates” was certainly known, but I think that’s right, we didn’t think in those terms that much until the inflation had persisted for a while.”
It was through open market operations that the Federal Reserve triggered an economic bubble and a Great Depression without a war and repeated defaults started in Latin America after the IMF’s Second Amendment in 1978 despite having low deficits and high revenue to GDP rations.
Mexico debt crisis in 1994 from open market operations took place with a budget surplus amid strong private credit.
It was through open market operations that the ‘independent’ Federal Reserves destroyed the Bretton woods, trigger Great Inflation and the housing bubble.
Muted Economy
When private credit is weak it is possible for and ‘independent’ central bank to print money and get away without too much instability.
Ironically the Federal Reserve agreed to buy Treasuries of multiple maturities during World War II to keep rates down with less impact on the BOP than in 1951.
But when the war stopped and private credit picked up, it halted the activities to prevent shortages and rationing from becoming worse. US officially ended rationing in 1947.
However, the Fed continued to defend the price of the Liberty Bonds leading to what is generally called the Korean War bubble.
The so-called Fed Treasury Accord that led to an ‘independent’ Fed came from the tug-o-war to end open market purchases of long-term bonds.
At the time the Fed had Marriner Eccles, a banker who was familiar with central banking (having himself transformed its operations while he was chair) who was running rear guard action.
However, that knowledge was lost within a decade and the Fed invented central banks swaps after fanning inflation and balance of payments problems with long-cycle rate cuts for full employment, followed by lean-against-the-wind policies (stabilization).
At the forefront of inflationism were post-Keynesians in saltwater universities, from the where IMF does most of its hiring.
IMF programs rocketed in the 1960s – Sri Lanka also started its IMF programs in the mid-1960s – as countries that did not follow Fed cycle ran into severe BOP deficits amid rising commodity prices including gold.
Reform Red Herring
There were no economic reforms in IMF programs at the time, and the programs were sharp and short to fix the BOP.
The economic reforms were an obsession that started after Margarat Thatcher’s reforms, which were essentially outside its last IMF program which the agency believed to be most successful and tried to replicate in Latin America with no success due to soft-pegging.
Competitive exchange rates instead triggered social unrest and more defaults as budgets became un-manageable.
Thatcher came to power in the stabilization crisis of UK’s 11th IMF program generally referred to as the winter of discontent, but kept tight monetary policy, cut direct taxes boost individual freedoms and choice and raised VAT.
The central bank is currently under a ceiling on domestic assets under the IMF program which crimps its ability to print money through open market operations up to a point, and interest coupons on its long-term bond portfolio is also deflationary.
Amber Lights
Its short term injections in recent months came partly as a result of selling down maturing bills in chucks instead of internally rolling over part of the stock to maintain gentle and steady deflationary pressure on central bank rupee reserves by controlled selling down of its Treasuries stock.
The central bank has now run of short-term treasuries. The complex two-way OMO will eventually bring the monetary house of cards down when private credit recovers and rates are cut.
Sri Lanka’s central bank has done very well so far.
But the obsession with the single policy rate and the use of open market operations (rather than liquidity from dollar purchases only) to push the mid-corridor rate towards the lower floor are warning signs of what is to come.
The single policy rate which will require more aggressive inflationary open market operations as private credit recovers and will bring the second default of sovereign default and social unrest closer.
The new administration will then be blamed for not carrying out reforms as others have been before.
These are tried and tested narratives, which were peddled by Anglophone statistical macroeconomists which were fine tuned from the 1960s and originated from the 1930s.
Macroeconomists will escape accountability as they have done for decades in other countries with exchange controls, inflation, depreciation and default, politicians and more importantly the poor will pay the price. (Colombo/Oct17/2024)