Hike rates

Sri Lanka needs to raise rates and provide monetary fiscal coordination to help rupiah: Bellwether

ECONOMYNEXT – Sri Lanka needs to raise the policy rate urgently and also remove a call-back obligation that creates fresh money to help stabilize the rupee in a free float and also ensure monetary fiscal coordination.

Monetary fiscal coordination comes from an International Monetary Fund program where there is usually a reserve currency program and a primary deficit or domestic borrowing target.

The central bank’s decision to drop the non-credible peg and end currency and energy shortages is a positive move.

Before the restructuring of the debt, the problem of the exchange rate must be solved.

The central bank’s decision to end subsidies for expatriate workers and stop printing money is also the right decision.

The 200 peg to the US dollar was not credible due to printing money to enforce the policy rate and sterilize reserve sales for fuel and other imports. In a well-functioning exchange rate regime, no allowance is given for imports.

In a credible peg, if reserves are sold for imports, a rate hike should automatically translate into the interbank market to prevent the currency from depreciating.

In a floating regime, foreign currencies are neither bought nor sold by the central bank and the banks’ rupee reserves and the policy rate are unaffected except by an inflation target.

No floating rate western central bank gives foreign exchange reserves for imports, mainly because they don’t have any in the first place. The use of reserves for imports, even in an indexed rate with reserves, is saving for consumption.

Imports must be limited to entries. Imports only exceed inflows when the central bank prints money. Floating the rupee is the first step.

Why the price increase

Rates need to be increased sharply for two reasons.

Immediate reason: term premiums need to be strongly positive to encourage exporters to sell dollars to sell and discourage borrowing in rupees. The cost of holding the dollar must be greater than the expected depreciation of the rupee.

Before the float, according to official data, the month forward was 200.84 rupees and the 3 month was 198.98. There is a rebate. It must be a premium of 1 or 1.50 rupees.

Without a sharp rise in rates, which increases the spread between rupee yields substantially above dollar yields, the stability of the rupee is at risk.

Second reason: Rates need to be raised to lower inflation and slow broad money growth. Depreciation inflation is a given. There is nothing that can be done about it. This is the result of the money printing of the last two years, which has upset the price structure of the economy.

However, the central bank can take steps to stop generating more inflation in the future.

However, inflation in Sri Lanka was 15.2% in February 2022, while neighboring countries with better central banks, such as Bangladesh, were only 5.32% in February.

Sri Lanka’s broad money is growing too fast, mainly due to the budget deficit, although private credit is a factor. Private credit is a factor, including by exporters who borrow in rupees and hold dollars (see above on interest rate differential).

Third reason: the difference between the overnight rate of 7.5% and the yield on 3-month Treasury bills is very large.

This allows financial intermediaries and their clients to get money from the counter, buy treasury bills and indirectly fund the budget, create currency shortages and further undermine the rupee.

To counter all these factors, a strict reserve currency program is necessary.

Why the surrender rule?

There are two facets to the assignment rule. On the one hand, exporters are required to sell dollars in the market. This activity is relatively harmless and does not increase or decrease the reserve currency.

The second part is where 25% of those dollars donated to the banks are sold to the central bank.

This action removes dollars from the float and simultaneously creates money. At the moment there are night shorts. This short is reduced by adding rupee reserves to the banks.

This is negative for the exchange rate, when floating. If it is a peg, it is under pressure from previous money printing.

Compulsory sales

Any forced sale must go to the treasury account in a standard commercial bank and not to the central bank which creates the money to buy it.

The money for the mandatory sales must come from the auction of bonds and taxes by the Ministry of Finance, without changing the reserve currency.

Fiscal and monetary coordination

For proper fiscal and monetary coordination and the IMF program is necessary.

Once the float stabilizes, Sri Lanka’s currency usually reverts to a fixed or flexible exchange rate.

IMF programs, since they involve a bailout loan to the central bank, also require a peg to eventually repay the loan.

For now, the central bank has called for fuel and electricity price hikes and sustained tax hikes.

But so far, the government is not acting. Using India’s line of credit to fund grants would be a bad move.

An IMF program would also contribute to debt restructuring.

For the moment, the central bank has called for increases in fuel and electricity prices. But so far the government has failed to act. Prices must be raised to prevent the Ceylon Petroleum Corporation from borrowing money and increasing credit and domestic demand. (Colombo/09 March 2022)