Sri Lanka is on the path to recovery now that monetary stability has been restored, but care must be taken not to create instability by trying to artificially push down interest rates. Many sectors of the economy are now operating almost normally, except construction and property. Exports are under pressure due to weak foreign demand. However bad loans are showing signs of peaking and new credit is starting. Even in construction, some activity
is starting slowly as people are getting more used to higher prices of raw materials. Next year government construction will also start on halted projects. Exports are a dampener, with weak external demand. However,
more people have also left the country after the currency collapse and remittances may compensate for the loss in exports. Sri Lanka’s interest rates are coming down generally.
BOP Deficit
The biggest threat to this country since the end of the civil war has been rate cuts enforced by open market operations.
The easiest and most simple rule of thumb to determine whether or not interest rates are below market in a country with a reserve-collecting central bank is the exchange rate. Having said that, the time to cut rates is when domestic credit demand is weak and the balance of payments is in surplus.
In October the central bank was still a net buyer in the forex market at the structure of interest rates that prevailed at the time. That means there was no net money printing. If money is printed either the currency will fall or the BOP will be in deficit. With the ceiling on Net Domestic Assets, in the IMF programme ,it is less easy to print money, but many developing country central banks it is less easy to print money, but many developing country central banks
will set high inflation targets anyway.
Domestic Cash Buffers
In November only part of the maturing bonds were rolled over. Instead, some cash deposits in commercial banks were used to repay bonds. This is 1000 thousand times better than using standing facility money or reverse repo money to repay bonds, which triggers forex shortages or currency weakness.
For one thing, it is necessary to find where the money came from. If they were found from Treasury bill sales, then there is no net benefit as interest rates before the bond auction would have been higher due to extra bill sales.
Therefore, while it may be possible that the cut-off rate in a particular auction may be lower, in the run-up to the auction, rates would have been higher than otherwise due to raising money earlier.
However, that is not to say raising money at higher rates short term is a bad strategy. A spike in the Gross Financing Need (going short-term when rates are high) is a normal market phenomenon when rates go up.
But to get the benefit, it would be better to reduce the auction volume so that some of the maturing bondholders know that unless they bid low they may miss the bid. The government can therefore benefit from a downward sloping yield curve with a higher GFN at the short end.
If the money was raised from taxes (the primary surplus) it would have been better to pay interest than repay the principal. It is always better to roll over paper as paper unless the government is running an
overall budget surplus.
Raising money from taxes can reduce the total borrowing requirement, though savings may be reduced. That however is not the biggest problem with domestic cash buffers, in the context of a fixed policy rate.
The Problem with Domestic Cash Buffers
Domestic cash buffers, regardless of whether they are built with taxes or borrowings, have one big problem.
One problem is that when the money is deposited in banks in an interest-bearing account, banks may loan the funds in the interbank market. If they loan to banks in the interbank market, it may trigger private credit and imports, nullifying the benefit of building the buffer in the first place. And if a large volume is suddenly drawn down, interbank lines have to be cut and a whole bunch of banks will go to the central bank standing windows to borrow.
It may not matter much now, but when private credit picks up, the banks that get the money from bonds that were not rolled over will lend the money triggering imports while a bunch of other banks, will end up borrowing from the window. Even if the money was placed in the central bank by the state bank, due to the policy rate, imbalances can happen.
This is not the case if the money was invested externally. That is why countries like Singapore or other stable countries with strong exchange rates, invest cash in sovereign wealth funds, even when the money is raised from borrowings, like the GIC.
Cash Buffers Under the British
Under British occupation, Sri Lanka had a fixed exchange rate without a bureaucratic policy rate and any cash buffers were deposited in the currency board.
Depositing cash in the currency board led to a liquidity shortage, a rise in interest rate, a surplus in the BOP and an increase in the foreign assets of the currency board. This is similar to what happens when Singapore’s
GIC issues domestic currency, its monetary authority converts the Sing dollars to foreign exchange and invests them outside the country.
When the cash was drawn down, liquidity built up, rates fell, and there was a deficit in the BOP leading to a fall in the foreign assets of the currency board. If there is a central bank however, even if the money was deposited in the central bank, due to the policy rate, interest rates would not go up and there would be no BOP surplus like in Singapore or Ceylon under the currency board, or Hong Kong.
When credit growth picks up, it will lead to liquidity injections to maintain policy rates and external instability.
Smoothening Gilt Rates Counterproductive
Smoothening gilt rates may also be counterproductive for another reason. This year there are heavy rains. Heavy rains tend to boost hydropower (raise GDP) and reduce the borrowings of the Ceylon Electricity Board. It may also lead to repayment of debt. That will automatically reduce overall credit demand.
However, in the first quarter, there is usually a drought. Rates mustn’t be suppressed in the first quarter. If there is a need to borrow more and that is an annual occurrence, rates have to be allowed to go up so that money flows into
g-secs in that period.
To roll over in that period rates may have to be elevated. In such cases, short-term rates should be allowed to go up. The instability, poverty and social unrest in these ‘developing’ countries which can never develop to the
levels of more stable countries is a result of obstinately trying to control money through artificial means.
When central banks are taken out of the picture, when countries have currency boards or are dollarized, interest rates magically fall, banking crises almost disappear (without access to standing facilities banks cannot overtrade or
take excessive risks) and fiscal metrics improve.
Even floating countries do well when the inflation target is low.
Most of the inflation that the world suffers in peacetime as a result of non-market interest rates, comes from the 1920s with interest rate manipulation – now called macro-economic policy – that was developed by the Federal Reserve.
Sri Lanka’s interest rates will fall, but when half the capital has been destroyed by inflation, it will take some time. Other than attempts to borrow short when there are revenue shortfalls or expenditure peaks, any other interventions are likely to backfire – as they have done before.
As the economy recovers, there may be pressure on interest rates. The worst possible response is to suppress the rates. That will push the country into another crisis and higher than required rates to stabilize – the formula for
chronically high-interest rates.
This country is not a second-class country. Its interest rates are high and inflation is high due to a third-class monetary anchor.