A grave new risk emerged to Sri Lanka’s monetary stability and sovereign credit with the Treasury pressuring the Central Bank to print tens of billions of rupees to repay maturing long-term bonds and manipulate rates down. Such monetary bombshells undermine all and any rate hikes, and wipe out in one stroke all the extra taxes people are now paying to expand the tax-to-GDP ratio to keep the mega state afloat.
When large volumes of money are printed to repay domestic debt, the unfortunate consequence will be that the country will run out of foreign exchange and be forced to default on foreign debt. In other words, infantile monetary pyrotechnics raise a frightening spectre of the post-World War I Weimar Republic in Germany.
It is always good to remember that every action the Central Bank, the Treasury or any arm of Sri Lanka’s European style nation-state takes, or socialists do, or nationalists do in the name of home-grown policy, there are precedents in Europe.
For the negative state action that hurts the poor or violates the rights of citizens and dehumanizes them, precedents are mostly in Eastern Europe.
For actions that restrain the state and enhance the liberties of the individuals and make them rich, the precedents are mostly in Western Europe.
Derailed
The Central Bank’s policy stance was derailed from November 21, 2016, when it started to buy Treasury bills outright and with printed money, even before the monetary pyrotechnics that exploded silently at the dawn of the New Year. Not content with controlling overnight rates, the Central Bank was trying to influence the yields deeper along the curve by purchasing Treasury bills held by banks and the public, and giving them printed money in return. As the Central Bank bought bills, long-term bond yields fell. Instead of rates moving up and inflicting losses on foreign investors, the outright purchases allowed them to exit with minimal losses or even profits compared to only a week or two earlier.
Foreign investors must have escaped thanking their lucky stars for the unexpected bounty.
The nasty minded may think that there was some hanky panky going on and foreign investors were up to dirty tricks influencing the Central Bank to drive down bond rates and protect them from losses.
Operation Twist?
However, others would say this is the misguided type of action that can be expected from a high inflation, balance of payments-generating central bank. If the Central Bank did not print money and manipulate rates – at the top of the credit cycle – how can this country get into trouble so often?
If there is high inflation or balance of payments trouble, the central bank is doing more wrong moves than correct ones. The outright purchase of bills started on November 21, 2016, with the purchase of 59 day bills with Rs2 billion of printed money. By December 9, up to 226 day bills were being bought outright. On December 16, 287 day bills were bought. The policy continued until December 19.
It must be pointed out that, in the festive season week, demand for cash goes up due to festival cash drawdowns, and some of the money printed around the Christmas holidays is harmlessly absorbed by notes in circulation as reserve money expands.
In all, about Rs73 billion of bills were bought, signalling rates down. It seems that, at the same time, the Central Bank was also selling down some of its bills through bill auctions, in a type of ‘operation twist’, a move devised by the US Federal Reserve in as far back as 1961. It was also employed after the recent credit bubble burst. It is one thing to run a ‘twist’ at the bottom of the credit cycle, but quite another to do it at the top of the cycle.
The Central Bank would have been able to collect a larger volume of dollars in December 2016 if this policy reversal had not taken place. This is because individual banks make credit decisions based on their own balance sheet, especially in the short term.
[pullquote]The Central Bank’s policy stance was derailed from November 21, when it started to buy Treasury bills outright and with printed money, even before the monetary pyrotechnics that exploded silently at the dawn of the New Year[/pullquote]
The Central Bank has, in the past, also rejected bill auctions and bought bills at various tenors, to influence longer-term rates. The net results of all these actions is higher inflation down the road, or bigger property bubbles, which would have been nipped in the bud had rates moved with the market.
Rejecting bids at auctions, undermining the auction system and printing money are the most dangerous monetary policy tools practised by Sri Lanka’s central bankers.
Own Goal
Here is one way the chain reaction of the Central Bank buying bills from the banking system with printed money can be explained. When stock market investors go out, there is little pressure on the balance of payments or the rupee. It is not always so when it happens in bond markets. Exiting foreign stock investors have to find buyers with real money. Especially when markets are going down, people do not buy on margin or bank credit. In fact, margin calls come in. Stock prices also fall, discouraging some sellers and inflicting some losses on them in any case. (When interest rates rise, bond prices also fall, unless prevented by central bank money printing).
Let’s say a foreign investor wants to sell Rs2 billion of bonds. If a commercial bank wants to buy the bond, it will have to find Rs2 billion from deposits or loan repayments. If it spends the Rs2 billion it got from deposits or loan repayments on buying a bond from a foreign investor, it will have to give up the opportunity to extend Rs2 billion in new credit.
But bond buyers can finance purchases with printed money, even if the central bank does not print money by outright purchases of Treasury bills.
But let’s say the central bank called an auction to buy Rs2 billion of bills. A commercial bank will now sell Rs2 billion of bills to the central bank and generate printed money of Rs2 billion. The commercial bank will now be able to buy Rs2 billion in bonds and give Rs2 billion in credit, since the deposits were not used to buy the bond (if it was given to the Ceylon Petroleum Corporation to buy oil, it will end up in the forex market as well). Even if the central bank did not call an outright auction, a bank will also be able to go to the reverse repo window, give the bond and get printed money. This is the reason why stock outflows do not cause much BOP trouble, but bond exits do.
But even if bond investors are not involved, a bank will be able to give extra credit than it would have been able to with its own deposits, every time the central bank buys bills.
This is how central banks created balance of payments crises before bond investors came to the scene. Bond investors first became a significant feature only in the 2008/2009 BOP crisis. A central bank that wants to collect reserves and keep the exchange rate steady must refrain from buying bills outright and instead use moral suasion and other tools to discourage continuous borrowings by banks and primary dealers from liquidity windows. In 2016 in particular, it was Perpetual Treasuries that borrowed like no tomorrow from the window, bought bonds and helped lose forex reserves. It was given money without bonds to place in the window, according to leaked reports.
There is no point in employing moral suasion on forex dealers. They are mere pawns of created money. In this context, it would be useful for Sri Lanka’s central bankers to visit Bangladesh and see how they conduct monetary policy, even if they view countries like Singapore, Hong Kong or Dubai as simply ‘too advanced’ or as having some similar inferiority complex.
New Year Bombshell
It is in this context that the monetary bombshell went off as New Year dawned. We have to re-build what happened from the broken shambles left behind, as official information seems hard to come by. The entire operation seems shrouded in mystery.
EconomyNext.com had made references to this event without any named sources. At the last press conference, the Central Bank governor also sidestepped the issue and instead referred the reporter to the Treasury. He had, however, gone on record as saying it was not bank ‘policy’, but a procedure involving solving a cashflow issue and advance accounts.
In other words, a milch cow operation or an ‘arm twist’ operation where the governor was forced to print money against his better judgement through fiscal dominance. The governor must be protected from being forced to engage in this type of transactions, via effective reform of the central bank law.
This is what we know
On December 30, 2016, the Central Bank’s Treasury bill stock went up from Rs219 billion to Rs330 billion. But, excess liquidity did not go up in proportion. In fact, excess liquidity fell to Rs39 billion on December 30 from Rs29 billion a day earlier. (Part of the original excess liquidity in December could have come from dollar purchases. Here was an opportunity lost to mop up liquidity and build up forex reserves. This is another instance of how reserve collections and dollar payments are directly undermined when money is printed.)
There are a couple of instances when liquidity may not go up when T-bills are taken to the central bank balance sheet. One instance is when external loans are settled with foreign reserves. But this time, liquidity came back again on January 2, when a large tranche of bonds matured but only about half of it was put to the auctions. The advance accounts reference also points to a clue.
If liquidity generated from Treasury bills was offset against provisional advances given in the past by the Central Bank on December 30, there will be no increase in liquidity. It then seems that, in January 2017, the Treasury demanded provisional advances again. Excess liquidity then shot up to Rs108 billion. On January 3, excess liquidity was up to Rs121 billion. No country suffering balance of payments problems can afford to allow this type of situation to occur.
Damage control
The Central Bank acted quickly to contain the damage from the first week of January. It progressively sold down its Treasury bills, refusing to roll-over maturing bills in its portfolio. By February 8, liquidity was back to zero, which took a little over five weeks. The T-bill stock fell from Rs330 billion on December 30 to Rs226 billion on February 9.
Data show that the Central Bank also sold $139 million (selling $204.5 million and buying $64.6 million) in January and $152.16 million (selling $297 million and buying $145 million) in February, mopping up some excess rupees that ended as imports. Liquidity became short again from February 8, as the rupee peg was defended. Asked whether the Central Bank will again repay bonds with printed money flooding the market, Governor Coomaraswamy was quoted as saying, “I hope not.”
This is important because, if large volumes of money are printed to repay domestic bonds, it will lead to forex reserve losses, and the government will eventually be forced to default on foreign loans, if investors refuse to roll over bonds.
It is a Mercantilist fallacy that the government’s foreign loan repayments are linked to export revenues or export surpluses. Export revenues do not go to the government. They go to the people who will save some and spend the rest.
The government has to raise money either through taxes or borrowings in the domestic market to repay foreign loans. Such loan repayments will create a deficit in the financial accounts and lead to a surplus in current accounts or even trade accounts.
[pullquote]A central bank that wants to collect reserves and keep the exchange rate steady must refrain from buying bills outright[/pullquote]
Weimar Republic
All this is related to a problem that Keynesians never understood. The phenomenon was famously underlined by the debates between Swedish economist Bertil Ohlin and Keynes in the 1920s over what was referred to as the ‘transfer problem’.
Keynes believed that war reparations led to balance of payments problems in the Weimar Republic, which eventually descended into monetary chaos. The allies were misled into thinking that a ‘favourable’ balance of trade was needed to repay foreign loans.
“The truth is that the maintenance of monetary stability and of a sound currency system has nothing whatever to do with the balance of payments or trade,” explains economist Ludwig von Mises. “There is only one thing that endangers monetary stability – inflation. If a country neither issues additional quantities of paper money nor expands credit, it will not have any monetary troubles.”
“An excess of exports is not a prerequisite for the payment of reparations. The cause, rather, is the other way around. The fact that a nation makes such payments has the tendency to create such an excess of exports. There is no such thing as a ‘transfer’ problem. If the German government collects the amount needed for the payments (in Reichmarks) by taxing its citizens, every German taxpayer must correspondingly reduce his consumption either of German or of imported products.
“In the second case, the amount of foreign exchange that otherwise would have been used for the purchase of these imported goods becomes available. Thus, collecting at home the amount of Reichmarks required for the payment automatically provides the quantity of foreign exchange needed for the transfer.”
Mercantilism
An export surplus was not needed to repay foreign reparations, or in Sri Lanka’s case, loans. However, exports will grow faster if there is bank credit and money printing. “All the German political parties shared responsibility for the inflation,” noted Mises. “They all clung to the error that it was not the increase of bank credits but the unfavourable balance of payments that was devaluing the currency.” Like Germany, Sri Lanka’s Treasury seems to be playing with a similar dangerous ideology. Like Germany, Mercantilists’ beliefs are widespread among all sections of society, brought about by years or decades of Mercantilist fallacies drummed into their minds.
Mises forecasts Germany monetary problems from 1912.
“But most of those men, between 1914 and 1923, were in a position to influence Germany’s monetary and banking policies, and all journalists, writers and politicians who dealt with these problems laboured under the delusion that an increase in the quantity of bank notes does not affect commodity prices and foreign exchange rates,” he said. “They blamed the blockade or profiteering for the rise in commodity prices and the unfavourable balance of payments for the rise in foreign exchange rates.”
[pullquote]It is a Mercantilist fallacy that the government’s foreign loan repayments are linked to export revenues or export surpluses[/pullquote]
What is needed in Sri Lanka now is to maintain monetary stability and the confidence of lenders to roll over most of the debt, while generating cash – in rupees – from taxes and borrowings to meet the obligations. The path to low inflation, currency stability and sound external credit worthiness is to stop printing money and auction all domestic bonds for real money.
The current administration is right to pursue a policy of auctions. But if money is printed to repay bonds, auctions are torpedoed in the worst way possible. The so-called gilt edge is also a fallacy. If Sri Lanka prints money to repay domestic debt, creating new consumption and imports, there is no way to collect foreign exchange to repay foreign loans or indeed to re-build forex reserves.
This column warned the Central Bank from late 2014 not to print money because such risks were no longer possible with foreign investors in rupee bonds. Many have already fled. Blaming fund managers like the Germans blamed the Jews will not help. With foreign reserves already depleted, additional printing will lead to foreign sovereign default as well.