Sri Lankan cabinet ministers back finance minister to seek IMF support
ECONOMYNEXT – Sri Lanka’s cabinet of ministers has given Finance Minister Basil Rajapaksa the go-ahead to approach the International Monetary Fund, a government minister has said as the loosely pegged rupee suffers the worst currency crisis in its history.
“The Minister of Finance told us (at the Council of Ministers) that we will have to go to the IMF. What are you saying?” Minister Chandrasena told Sri Lanka’s Derana Television on a late night talk show.
“We all said to go. I also said to go. No one objected.”
Sri Lanka has a loose, Latin American-style peg put in place by an American money scholar in 1950 that depreciates whenever domestic credit picks up and economists using Keynesian dogma try to control interest rates. interest by printing money.
The rupee fell from 203 to around 265 to the US dollar over the past week after the central bank launched a currency float (suspension of convertibility) to end sterilized interventions.
Analysts said a buy-back rule requiring commercial banks to sell dollars to the central bank for fresh money undermines the float and further weakens the currency.
Sri Lanka’s Keynesian economists who favor government spending, fiercely oppose market-determined interest rates, and push the country into currency depreciation after creating large domestic credit imbalances with artificially low interest imposed by money printing (central bank credit).
Many ministers publicly supported the choice of an IMF program, while anti-austerity economists opposed it ideologically.
The IMF mainly stabilizes a country by raising rates to reduce domestic credit and also raising taxes to reduce the deficit, which also helps to moderate interest rates.
Maintaining a fixed or stable exchange rate by allowing short-term rates to float is the simplest monetary regime in the world. It was the cornerstone of economic stability in most East Asian countries.
The minister’s comments came as the IMF’s Asia-Pacific director, Changyong Rhee, is on a visit to Sri Lanka to brief President Gotabaya Rajapaksa on the Washington-based lenders’ staff report of the board’s comments.
The IMF has warned that Sri Lanka’s economy could implode unless money printing is stopped.
Economic analysts have warned since the central bank launched aggressive open market operations (targeting the overnight money rate with excess liquidity) that the country is asking for a monetary collapse.
Analysts also warned that Sri Lanka was not Greece but had a Latin American-style central bank that was modeled on Argentina’s BCRA and that the results would not be the exaggerated problems of the Western anti-austerity brigade but a real pain for all and the poor in particular.
Sri Lanka’s monetary collapse will accelerate unless swift action is taken: Bellwether
Sri Lanka isn’t Greece, it’s a Latin American-style soft-peg: Bellwether
What is Greece?
Greece had a monetary union with a strong floating exchange rate, which was the euro. When it emerged that Greece had falsified debt figures, amid an economic downturn, lenders refused to roll over debt and there was a sovereign default.
But the currency did not fall. There was no destruction of wages. Although some people lost their jobs in the general slowdown, their deposits in banks that did not fail remained intact.
There was no explosion of inflation because Greece had the euro. To understand what this means, imagine that everyone in Sri Lanka receives salaries in dollars, has bank deposits in dollars, and pays taxes in dollars. The government could use “dollar” taxes to pay salaries and also repay bonds to foreign or local lenders.
When the economy contracted and tax revenues fell, Greece had to resort to “state austerity”.
It’s about cutting public sector wages and raising taxes for people with higher incomes. It’s like a Sri Lankan government employee having a salary in dollars, losing 5 or 10%, then the richer people pay higher taxes or everyone pays taxes if the value added tax is increased. Even if the VAT was increased from 15 to 20%, people would only lose 5% of their salary.
Under the euro, a local business can still repay foreign loans. They can also borrow domestically or use their bank deposits to repay foreign loans. Importing goods is not a problem because the euro is accepted abroad.
Fuel or electricity prices have not risen sharply. They were the same as any stable eurozone country like Germany or France. Since there was no explosion in inflation, the value of bank deposits remained intact. Although there is a sovereign default and possible haircuts on the state debt, there is no private default or haircut.
But a falling currency imposes a haircut on all public and private debt, including bank deposits in solvent banks. Pensions are rendered worthless, hitting the elderly the hardest.
A collapsing loosely pegged currency will put all citizens other than the very wealthy in serious trouble, unlike a strong floating exchange rate like the euro.
Three Sins and a Monetary Collapse
In a loosely pegged monetary regime like Sri Lanka, the currency continues to fall whenever the central bank intervenes in the foreign exchange markets and then prints money to keep interest rates low.
As long as the currency is not floating, there is no end in sight for the depreciation of the exchange rate, especially if interest rates are not raised and credit does not slow down. What usually happens in Sri Lanka and other soft pegs is that ultimately rates have to be raised and the currency floated. This is the phenomenon called ‘rawulath ne kendeth ne’ in this column.
When a currency is floating, this cycle of sterilized intervention is broken.
Soft-pegs are a horrible slippery slope, not like Greece
Latin America has loose pegs and central banks that inject money in multiple ways through different windows and tenors like in Sri Lanka which is one of the most dangerous monetary regimes in the world.
Sri Lanka’s central bank is not only injecting money overnight, but also through longer-term reverse repo transactions at overnight rates during monetary pressure. It is not an official crime in Sri Lanka.
The central bank is also injecting overnight money below the ceiling rate despite the monetary pressure. It is not listed as a crime against the nation in the penal code.
The central bank also buys treasury bills at auctions to inject money during monetary pressure.
Luckily, in the current episode, it’s been minimal. It’s not listed as a crime either.
All these actions must be reviewed in detail to avoid economic collapses in the future.
In Latin America – unlike Greece – when the currency falls sharply, prices rise and people’s standard of living plummets because most of the money goes to food and medicine. This is failing many businesses as demand plummets.
Then the banks have bad debts and suffer losses.
Unlike Greece, the government of a loosely pegged country cannot raise funds in domestic markets and repay foreign loans, even at prohibitive interest rates. The government can fail. Downgrades will compound the problem, pushing interest rates higher.
As prices rise with currency depreciation, the value of bank deposits evaporates. If the currency drops 50%, local businesses will now have to borrow more to repay foreign loans, which will create massive holes in their balance sheets even if forex were available for purchase.
If exchange controls take hold, there will be no more dollars to buy with the domestic money they have borrowed.
It is not possible to freely import goods when a soft-peg collapses as there will be currency shortages due to sterilized intervention. Import controls may also come.
As the cost of fuel or electricity increases (oil prices go down and it rains in Sri Lanka), if prices are not increased, more money will be printed to subsidize energy, which will drop the currency.
In Latin America, energy price controls have led to currency printing and rationing. There may be power outages and fuel shortages.
In Sri Lanka, due to drug price controls by the National Drug Regulatory Authority, drugs may disappear from the shelves.
In the soft pegs of Latin America, numerous price controls have been imposed. Instantly, goods come off the shelves and black markets appear.
With import controls, more companies will go bankrupt. People will be laid off as incomes drop. Banks will make more losses. Rates will eventually rise. More businesses can fail.
If this situation persists for several months, there may be runs on the banks. If money is printed to bail them out, the currency falls even further. This phenomenon has been observed in many soft anchors in Latin America and also in Indonesia during the East Asian crisis.
The debt-to-GDP ratio will explode until inflation catches up. The share of external debt will also increase.
This is what is happening in Latin America. It’s not Greece.