But to get the full benefit of these changes and strengthen the currency back to levels they were in mid 2011, the Central Bank has to keep a lid on excess liquidity or the positive clearing balance in the banking system.

Flashback

As predicted, like the proverbial cracked record authorities fell back on the usual deceptive excuses about oil imports, the trade deficit and they resorted to curbs on car imports as well.

In BOP 101 fuss-budget predicted the following scenario: "When the crisis gets under way, the central bank will sterilize partially. There will then be liquidity shortages and rates will start to go up anyway.

"Eventually the central bank will start raising rates."

All this has come to pass. What has not come to pass is panicking foreign bond buyers. All credit to the economic managers who made this possible. Otherwise Sri Lanka will be dismissed as a yet another victim of hot money and not a victim of a soft-peg.

Treasury bill yields are now about 500 basis points above mid 2011.

The prime lending rate is close to 400 basis points higher. It is somewhat unfortunate that it took nine months for the corrections to happen. But that is the way of soft-pegged balance of payments crises.

So why is there still pressure on the peg?

Money Creation

The crisis should have stopped in February with energy and rate hikes and the float. The problems continued because the Central Bank continued to sterilize forex sales for oil imports and left forex purchases unsterilized.

Both transactions create money.

Movements in interbank liquidity from March 2011 seem to indicate to this columnist that the slide in the rupee could not only be halted but also reversed, if only the Central Bank would aggressively sterilizes any forex purchases it makes.

If excess liquidity is kept high, credit will have to be reduced through high interest rates alone, and high interest rates will have to persist for longer than necessary.

That need not happen if liquidity is mopped up, via outright sales of central bank Treasury bill holdings.

For the sake of clarity, let's get a few things clear.

In a pegged exchange rate balance of payments crisis, what occurs is not a 'shortage' of foreign exchange. What occurs is an excess of rupees, injected by the Central Bank into the banking system.

There is nothing particularly 'wrong' with the economy. There is just some imbalance in the rupee monetary system involving credit demand which needs to be slowed.

To understand this better, it is necessary to get a clear understanding what classical economists call 'reserve pass-through'.

Reserve Pass-through

At the periphery of the economy outside the banking system, there are dollar transactions through the havala system, in the pavements of Colombo.

Then - outside the domestic rupee banking system, but inside banking system - there are dollar transactions via foreign currency accounts.

Going in some more, inside the banking system dollars, are sold to banks by exporters and expatriate workers and their families for rupees and they are in turn re-sold to importers.

These transactions result in existing rupees shifting from bank accounts of importers - like the Ceylon Petroleum Corporation' to the account of an exporter or a family member of an expatriate worker.

None of these transactions change the monetary base (reserve money), though they are cleared via the rupee money base (reserve money) because the transactions involve money already created by the Central Bank.

In other words there is no 'reserve pass-through'.

Reserve Money

At the core of the domestic banking system is reserve money, through which all domestic transactions are cleared.

Reserve money is the total notes and coins printed by the Central Bank. This includes notes in circulation in the hands of the public plus the statutory reserves deposited in the Central Bank by other banks.

It also involves the excess clearing balance even though it may not be defined as such.

The monetary base becomes bigger or smaller either by the sale or purchase of Treasury bills, or the sale or purchase of foreign exchange by the Central Bank. To buy either type of paper, rupees are 'printed' by the Central Bank and released into the banking system.

If the Central Bank buys dollars - lets say it buys 200 million dollars from the Bank of Ceylon bond proceeds, through a swap transaction, it creates 26 billion rupees.

Therefore central bank generates 26 billion rupees of loanable reserves in the banking system.

When this money is loaned by the commercial bank to its customers, the Central Bank must be prepared to sell the dollars through an unsterilized sale, which will mop up the rupees and keep the exchange rate stable.

Timing

If not, the rupee will fall some more because in that period - say a few weeks - the rupees flowing into the banking system will exceed the dollars.

The alternative is for the Central Bank to sell down its Treasury bill stock.

Foreign exchange inflows can vary from time to time. On some weeks there may be more, on some weeks there may be less. Inflows and outflows are matched, through the monetary system over a given period to keep the exchange rate stable - let's say for the sake of argument - during four weeks.

Principle number one is that an unsterilized forex purchase must be matched, in the coming days or weeks by an equal unsterilized sale if the exchange rate is not to weaken.

This will also ensure that the foreign reserves remain the same unless there is an increase in money in circulation due a real increase in the demand for money in the economy.

Any attempt to build foreign exchange reserves, through outright forex purchases or swaps, will result in a weakening of the exchange rate, if they are not sold back to the banking system to mop up the rupees created, when the rupees generate imports.

To lock up the foreign exchange - say from the Bank of Ceylon bond - Treasury bills must be sold from the Central bank stockpile into the banking system, either to the selling bank, or to other banks or to customers. This will prevent the rupees from being used by people and being redeemed for the forex reserves in the future.

If money is printed by purchasing of Treasury bills to finance the deficit or to sterilize forex sales, a similar effect will be seen, with the difference that in the case of money created by T-bill purchases, even an unsterilized forex sale will result in a foreign reserve loss.

A related issue is the dollars given to the CPC to cover oil payments.

Oil dollar problem

If dollars are given to CPC and those sales are sterilized with liquidity injections, the rupee also falls.

First the Central Bank gives dollars to CPC in return for rupees. (The problem is made worse if CPC is running losses. If it is running losses, somebody else is spending that money and already creating import demand. If it is running profits, it has already killed import demand for non-oil goods.)

After giving dollars - if there were no excess liquidity from previous dollar purchases in the banking system - the Central bank will then inject rupees into the system to prevent a liquidity shortage and a spike in interest rates. This is a sterilized sale.

However there is a mechanism through which the Central Bank could give dollars to CPC without a reserve pass-through.

According to the Central Bank annual report, the Treasury has given CPC, 50 billion rupees in bonds to offset fuel given to state entities.

If the central banks takes on the bonds (it can re-exchange them withe the government for bills) it can give dollars to the CPC's supplier with no 'reserve pass through' and therefore no exchange rate depreciation.

This is how government loans are settled anyway.

If CPC is in fact generating profits, then an equal amount of non-oil imports by CPC customers must have been prevented, and there should be ample dollars for it to buy in the market.

This is basically 'Ricardian equivalence' applied to the foreign exchange market.

If CPC and CEB is running cash profits, it is only liquidity from unsterilized Central Bank dollar purchases or swaps that is keeping the exchange rate down.

Wishful Thinking

It is wishful thinking to believe that a foreign exchange peg can be maintained by printing fresh money. But that is exactly what a soft-pegged central bank does in an intervention.

This is not economics, it is wishful thinking, propagated by Keynesian type interventionism.

Soft pegs were built with sterilization mechanisms by interventionist pro-establishment economists partly to be able to counter a shock to the pegged country from a contraction in the anchor currency nation.

The Bretton Woods was fundamentally flawed. It was partly a political compromise between US hegemonic desires to control the global money supply and a wish by a war-weakened Europe to maintain some semblance of independence.

Both Keyenes, and Harry Dexter White, an interventionist secret communist, preferred to create a globally inflating central bank.

But the roots of the mis-understaning goes beyond the Bretton Woods in to the mists of the first World War. In the last century, Keynes claimed that there was a 'transfer problem.'

It was explained by Bertil Ohlin and even more clearly by Austrian economists why it was not so.

A net payback of foreign loans will result in a reduction of imports and possibly a trade surplus, provided no new money was created by the Central Bank.

Assume that the Central Bank takes 26 billion rupees in bills from the Treasury and settles 200 million dollars due to a foreign donor. If the bills are subsequently sold to the banking system, 26 billion rupees in potential credit and imports will be blocked, reducing the trade balance.

A trade surplus is not needed to repay loans. Loan repayments on the other hand can generate a trade surplus, in the absence of central bank accommodation. There is no 'transfer problem'.

Measures like exports to debt service (or reserves in months of imports for that matter) are not worth the effort taken to write them out.

All this also shows than any delays in settling CPC imports through credit will result in an even bigger trade deficit than needed, due to the timing difference.

To sum up:

(a) If the Central Bank wants to keep the exchange rate at 130 rupees (and foreign reserves largely unchanged) it has to match unsterilized foreign exchange purchases including swaps, with unsterilized sales.

(b) If it wants to strengthen the currency, or build reserves quickly or both, it has to sell down its Treasury bill stock.

This is another way of saying that the Central Bank has to make sterilized purchases, at least until the exchange rate is taken to its desired level.