Now that Sri Lanka’s central bank has made a pro-cyclical rate cut as private credit is recovering, reminiscent of its actions in 2015, 2018 and the second half of 2019, the time has come for the government to start taking counteraction to reduce the risk of another default.
One is setting up a dollar trading purchasing mechanism at the Treasury.
An important point to remember is that Sri Lanka defaulted due to extreme macroeconomic policy involving severe rate cuts and tax cuts, including car import bans that slashed revenues and triggered more money printing to maintain the reduced policy rates.
All these policies were cooked up either at the central bank during the Yahapalana and Gotabaya Rajapaksa administrations by the Monetary Board itself, Treasury officials or Secretaries who were former central bank staff and therefore had no fear of open market operations or rate cuts.
The macroeconomists will fly under the radar, and the Finance Minister, the President and the entire 225-member Parliament will be held accountable by the people for both depreciation and default.
Macroeconomists will likely oppose any direct move to counter inflationism on the grounds of central bank independence.
However, setting up a dollar purchasing desk (which can be done through a commercial bank or banks) is not a challenge to the central bank or its inflationism. All SOEs have that freedom. There is no reason for the Treasury not to have that, too.
Monetary Defaults with German-style Debt
While Sri Lanka defaulted amid a combination of rate and tax cuts (most East Asian nations also cut taxes and borrowed more, but nothing happened), Latin American countries defaulted simply from the shattering impact of open market operations.
Due to their proximity to the United States, Latin America’s central banks are most exposed to spurious monetary doctrines from Saltwater universities.
Argentina has defaults with relatively low debt in the region of 40-60% of GDP and deficits of 5% of GDP or less.
The serial defaults started after the IMF’s Second Amendment, which led to unanchored monetary policy and the explosion in central bank domestic assets, just like in Sri Lanka, with forex shortages, currency collapses coming in the year before the actual default.
The debt-to-GDP ratio then explodes like central bank assets do, with foreign debt ballooning due to the currency collapse, interest rates rocketing to save the peso and the central bank, and tax revenues collapsing in real terms as the economy contracts.
In the post-IMF Second Amendment defaults, Argentina’s debt-to-GDP ratios were around the same as Germany’s, according to the IMF’s own data, just before massive money printing began. So, what the IMF and macroeconomists say about the GFN, tax-to-GDP ratios, has to be taken with a pinch of salt. These are just statistics, not economics.
The problem is monetary instability. Before every default, BCRA’s assets explode as macro-economists follow Saltwater monetary ideology propagated by the IMF with policy rates and ‘monetary policy modernization’.
That is why Argentina’s defaults are serial. IMF programmes do not help because they try fiscal fixes, but the flawed operating system of trigger-happy central banks destabilizes fiscal metrics.
In a pegged exchange rate regime, it happens very fast because forex shortages emerge. It is more difficult for a central bank to bankrupt a floating regime. But the Federal Reserve is having a jolly good try, and others with ample reserve regimes are also having a go at it.
Banks of Issue Before the Policy Rate
When central banks were set up in Europe about two hundred years ago, they acted as bankers to the government or the king. They sold debt as an agent of the Treasury and provided gold (or foreign currency in some countries) to settle debt.
In different countries, reserves were given in different ways, but since most of these banks were private, there were mechanisms to do it, and they were not outright appropriations, which hit shareholders.
Because these central banks did not have policy rates, and had no belief that they could run get-rich-quick schemes to push up employment, growth or inflation, there was no real problem in giving reserves or managing reserves for the government.
Without a policy rate, any reserves sold for cash (bank notes) automatically reduced reserve money and credit and pushed up interest rates, which led to a recouping of foreign reserves.
Any reserves given as a loan could similarly be repaid over time in gold from money raised from treasury securities issues. Without a policy rate, there is no question of having foreign exchange shortages.
The government could also go to the market and buy gold or foreign exchange with its tax revenues or the money raised from Treasury bills or bonds. This is the crux of the matter.
The difference between the government and the central bank is that the government can buy dollars in the market without expanding reserve money, but the central bank cannot. Any dollar purchases by the central bank (from an earlier deflationary policy) lead to an expansion in reserve money and a fall in rates.
As a result, the government’s ability to raise dollars depends on the central bank’s willingness to run a deflationary policy. Once the IMF’s falling ceiling on domestic assets of the central bank is removed, there is no tool to force the central bank to run deflationary policy (other than coupon payments on its debt).
As an independent agency obsessed with a 5% inflation target, it is bound to run an inflationary policy and put the government in difficulties.
The money printing in the last quarter of 2024 and the latest pro-cyclical rate cut make it urgent that the Treasury raise its own dollars independent of the central bank. The mid-corridor rate (called the single policy rate) and the 5% inflation target will have precisely the same outcome as they did during the Yahapalana administration.
Public finances will be endangered, but the parliament will be helpless unless it passes a bill requiring the Treasury to buy its own dollars in the market.
Ceylon Government Deposits in the Currency Board
Before the creation of the central bank with a policy rate, there was no such problem. When the Ceylon government deposited cash in the Currency Board, it automatically led to a contraction in reserve money and credit and a rise in foreign reserves of the currency board.
The same thing would happen if the Ceylon Government gave cash and asked for dollars from the currency board. Dollars would go out, but they would be replenished when reserve money and credit contracts disappear into the currency board due to government tax or loan proceeds.
In Singapore, the Monetary Authority, which does not have a policy rate, engages in some complex operations. All cash operations of the Singapore government pass through MAS, as does the CPF which tends to influence reserve money and interest rates. As there is no policy rate, Singapore can build reserves easily.
Outside of Singapore, especially former cabinet ministers and prime ministers who directly worked under Goh Keng Swee, officials of a few other countries and a few living classical economists, this knowledge no longer exists.
In a central bank with a policy rate, building reserves, maintaining monetary stability or repaying debt is difficult. The mechanism set by John Exter to give reserves from the central bank, which had a fixed exchange rate, was to issue a new Treasury bill and buy reserves from the central bank.
This does not lead to a change in reserve money – any money created and deposited in the Bank of Ceylon is returned to the central bank immediately to buy reserves, and at a net level is the purchase of a Treasury bill by the central bank in return for foreign reserves.
Unlike a currency board, this transaction does not lead to a tightening in the credit system (a rise in interest rates or a contraction in reserve money) and an automatic increase in foreign reserves. To rebuild the reserves, the central bank has to sell down the Treasury bills, which will lead to a contraction in credit and a rise in interest rates.
In the new monetary law, the central bank is not expected to buy Treasury bills directly. If existing rupees are given to buy dollars, and the interest rate rises, the central bank will print money to push down the Overnight Policy Rate.
Interest on the Bond Portfolio
A further complication has arisen. The central bank previously had Treasury bills, which were zero-coupon instruments.
The bond portfolio held by the central bank now has coupons. When the government pays the coupon, the reserve money will contract. In other words, coupon payments on the CBSL bills lead to a deflationary policy.
However, as private credit picks up and excess liquidity falls from coupon payments, money will be printed under the single policy rate to maintain the OPR and offset the disappearing cash from the coupon payment into the central bank. That is to say, the deflationary policy will be reversed.
That will lead to more domestic credit, lower interest rates than are required to repay debt, forex shortages, and reserve losses. This makes it very dangerous for the Treasury or the Finance Minister to depend on the central bank for dollars to repay foreign loans, and parliament’s control of public finances.
Yahapalana Foreign Borrowings
That is partly why Sri Lanka defaulted. Flexible inflation targeting – or operational frameworks with different labels but with the same flaws and rejection of economic principles are also responsible for peacetime defaults in Latin America and some African countries.
During the Yahapalana period, flexible inflation targeting and a low policy rate led to reduced reserve collections, but it was covered by extensive foreign borrowings, undermining public finances. Extensive foreign borrowings led to artificially lower interest rates, excessive investments, bigger savings, and investment gaps (current account deficits).
That is why cement imports were higher during the Yahapalana administration than during the Rajapaksa administration, when all those investments were supposed to have been done with Chinese loans.
The $10 billion ISB’s and the syndicated loans, including from China, to offset artificially low interest rates from flexible inflation targeting and potential output targeting, dwarfed China’s Belt and Road loans.
After defaulting and being kicked out of financial markets, the Treasury can no longer depend on new external borrowings to cover up for rate cut errors from targeting high levels of statistical inflation and rejecting economic principles and laws of nature.
Buy Dollars from Treasury Bill Proceeds
To head off another default, the Treasury must buy its own dollars from money raised from markets and taxes. It should set up its own FX dealing desk to do that. It can also give the money to a commercial bank and instruct them to buy dollars as importers or the Ceylon Petroleum Corporation.
The additional funds raised from Treasury bonds will lead to a rise in interest rates and crowding out of private credit. The idea is to switch the dollar settlements with rupee loans.
Since the government is running an overall deficit in the budget, it is impossible to repay all debt on a net basis. However, switching dollar debt to rupee debt is possible if the central bank does not have a deflationary policy.
If the central bank runs a neutral policy, influencing only short-term rates and not transmitting the rate along the yield curve, the Treasury will be free to raise rupees and buy dollars at other rates. The central bank should be barred from yield curve targeting and confined to a bills-only policy.
Then the agency will be unable to influence longer-term rates as it did in the ‘Operation Twist’ style action through which the Yahapalana economic policy was discredited and ultimately brought down.
If the central bank prints money through open market operations and triggers forex shortages as it did in 2015, 2018, and 2020, the government will not be able to buy dollars in the market, just as CPC was unable to in 2018.
At the time, the government also resorted to heavy borrowings through the Active Liability Management Law, again understating the actual interest rate required to generate dollars to repay maturing instalments. As the central bank ran an inflationary policy to cut rates, the CPC, which had the facilities to buy its dollars, was also told to get suppliers’ credit, which was turned into state bank loans.
The foregoing shows that while a dollar trading desk reduces the risk of the Treasury ending up with no foreign exchange if the central bank refuses to run deflationary policy using its ‘independence’, and continues to cut rates, it may be able to buy some dollars at least.
However, there is also no guarantee of avoiding default if the central bank insists on running an inflationary policy. In that case, all bets are off.
No Domestic Buffers Can Bring Down Rupee Rates
The foregoing also sheds light on another policy error during the Yahapalana regime and why the government cannot build a domestic ‘buffer’ by overborrowing from Treasury bills as it has recently.
Before the central bank, without a policy rate, any extra borrowing or cash reserves deposited in the currency board automatically turned the cash into foreign reserves, which were invested in third world countries.
However, under the current framework, any excess cash raised is deposited into state bank accounts. If the state bank deposits the money in the central bank’s standing deposit facility, it will accumulate foreign reserves if private credit is weak, through what is called private sector sterilization, or more commonly, a ‘liquidity trap’. Some of the money deposited in the central bank window by the risk-averse foreign banks is in a liquidity trap.
However, if the bank uses the money to give loans or lend it in the interbank market, it will be used to generate imports. No foreign reserves will be built.
If bids to a Treasury auction are rejected, and the Treasury asks to withdraw the state bank deposit, the state banks will not have cash to give if they have already loaned customers or other banks.
If they cut the interbank loan, the other bank will have to get cash from some other bank and give it to the Treasury, crowding out other credits and pushing up interest rates. If interbank loans cannot be cut or the funds are already in securities or other loans, the state bank will be forced to borrow from the central bank through the reverse repo window.
If that money is used, bond rates will be kept down. However, there will be currency pressure and foreign reserve losses when the new liquidity is spent. That is why the Yahapalana era’s buffer strategy failed, leading to more external instability.
Investing Buffers Abroad
Suppose the Treasury or central bank bureaucrats want to keep down interest rates by not accepting all offered bids at a particular auction. In that case, the ‘buffer’ must be invested abroad as a foreign reserve or a sovereign wealth fund.
This is why Singapore’s GIC funds are invested abroad. Other foreign reserves are similarly invested. Money to do that comes from the MAS, where Central Provident Fund cash is invested, leading to a reduction in reserve money and a build-up of foreign reserves, as happened in the Ceylon Currency Board. The Monetary Authority of Singapore’s profits are also similarly invested.
The Treasury can buy dollars from the market if money is not printed, but policy rates are too low for the central bank to collect foreign reserves as rates are signalled down.
When the Treasury raises money from bill or bond sales to buy dollars, rates increase. If the buffer strategy is used to dampen rates by drawing on state bank deposits, which are covered by central bank refinancing for the single policy rate, forex shortages will emerge.
That means the Treasury should have a trading desk and convert its excess cash balance into a foreign reserve. That is why Singapore has foreign investment reserves. Using those reserves, Singapore can ‘stimulate’ the economy without creating forex shortages, inflation or instability, unlike in the case of a ‘monetary easing’ of a conventional central bank.
However, the ‘independent’ central bank has the power to go against the move, create forex shortages and make it impossible to build a sovereign wealth fund through rate cuts.
In the words of Donald Trump, a central bank that is sufficiently obsessed with the policy rate and a high inflation target can ‘screw’ the government, whatever the evasive actions it takes and push the country into a second default like Argentina’s central bank does.
Other strategies to block that problem require bolder actions directly to tackle inflationism, which will be more complicated to implement.