The bottomless pot of Sri Lankan monetary policy

Originally appeared on The Morning

By Dhananath Fernando

A student asked their teacher: “What’s the most amazing, incredible thing in the world?” The teacher responded: “The most incredible thing in the world is that we see people leave all around us, but we never think it’s going to be us. It’s an everyday experience, that people known to us and loved ones leave us. Even experiencing it every day, our mind can’t think that we would also be one of them. Isn’t that incredible?”

Sometimes, it is the most obvious things that we fail to understand. Sri Lanka’s monetary policy definitely falls into this category of things. We see it and experience it every day, but still fail to understand or notice the big elephant in the room. 

The monetary policy is the set of rules under which a monopoly state agency produces paper money. The public is forced to use the money because the government has given it a monopoly and arrests anyone who keeps large volumes of foreign money. There are also restrictions on keeping deposits in foreign money to protect against inflating and depreciating money.

Good central banks will produce stable, low-inflation money. Bad central banks will produce large volumes of money, which generates high inflation and also results in foreign exchange shortages and depreciation.

Some people who run central banks try to avoid printing excess money, if they believe that high inflation and currency depreciation is bad. But sometimes, the Finance Ministry will pressure them to print money to finance the deficit or keep interest rates down.

And central banks will be forced to follow the orders of politicians. To avoid this kind of pressure, which is called fiscal dominance monetary policy, central banks ask for independence from the Finance Ministry.

But there are other activist central banks that will try to push growth on their own by printing money and artificially pushing interest rates down. Such banks will create monetary instability regardless of whether they are given independence or not. 

Some countries have solved this problem by putting controls on their central bank so that its officials are unable to print excess money, whatever their ideology or economic beliefs are. To do this, it is necessary to reduce discretion and bring them under the rule of law.

One such law is a strict inflation targeting law of around 2%. To target inflation, however, it is necessary to have a pure floating exchange rate.

Countries with central banks that create the most trouble or instability usually have pegged exchange rates. They are usually called soft-pegged exchange rate regimes.

The simplest way to restrain them is to fix the exchange and take away their ability to manipulate the interest rate by prohibiting the purchase of domestic securities. This is done by a currency board law which results in a fully credible peg or a fixed exchange rate.

The exchange rate can also be fixed to a great extent by having a wide policy corridor and managing the ability to control short-term interest rates on a daily basis.

The more discretion that is given to the central bank, the more tools they will use to inject liquidity to manipulate interest rates and then create instability. 

A third way is to dollarise. That is to allow foreign currency issued by a better central bank – such as one that is restrained by an inflation targeting law, or a currency board law – to be used in the country. It can be extended to allow multiple foreign currencies to be used as well.

Then, there cannot be any Balance of Payments crises anymore. This is what the Colombo Port City has done. It will be a multiple currency area.

The Central Bank’s recent strategy has to be evaluated with its policies over the last few months and in recent weeks. Below are a few decisions taken over the last few weeks:

1. Over the last week, the Central Bank urged the private sector to borrow foreign currency offshore funding and promised to give a zero-cost swap facility. Put simply, this means private firms are encouraged to borrow money in foreign currencies and “sell” it to the Central Bank for rupees. The Central Bank gives them the foreign currency back at the same exchange rate they sold it at a specified future date – say, one year, at the exact same rate. However, if the rupee rates are very low, it is doubtful whether this will be a very profitable activity. Companies that could borrow in foreign currencies can invest in Sri Lanka Development Bonds and government securities which are denominated in US dollars

2. In another news story, Sri Lanka requested and received a $ 200 million swap facility from Bangladesh. Interestingly, the IMF (International Monetary Fund) approved a $ 732 million facility for Bangladesh in May 2020 as emergency assistance to address the Covid-19 pandemic

3. In another move, the Finance Ministry has raised the limit on borrowing through treasury guarantees to 15% of GDP (gross domestic product) from 10% of GDP. This will allow the Government to borrow more off the balance sheet through state-owned enterprises and spend it through those enterprises. So the loans taken through treasury guarantees will not come under central government debt. Central government debt is already at 101% compared to our GDP, so space is limited for the Central Bank to borrow. The Bangladeshi Central Bank has also asked for a treasury guarantee, according to reports in newspapers in that country

When evaluating all these moves, it is clear that Sri Lanka is drifting towards a very hard situation on raising foreign exchange, as it has been highlighted in this column as well by many experts during the last 12 months. 

We have to ask ourselves: “With so many reactive and stringent measures such as import controls, why are we struggling to fix this problem?” That is where we have to recall the story of the student and the teacher. Sometimes it’s the most obvious thing that we fail to understand. That is, our monetary policy. That is, demand and supply of money. Our Central Bank has been supplying money following MMT (Modern Monetary Theory) utilising the space of low inflation. It is true the inflation is low, but the excess money we print will chase behind imports. It is the same as trying to fill a pot without a bottom. 

Let’s consider a simple example. Even if I grow all the food items that I require in my backyard, the moment I switch on a light at my home, I am spending on imports in the form of fuel for electricity. The moment I switch on my internet router, which consumes electricity, it is the consumption of imports. The moment we build flyovers, highways, and even a simple act of giving away 1 kg of dhal to an affected family mean we are spending on imports. So the only way to cut imports, if we really want to, is by minimising our consumption. 

Or else, we have to increase taxes. The Government has clearly stated that they do not intend to increase taxes. Even increasing taxes will not be a solution without fixing government expenditure, however. Currently, 86 cents of every rupee of tax collected is spent on government employees.

So to minimise consumption, the Central Bank has to absorb money from the system by selling the treasury bills they have rather than buying it from the market. When the Central Bank buys treasury bills, we call it money printing or quantitative easing. The more money we inject into the system, the more we spend, and we will spend more on imports. That is the Balance of Payments crisis we face at the moment, and that is why so many hard and well-intentioned efforts by the Central Bank haven’t seen the expected results materialising. 

Many are of the view that reactivating tourism and attracting higher foreign direct investments (FDIs) will be a permanent solution for this problem. Increased numbers in tourism and FDI will help to ease the situation, but it is not the permanent solution. There have been grand expectations expressed at the recent Sri Lanka Investment Forum to bring the per capita GDP to $ 8,000 by 2030 and a list of very aspirational goals. All the outputs are welcome, but without fixing our monetary policy and failing to understand the most obvious reason why we are failing, Sri Lanka will remain where it is today for the next decade. We must remind ourselves of the story of the teacher and the student on how we have failed to understand the obvious realities and realise that current policies have failed while trying to fix all the other issues in the periphery. Monetary stability is not everything, but without monetary stability, everything is nothing

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.

Consumers rear-ended by reer depreciation?

Originally appeared on Echelon

By Ravi Ratnasabapathy

What really is driving the currency weakness? The Central Bank must consider both fundamentals and monetary factors.

Sri Lanka’s currency has fallen rapidly over the last two months, raising fears of yet another crisis. Sri Lanka’s Rupee depreciation over the past six months against the US Dollar is at a much higher rate than the historic annual average of around 10% over the last couple of decades. A stable exchange rate reduces transaction costs and uncertainty in international trade, thereby stimulating trade. It is one of the most important macroeconomic variables in the economy; it affects inflation, exports, imports and economic activity. Budget deficits are the source of much instability. The painful tax increases that addressed this issue were expected to result in stabilisation of interest rates, exchange rates and inflation. The recent depreciation of the currency is therefore puzzling and worrying.

The problem seems to be in the new inflation targeting regime based on the Real Effective Exchange Rate. What this means is that Sri Lanka will target an inflation-adjusted exchange rate index relative to competitors to keep the Rupee competitive. It appears that the depreciation of other currencies has led the Central Bank to loosen monetary policy, causing the currency to fall. What are the implications of such a policy?

Export growth is correctly identified as critical for development, and the Central Bank objective seems to be to keep the exchange rate competitive; but is this necessary? Previously, competitive exchange rates were seen to be crucial for exports, but a recent paper published by the World Bank in 2015 (Depreciation without Exports? Global Value Chains and the Exchange Rate Elasticity of Exports) suggests this is changing (although the view is not universal; other studies seem to contradict this).

The paper finds that the emergence of global value chains (GVCs) has resulted in a decline in the effect of real exchange rates on export performance. This has been linked with the emergence of GVCs through the following three mechanisms:
1. Firms need to import to be able to export; therefore, their exports contain not just domestic but also foreign inputs.
2. Stable supplier-buyer links are valuable, so the cost of switching suppliers in case of a real exchange rate change in a given partner’s country becomes non-negligible.
3. Large leading firms account for an increasingly larger portion of world trade, and these firms may find it easier to hedge against real exchange rate changes along their production network.

The study finds that when firms’ share of imported intermediates is greater than 30 percent, the effect of real exchange rates on export participation fades. Thus, as countries become more integrated in global production processes, currency depreciation only improves the competitiveness of a fraction of the value of final goods exports. The objective of Sri Lanka’s new export strategy is to integrate to GVC. If this paper is correct, the currency may not play a significant role in improving our entry into GVCs.

As yet, Sri Lanka is not well integrated into global value chains; so does the currency depreciation help existing exports? This does not appear to be the case.

“It appears that the depreciation of the other currencies has led the Central Bank to loosen monetary policy, causing the currency to fall. What are the implications of such a policy? ”

A Central Bank staff research paper by U P Alawattage in 2005 titled Exchange Rate, Competitiveness and Balance of Payment Performance examined the effectiveness of the exchange rate policy in Sri Lanka in achieving external competitiveness since the liberalisation of the economy in 1977. It analyses quarterly data covering the period of 1978:1 to 2000:4 and finds that the Real Effective Exchange Rate (REER) does not have a significant impact on improving the trade balance, particularly in the short term.

The other major concern is the impact of the currency on domestic prices and confidence. For small economies, changes in the exchange rate can have an important influence on prices. It not only affects prices of imports but also import-competing goods, and local goods that are tradeable internationally. When the currency depreciates, local prices of these goods and services tend to rise quite quickly, and by a similar amount as the depreciation of the exchange rate.

When import prices rise, demand is driven towards domestically produced goods and services. In the absence of offsetting factors, this results in more pressure on local production capacity and a bidding up of prices. This leads to increased demand for labour and capital pushing wages and interest rates.

The direct effect of the currency depreciation will generally contribute to an overall price level increase in proportion to the share of tradeable goods and services in GDP. Published as a Central Bank study in 2017, a paper by S M Wimalasuriya titled Exchange Rate Pass-Through: To what extent do prices change in Sri Lanka? suggests that the exchange rate pass-through into import prices is around 50%; that is, import prices increase by about 0.5% (and those of other consumer prices by 0.3%) as a result of a 1% depreciation of the Nominal Effective Exchange Rate.

Therefore, the overall cost of living will rise further. Tax increases – VAT from 11% to 15%, PAL from 5% to 7.5% – and the currency depreciation over the last couple of years has already added significant costs to household budgets. Add to this increases in fuel, gas – all necessary due to increases in global prices – and the combined burden is huge. To add even further inflation through currency depreciation will impoverish many and increase popular discontent. Pursuing unpopular policies is sometimes necessary but the combination of depreciation amid fiscal tightening looks dangerous and perhaps even unnecessary.

Exchange rates can move for a range of reasons, which can be simplified into two categories: “real” factors, or in other words, changes in relative fundamentals; and “monetary” factors. “Fundamentals” would, for example, include changes in the terms of trade and productivity, while “Monetary” factors are changes in the money supply.

In practice, policymakers may find it difficult to distinguish how much of a movement in the exchange rate is due to changes in the fundamentals and how much may be inflationary (or deflationary), although in the current situation, monetary factors seem to be the cause.

Thus, in Sri Lanka, where inflation expectations are not well anchored, the prudent monetary policy response would be to tighten rates, at least until there are grounds for being more confident that it was the fundamentals that had changed. The immediate political considerations suggest the same action.

A currency’s exchange rate contains important information about the country’s monetary position and the credibility of domestic monetary policy. The popular perception of the current stance is that it is either weak or out of control. For businesses, it is creating a new level of uncertainty, which is not being helped by ad hoc administrative measures (increasing LC margins on cars for example) to arrest some of the effects. For consumers, it fuels inflation, adding to the woes of fiscal tightening.

The Central Bank should revisit its inflation-targeting regime and tighten rates to stabilize the currency.