This was perhaps a mis-understanding that we should have cleared up in 1971, when the Bretton Woods system collapsed.

The issue came to light on January 04, when the Treasury revealed that it was seeking a billion dollar loan from the IMF for the budget rather than the Central Bank, where IMF money is usually loaned to.

On the surface this seems a reasonable demand. But if one goes deeper it can be shown that the effects on the economy from both disbursements are the same, depending on the overall economic and foreign reserve targets that are set.

First Glance

Let's start with the objections. Funds given to the Central Bank for foreign reserves are invested in developed countries and there is no 'reserve pass-through' the domestic monetary system. The Treasury insists that it wants to spend any money from the IMF.

The money in foreign reserves - if invested in US Treasuries - will be used to bridge America's deficit and cannot be used by Sri Lanka's Treasury to spend. The IMF money also does not trigger imports therefore do not contribute to the trade deficit.

This column has not favoured the collection of foreign reserves far above the domestic monetary base (much more dollars than are needed to cover all rupees issued by the Central Bank).

By end-November 2012 Sri Lanka's foreign reserves were 6.4 billion US dollars. The domestic monetary base (rupees issued by the central bank) was about 470 billion rupees or 3.7 billion dollars.

There is more than 100 percent backing by foreign reserves of local money.

Even if all the rupees were exchanged for dollars and the economy 'dollarized' there would be almost 2.7 billion dollars left over. Certainly Sri Lanka's forex reserves are more than adequate.

But this is true only as long as the Central Bank engages in unsterilized exchange rate defence (no fresh money printed) and allows interest rates to adjust to credit demand.

Reserve Target

In practice Sri Lanka has had a soft-pegged exchange rate law since 1951. Unlike a currency board law, a soft-pegged law goes against the laws of nature.

A soft-pegged central bank that tries to target both the exchange rate and interest rates at the same time through sterilized foreign exchange sales, trigger steep reserve losses and balance of payments crises.

This column has also objected to large volumes of foreign reserves as it tends to make the Central Bank to defend the exchange rate through sterilized forex sales and delay needed corrections to the credit system.

But large reserve may serve the purpose of giving comfort to foreign investors even though they may be thrown away during sterilized foreign exchange sales crises.

During the last crisis from mid 2011 about two billion dollars were busted up in a few months. Foreign investors and rating agencies who also have a peculiar view of balance of payments in pegged countries want large amounts of reserves.

Sri Lanka also perhaps needs a buffer against cross-currency movements as the central bank seems to have significant non-dollar assets as well as an aggressive investment strategy.

Sri Lanka also has to start repaying 2.5 billion US dollars of the IMF loan it has taken. That means some fresh foreign reserves are needed to maintain the current level of reserves.

Given the recent developments in the decline of rule of law and justice, it may make sense to have some reserve comfort as steadily falling reserves may spook bond buyers.

The starting point therefore is a foreign reserve target.

Roads to Rome

Let's assume for the sake of the argument, that to replace the IMF repayments we need at a minimum 500 million US dollars this year.

How do we go around collecting the reserves?

The first scenario is to sell down 64 billion rupees in Central Bank Treasury Bill holdings and build up 500 million US of foreign reserves at the expense of (crowding out) domestic credit. This is a sterilized foreign exchange purchase.

Domestic interest rates however will go up and the economy may not grow as fast as it could have. (More on this at an older column Sri Lanka's monetary crowding out and Bretton Woods).

The second scenario is to do it the way Sri Lanka is asking. Give 500 million US dollars to the Treasury.

The Treasury then purchases goods and services and a transaction is cleared through the domestic monetary base, which will eventually trigger imports. Such spending increases imports and does not result in a build-up of foreign reserves.

To build up foreign reserves after the Treasury has spent the money the Central Bank could still sell down its Treasury bills and engage in a sterilized foreign exchange purchase.

Then foreign reserves are again built up at the expense of domestic credit, (by transferring potential domestic credit to foreign reserves).

These effects are almost similar to scenario one. The Treasury is again deficit spending at the expense of private sector credit. There is a transfer of private sector credit to forex reserves.

The third option is to use the traditional mechanism and get the IMF to disburse the funds directly to the foreign reserves through a second program. IMF gives the money to the central bank (by passing the domestic monetary base and credit system) and reserves go up.

The domestic economy keeps ticking with no disruption because there is no 'reserve pass through,' that is to say no transaction is cleared through the domestic monetary base.

No Difference

An IMF loan to the central bank therefore has the effect of allowing forex reserves to be built up without curtailing domestic credit.

The important point for the authorities is to understand the following.

An IMF disbursement direct to the Central Bank allows the Treasury to borrow and spend the same amount of money from the domestic economy, with no change in interest rates.

Therefore depending on the overall program of reserve collection, government debt and reserve money or inflation there is no material difference between a disbursement to the Treasury and a disbursement to the Central Bank.

It can now be clearly understood that a provisional advance (a type of printed money overdraft given to the Treasury under Sri Lanka's monetary law) that is subsequently sterilized by the Central Bank has the same effect on the economy as money directly borrowed through a Treasury bill auction.

If a provisional advance is not sterilized, foreign reserves will be lost or the exchange rate will depreciate if the peg is not defended and inflation generated.

The Bretton Woods system and Sri Lanka's central bank was built during a period of resurgent Mercantilism, where teachings of the likes of Ricardo and more recent warnings from Misses and Hayek were thrown away in favour Keynesianism.

If this is taken further, it will be understood that increasing exports will not create a trade surplus. Increasing exports will simply increase imports, if that is where the money earned from exports will be most productively used by the recipients.

Our trade deficit is partly caused by foreign borrowings which are spent by the state. Trade deficits are caused by savings propensities. Exchange rates have little to do with it.

Exchange rate pressure is caused by surges of liquidity. This is why the Central Bank should guard against planned moves such as reverse repo term auctions. In some ways term auction injections are more dangerous than provisional advances, because the Central Bank still has a chance to kill liquidity from a provisional advance.

Trade deficits have very little to do with exchange rate weakness. Car imports do not create a balance of payments crisis.

Sri Lanka's rupee is just as good as any other currency - depending on what rules the central bank enforces (how much money it prints).