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Mon, 22 December 2014 21:44:50
Sri Lanka's demand for fiscal funding from IMF is not relevant: fuss-budget
28 Jan, 2013 10:46:29
Jan 28, 2013 (LBO) - Sri Lanka's demand for budgetary support from the International Monetary Fund seems to stem from a particular understanding of the balance of payments and credit and trade that became prevalent in the last century.

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).

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READER COMMENT(S)
7. Rain maker Jan 30
I do not think SL can dollarise the currency. Your figure of 570 Billion rupees being the monetary base is way off. Even the deposits of HNB and Commercial Bank exceed this.
6. ana perera Jan 30
@fuss
Appreciate taking trouble to respond. On the item a) in your response, I would be thankful if you could explain, with what the column and the response asserts, "It really does not matter who gets the money because based on the overall program, if the effects are the same", doesn't the principle in modern societies - monetary and fiscal policies are separated - and wherever possible monetary policy is not allowed to be influenced by politics, the idea operationalised with central banks to be as independent as possible come into question, in a very serious manner?

Re. b) and c) in your response, while they are informative, educating and consistent with the position columnist has taken throughout on this issue, it is not clear if they correspond with the questions b ) & c) in my 29th post. Thanks again.

5. fuss Jan 30
@anaperera
Thank you for your comments. Here are the responses.
a)IMF has provided money to fiscal authorities for example in Europe where countries do not have central banks/have floating rates.

But that is really irrelevant as the column says. It really does not matter who gets the money because based on the overall program, if the effects are the same.
The separate scenarios were painted to show the path the money would take after disbursement, through the monetary base or out of it, eventually leading to the same outcome.

To summarise:

If rupee liquidity was sterilized to build forex reserves, domestic credit would contract. By giving forex direct to the Central Bank (which is what the IMF usually does as you say) the same amount could be domestically borrowed by the Treasury by making use of the space provided coming from the disbursement to the Central Bank. As a result there is no real difference between disbursing money to the Treasury vs the CB based on the overall program's reserve target (or inflation target for that matter).

That is of course assuming that authorities see a need to build reserves or maintain reserves, which this column makes the point that it does. At least to keep those who watch reserve levels happy, including bond buyers and rating agencies.

b) Exchange rate appreciation or depreciation is due to monetary policy and its transmission through the credit system. If purchases are sterilized (liquidity is killed), the outflows are less than the inflows. Therefore the exchange rate tends to appreciate giving the central bank chances to buy more dollars or appreciate the currency even more. This is the opposite of what happens in a BOP crisis where fresh liquidity is poured into the banking system and dollars are sold from forex reserves (sterilized forex sales). The liquidity injections create a greater demand for dollar outflows than inflows.

c) About the level of reserves. No level of reserves are healthy if a central bank sterilizes forex sales (soft-peg). Absolutely any amount of reserves can be depleted by continuous liquidity injections that occurs during sterilized forex sales.

The point made by this column is that there are 2.7 billion US dollars in excess of the monetary base (reserve money) now. But keep in mind that 2.5 billion is borrowed from the IMF, so we have to pay it back in the next few years. Then there will not be any extra reserves left. When reserves fall each year with IMF repayments it may make investors jittery. To repeat what was said before, in order make up for IMF repayments, the central bank has to kill domestic credit by selling down its bill holdings. If IMF gives money to the CB, that credit could be made use of by the Treasury. So giving the CB money is virtually the same as giving the Treasury money.

There are also other arguments about measuring reserve adequacy such as short term debt and so on. This column did not go into them because trying to actually make any payment through sterilized sales forex sales leads to a crisis.

4. anaperera Jan 29
This piece in the Thrift Column gives rise to some major questions:

a) is the second scenario "... is to do it the way Sri Lanka is asking. Give 500 million US dollars to the Treasury." a realistic one? Notwithstanding the Treasury Sec. mentioning that, the two Bretton Woods institutions have clearly separated mandates and can IMF be swayed by a request of a member country to provide finance (devt finance) to a Treasury?

b) In the "Roads to Rome" section the discussion is built upon scenarios on replacing (or replenishing) the reserves due to 500 m USD installment to IMF this year.

If the discussion is on "collecting reserves" as referred here depleted due to IMF payment, it is not clear the 3rd option mentioned here "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." fits into the discussion.

Isn't it a strange logic to apply on a column by a respected central banker, though theoretically possible?

c) this column also refers to "healthy" reserve levels with the usual caveat and how the central bank busted billions of USD in the last crisis. Since this is a current affairs column, not purely academic piece of work, isn't it strange the column obviously omits that the steady appreciation in the last weeks of LKR vis a vis USD can't be attributed to market forces alone and could well make the assertion that our reserve levels are healthy a "walk on thin ice"?

3. Antoinette Jan 29
Let them eat cake.
2. Wadda Podda Jan 28
@Kawadyboy. Why are you helping them with the objective questions ? Are you not supposed to be the enemy. Let them choose (1).
A bit of instability can help. But make sure you park your money somewhere else till the dust settles.
Happy Thaispusam.
1. kawdaboy Jan 28
In a nutshell, the choice for the Central Bank of Sri Lanka between the Devil (1) & the Deep Blue Sea (2).

1.Loose monetary policy = GDP up = Inflation up = BOP crisis = Reserves get shot to bits.

2.Tight monetary policy = GDP down (as seen on last quarter) = Inflation manageable = BOP manageable = accumulate Reserves.

I will stick to the Deep Blue Sea!