There is a persistent imbalance between loans made and deposits raised by the banking system, indicating that a market clearing interest rate is needed to maintain the peg to the US dollar.
To head off any 'balance of payments' problem the central bank has to weaken the rupee or allow interest rates to go up. If neither happens, credit expansion is on track to crash land in the balance of payments.
But a recent experience in July showed that rates will not be allowed to go up in practice.It now looks increasingly likely that July was a dress rehearsal of things to come.
The buck stops at the BOP
It is inevitable that, in a pegged exchange rate, all excesses, by the state or business, and all policy contradictions end up in the balance of payments. It is not just about inflation, revising indices to understate inflation or even the Taylor Rule.
The basic problem is a matter of interest rates and credit. Let's look at what happened in July.
On July 01, there were 63 billion rupees of excess reserves in the system. Most of the excess reserves came from foreign inflows, though a part was printed domestically.
Excess reserves also earn interest at 7.00 percent to the banking system and that interest is printed money. That interest, when paid out will eventually also drag out foreign reserves.
When the central bank transfers profits or gives 'provisional advances' the same thing happens. In a peg it is better to give profit transfers to the state in dollars instead of rupees and recognize this problem early in the game.
By July 15, excess rupee reserves in the banking system had fallen to 26 billion rupees as credit to government and private sector increased. The central bank was steadily selling dollar reserves as the excess rupee reserves were spent by people who got the loans, which in turn generated imports.
Short term Rates
In theory, the central bank has a policy rate corridor of 7.00 percent to deposit excess reserves (repo) and 8.50 percent to print fresh money (reverse repo). That means without state intervention, the market rates can go up to at least 8.50 percent.
In July, as excess reserves were loaned out by banks call rates did go near the reverse repo rate as the central bank sold 416 million dollars to maintain its peg. But starting from about July 12 rate increases were stopped.
On June 01 the minimum overnight call rate was 7.25 percent. By July 15, six weeks later the minimum call rate had gone up to 8.05 percent as the banking system tightened.
But by around July 12, the central bank's Treasury bill portfolio started to increase. From then on till July 27, when sovereign bond proceeds came, the central bank's Treasury bill stock went from almost nothing to 15 billion rupees.
The Central Bank by this action showed that it was prepared to print money, sterilize the balance of payments in an expansionary fashion and was willing to trigger a crisis. However it was obviously a gamble pending the dollar bond.
In July 416 million US dollars was sold to maintain the peg.
Saved by the Bond?
On July 27 bond proceeds came and liquidity (and fresh dollar reserves) came in.
On July 28, excess liquidity went back to 77 billion rupees and the T-bill stock was almost nothing at 680 million rupees. A developing BOP crisis was seemingly averted at the last minute and the country was saved by the bond.
But by August 19, within the space of three weeks, excess liquidity had come down to 46 billion rupees indicating that the central bank is selling dollars at the rate of about 100 million dollars a week.
So credit is still being given at a fast pace, beyond the rate at which deposits are collected by banks.
The sovereign bond liquidity then - like most state interventions - seems to have just added fuel to the fire, by pushing rates, which were correcting upwards, in the opposite direction and also giving more reserves to banks to add to the credit momentum.
If this pace is kept up, next month, excess liquidity will be down to 25 billion rupees - the threshold at which authorities started to print money in July.
If authorities won't allow the system to tighten and instead sterilizes the balance of payments in an expansionary fashion (purchasing Treasury bills to print money like in July) a full blown balance of payments crisis could be triggered.
Before the authorities start lying let's get a few things clear.
BOP problems have nothing to do with trade. BOP problems have nothing to do with oil. If they had, we should not have had a BOP crisis after oil prices collapsed in late 2008.
And they most certainly have nothing to do with car imports.
It is not the trade deficit as fiscalists or mercantilists would say either. A BOP crisis is a result of contradictory interest and exchange rate policy that is inherent in what is called a 'soft' or unstable peg.
An interest rate policy that is inconsistent with maintaining a currency peg, to put it more simply.
BOP problems (shortages of foreign currency) are caused by excess rupees created by a central bank without equivalent reserve backing. That money may not always be created to finance the government.
Non-sterilized interventions are not a problem. That is, if dollars are sold for rupees and rupees go out of the system and rates move up as a result, it is an automatic balancing mechanism.
That is how a currency board or a 'hard peg' works and has done for centuries. Sri Lanka had a hard peg until 1951 and the exchange rate was fixed.
The problem is not the sale of dollars for rupees (which creates a rupee liquidity reduction), but the offsetting transaction in the money market to re-inject lost liquidity. This is called sterilized intervention.
A balance of payments crisis can happen even with a budget surplus, as East Asian countries found to their cost.
The only sufficient condition is for the central bank to sterilize outflows and resist an interest rate increase that is needed to re-balance credit and deposits in the banking system.
But in this case there is data to show that the government also borrowed heavily from banks in June contributing to credit growth. There is no point in keeping Treasury bill rates at 7.25 percent and borrowing from banks to deceive the people about the interest rate.
Authorities are also deceiving themselves if T-bill rates are not adjusted and instead borrowings are shifted to commercial banks.
That must have added to the credit demand in the economy which helped eventually cause the 416 million dollar reserve sale to prop up the rupee in July.
Ultimately banks also have to raise rates to take deposits to fund the credit.
It may not be the annual budget deficit that pressures the peg. Even a short term spike in government borrowing that puts pressure on a banking system that is already giving credit strongly to the rest of the economy can pressure the BOP if rate increases are resisted.
If authorities want to maintain stability government cash flow problems - even if short term - must be passed on to the market so that the economy can adjust to state excesses.
If not, these little deceptions either end up in inflation or the balance of payments. By altering the inflation index, it is possible to deceive people somewhat. But the BOP and exchange rate is a different kettle of fish.
There is now a very large gap between the wholesale price index and the new Colombo Consumer's price index. By April the wholesale price index was up 20 percent compared to the CCPI at 9.8 percent. The revised CCPI was even lower at 8.9 percent.
Without exchange controls it is not possible for rulers to cheat the people on the exchange rate.
In this context the central bank must be commended for continuing to relax exchange controls despite elements of Sri Lanka's ruling class who are now in the opposition trying to deceive citizens about it.
Market clearing rate
Another way to understand the current problem is this way. Loans are being given by the banks at a rapid pace. Banks have also approved a lot of facilities, to say build hotels. These require imports. It is not just cars or oil.
Oil becomes a problem usually because governments refuse to raise prices and print money or gets credit to make up for tax shortfalls pressuring the banking system.
The rapid drawdown of excess reserves can be more easily understood in this way. Banks are not getting enough deposits to make all the loans they are giving now.
To correct the problem rates have to go up, which will increase deposits and reduce loans and re-balance the banking system. This process is a little slow and the sovereign bond may have cost valuable time. T-bill markets however can work faster.
What happens if the central bank sterilizes their interventions? More reserves (deposits) will be created out of thin air and will be given to banks to make more loans (or keep making the same amount of loans as before).
But unlike the current excess reserves, most of which were collected through dollar purchases, there will be no dollars backing the new rupees, only T bills, resulting in net losses in dollar reserves without an equivalent fall in domestic money liabilities.
The usual sequence of events then - whether it is Thailand, Indonesia, Argentina or Sri Lanka - is as follows. The problem with soft-pegged central bankers is that they neither want to float nor raise rates.
And they get very cocky when there are a lot of foreign reserves.
So they keep sterilizing, giving ammunition for the holders of the new rupees to hit back and demand more dollars. Only the central bank can make the bullets to attack its foreign reserve buffer. A 'speculative attack' cannot be mounted with dollars. Domestic money is needed.
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. But by that time confidence in the peg will be lost. Bond holders will try to run, exporters will keep dollars and demand packing credit in rupees.
Then exchange controls come. In Sri Lanka it may include curbs on car imports by raising taxes on cars or letter of credit margins on cars and other imports. Penal rates on exporter packing credit are also another indirect exchange control.
At one point lending rates will no longer make economic sense for some businesses. They will start to default.
By this time banks will also be borrowing at high rates.
Then deposit rates will hit levels where it makes no sense even for banks and finance companies to borrow. Bad loans will damage bank balance sheets. People will demand their deposits from banks also. A reserve money problem will then become a broad money problem.
That means a banking crisis will also be created and not just a currency crisis. The economy will tank. Then the International Monetary Fund is brought in.
This, in a nutshell is how a soft-pegged central bank creates a balance of payment cum banking crisis and a steep economic downturn.
But that is a worse case scenario. That need not happen if markets are allowed to work either by allowing rates to move in way that is consistent with the peg, or allowing the peg to break to maintain the targeted policy interest rate.
Already the spot dollar is near 110 rupees, a level last seen in April.
On Friday the central bank said foreign reserves hit 8.1 billion dollars in August, an all time high. Foreign reserves are now twice the reserve money, indicating that every rupee note held by the population can be repaid with two dollars.
But such large reserves can make soft-pegged central bankers more reckless and delay interest rate adjustments and extend contradictory monetary and exchange rate policy.
The greater the foreign reserves, the longer it takes for complementary policy to emerge, by adjusting either exchange or interest rates. This gives more time for a banking crisis to develop.
It has been shown in the past that Central Banks will float the exchange rate only when reserves fall to very low levels. In Sri Lanka, we know from the 2008-2009 experience that it was a billion dollars.
But Sri Lanka need not go there. If Sri Lanka wants a peg, the country will have to re-build a currency board like Hong Kong did in 1982 and make contradictory exchange and interest rate policy legally impossible.
In other words stop targeting rates, don't intervene in Treasuries auctions and don't sterilize forex interventions.
If not, the peg will break.