The next challenge for the Central Bank is in March and April when reserve money peaks, eventually tripping up monetary policy. That is also the time that the currency regime veers in a different direction.
This is what undermined the quantity targeting framework last year. While it is good that the central bank is under some self-restraint, given that no go-ahead is given for either inflation targeting or a currency board, the current system is extremely tricky to operate practically.
Let's get a handle on the overall interest and exchange rate policy we seem to be running now, and see how different policy conflicts are pulling the monetary system in different directions.
In December, the Central Bank raised large volumes of money for the Treasury, printing hardly any money. Rates went up, and rates came down in January with lower credit demand.
The secondary government securities market suddenly came alive as soon as interest rates were freed.
In fact, secondary market rates started to move below auction rates and there was very active trading as money poured into the g-sec markets as financial repression ended. It was beautiful to watch.
In January the rates came down. Ideally the government should have used this opportunity to raise more money but partly due to the availability of central bank credit in the form of provisional advances as well as other reasons, borrowing requirements in the first quarter are lower.
Short term high volatility in rates and yield curve can have odd effects, but it is good news for bond traders who can make quick profits. But provided the market is freed, arbitrage may gradually close this gap in several ways and smoothen the yield curve over time.
Private borrowers may get used to raising more money for longer during this time as there is less crowding out. Also a new dimension has come in.
There is evidence that some hedge funds sold bonds during the period, betting that rates will jump again later. Volumes were small but this is arbitrage in a hurry. Aren't markets beautiful?
Monetary Framework - Guess the regime
The discussion above shows that the Central Bank has no control over the yield curve, whether overnight or longer. It is no longer conducting 'monetary policy' in the way it is normally meant in other central banking regimes.
A central bank is set up to control interest rates and to manipulate the price of credit. In a market economy a central bank is an anachronism that controls the price of credit artificially and usually gets into trouble.
When central banks make credit too cheap for too long, economic turmoil follows. It creates property and stock market bubbles and loan defaults that we are seeing in the US and Sri Lanka.
With the reverse repo window also closed in Sri Lanka, a situation very close to a currency board is found except that interest rates are higher than it would have ever been under a currency board regime because the capital account is only partially open.
People who believe in central banking and its supposed ability to keep full employment lay much emphasis on 'monetary policy independence'. Well, we don't have it. We have free-for-all-interest rates even in the overnight market subject to the 12.00 percent floor, while usually exceeding the 19.00 percent ceiling.
(And isn't our banking sector resilient? Aren’t our long-suffering borrowers and corporates resilient in the face of 20 percent plus interest rates? In the US, when rates go to five percent the so-called Wall Street giants go whining to the Fed for rate cuts like a bunch of namby-pamby cry babies.)
However, a policy rate environment and open market operations are needed to operate a floating currency regime.
Exchange framework - Guess the regime
Despite the rhetoric spewed out by the Central Bank, Sri Lanka does not have a floating exchange rate. Sri Lanka has a soft-pegged exchange rate with some flexibility. This can be easily shown by the extent of sterilized intervention.
In fact Sri Lanka's foreign reserves now exceed reserve money making it possible to have a currency board, and even dollarize the country and eliminate inflation overnight.
It was amusing to see the Central Bank making completely contradictory statements in the 2008 Monetary Policy Roadmap.
"Sri Lanka continues to follow a floating exchange rate regime, where the market forces of supply and demand largely determine the exchange rate," it said in once place.
Amazingly elsewhere the Central Bank said:
"It would also be useful for us to note that the reserve money growth would be facilitated by the growth in Net Foreign Assets (NFA) and Net Domestic Assets (NDA) of the Central Bank.
"Further, any change in reserve money due to a change in expected growth in NFA would necessarily have to be offset by a corresponding change in NDA."
These are polar opposites. By sterilizing Sri Lanka is running a pegged exchange rate by definition.
The fact that Sri Lanka now has a fully foreign reserve backed currency also shows that the country does not have a floating rate. In a floating rate environment the monetary authority runs reserve money out of domestic assets (CB credit or gold earlier) not foreign reserves, because it does not intervene in the forex market.
This is the problem with monetary policy here. We are confused. We have multiple anchors as Steve Hanke said (Read Dragging Anchor), which is another way of saying the same thing.
We have an exchange rate anchor with the US dollar, with a very soft peg, where the central bank is not only prepared to sterilize foreign flows but is also willing to do the opposite and cause a currency crisis as seen repeatedly.
A country with a peg (hard or soft) will import inflation. That is the anchor currency inflation, in Sri Lanka's case US inflation. With US inflation rising even hard peg countries like Hong Kong are having problems.
When the central bank maintains a fairly hard peg, net foreign assets or the balance of payments fulfills all the money needs (reserve money requirements) of a country.
That is why any debt monetization and discount window activity tends to be inflationary in a pegged environment. This is the problem facing Gulf countries and driving them to break the peg with the US dollar.
That is why there is a close co-relation between central bank credit and inflation in this country. This columnist has previously explained why. It essentially captures the difference between a currency board and a central bank (soft-pegged).
Also the outstanding T-bills or CB credit behaves like a flow because it is tied to annual budget cycles. Read Money Money. However one can just as well compare growth rates.
It won't happen like this in the US or Australia which run reserve money out of central bank credit and have a floating exchange rate. In other words this is a classic soft-peg problem. Inflation jumps when central bank credit jumps because the real money demand is already completely satisfied through the peg. The country also does not have a floating rate to balance domestic asset movements.
There is another complication. Because the capital account is not free, foreign capital flows cannot easily leave the country here.
Therefore the problem becomes more acute than Hong Kong which is running an orthodox currency board and all kinds of capital comes in and goes out without causing a problem.
Singapore is operating a very complicated system which will take pages to analyze so we will leave it aside for the moment.
But our system is very complex and has built in multiple policy contradictions. We have multiple anchors like Steve Hanke said. The central bank is targeting the exchange rate and money supply at the same time. It can be done as long as the balance of payments is in surplus.
As of February 2008, the Central Bank is now running a system that is very close to a currency board, with freely fluctuating interest rates, a partially closed discount window, and active intervention to prevent the rupee going up. The rupee will be rock steady under these conditions.
But because we have capital controls, the Central Bank has to deal with excess liquidity from capital flows also.
All this is very interesting academically, but practically our monetary regime is loaded with basic theoretical policy conflicts which are nightmarish.
These policy conflicts cause the system to unravel from April onwards.
Since fuss-budget started to analyze this economy one fact has stood out like a sore thumb. Somewhere in May-June the country is shunted into a currency crisis with clockwork regularity.
One of the triggers is the sharp increase in reserve money in April. Look at the Policy Logjam graph. Plotted in the graph is reserve money, reserve-money-with-excess liquidity and the exchange rate. The exchange rate is in fractions of dollars for a rupee.
The April peak is caused by several factors. There is a large festival related drawdown of cash from the system.
Last year in April reserve money went up to 277 billion rupees, which was higher than the end-of-the-year money target.
A part of this cash need is satisfied by foreign flows. The entire export sector gives festival advances by selling dollars. In the first and second quarters of 2007 foreigners were also buying bonds. Ideally a hard peg should satisfy the entire cash requirement out of the balance of payments.
However in April the government also gives festival advances to state workers. This is usually printed. This is the root cause of the problem.
When the behaviour of the rupee is plotted against reported reserve money and reserve-money-with-excess-liquidity, some trends can be seen.
The rupee was weakening only a little in the first quarter after recovering from a bout of money printing the previous year. The blue area is reserve money and the orange is excess liquidity.
With the central bank pussyfooting around excess liquidity the rupee started to crash last year after May. By late July/August there was full scale sterilized intervention to defend the currency and the rupee was going down like a stone as reserve money was kept within targets.
Consider this. Before April the central bank was sterilizing dollar flows. In April the rupee is floating and appreciating.
Then the rupee comes under pressure from May onwards. The central bank then abandons all pretences of floating and tries to intervene.
The central bank is essentially switching between different exchange rate regimes.
When the exchange rate is targeted, the balance of payments supplies all the money needs, so there is no room to add domestic assets. When it happens, inflation and currency pressure is the result.
The problem with excess liquidity is that it is not only available for lending the next day but more importantly it is available for payment settlements.
The ability of commercial banks to 'reserve short' and go excess reserves are extensions of the same problem. A bank could reserve short up to 10 percent in this country.
In other words it is like a backdoor reverse repo window. For all these reasons (and a closed capital account) the reported reserve money does not really reflect the ability of the financial system to generate inflation.
What's to be done?
Last year in the midst of all this promises were made that rates would fall. That way lies madness.
The central bank should make all efforts to persuade the government to collect some cash ahead of time or raise it abroad, and like in December 2007, stay away from the primary bill market and stop funding state worker salary advances which is the core problem.
Then if the central bank wants to defend the currency after April, it should engage in non-sterilized intervention until post-festival excess liquidity is exhausted and not try to control the rates or keep to reserve money targets. If reserve money has to shrink, let it shrink.
Without a policy rate regime, a floating rate also cannot function effectively.
The 'problem' with capital flows and excess liquidity is caused by exchange controls. But by sterilizing capital flows the central bank is also denying the economy of the benefit of external capital and keeps rates unnecessarily high.
Here is another policy contradiction. There is no point in the Treasury telling private firms to borrow abroad if the central bank is going to sterilize and appropriate the money.
The 500 million dollars ended up pushing up foreign reserves because of sterilization and it was used to repay banking system overdrafts without causing real economic transactions. Otherwise all capital flows should increase reserves. It does not happen like that.
Technically there is no harm in opening the capital account for foreigners to buy bonds, if there was an institutional framework to support it, like a credible peg -- in other words a currency board. Or a floating exchange rate. We have neither.
A currency board will impose a hard budget constraint. Even then, if a government continues to borrow abroad irresponsibly, there could be sovereign default.
But there need be no currency collapse and economic collapse and bank collapse in a currency board environment. A simple sovereign default will be enough.
But in a pegged exchange rate regime, a country can have a currency+economic+banking crisis to the extent that bond maturities are financed with central bank liquidity (printed money) initially and the currency is defended and then finally let go, followed by eventual sovereign default as well.
A currency board in Sri Lanka will probably hurt the exporters less than a floating rate because there will be more time for adjustment.
Remember the bi-polar view? It says that only currency boards and floating rates will work and 'non-credible' pegs do not work and are disappearing into currency unions/dollarization or currency boards or to full floats.
Former IMF first managing director Stanley Fischer who saw the East Asian crisis at first hand paid a back-handed compliment to Steve Hanke and Kurt Schuler for their "tireless proselytizing" of hard pegs in a landmark address where he basically wrote off soft pegged exchange rates (read Is the bi-polar view correct? )
Pegged exchange rates seem to be relics of colonial era currency boards that have failed to grow up in to full functioning floating rate central banks.
That is essentially what the bi-polar view means. Soft pegged exchange rates/central banks are an immature system which can be very costly to the poor as has been proved in Sri Lanka.
Next year, around this time, hedge fund-held rupee bonds will mature.
Before that happens get the fiscal house in order, re-think our monetary regime and start dismantling the policy conflicts that are pulling an inherently unstable system in different directions.
If the war intensifies and credit quality is called into question by rating agencies, the authorities would not be able to play the same games with hedge funds that it is now playing with the EPF and cancel bond auctions.
Aren’t markets beautiful?
Bouquets and brickbats to email@example.com. You may also click the response tab to write comments.Postscript
Error corrected. Last year promises were made after April that rates would not rise. Not fall.
Financial repression or the way interest are manipulated downwards by the central bank is also part of the monetary problem in Sri Lanka.
The discussion below relates to recent development in government securities markets.
Defenders of the powerless
One of the problems in the market is that the employee's provident fund (EPF) is mis-used by the authorities to repress rates. However, now there are some large bond buyers and dealers who can challenge the anti-market practices of the EPF managers.
The problem is that the EPF does not act in the best interest of its beneficiaries as a genuine market participant would.
In fact the big private bond players must realize that they are the last hope that the little people have, such as EPF beneficiaries who are slaving away in the hill country tea estates or garment factories.
Fuss-budget could say that big bond players have a bounden duty to protect the little people from the authorities and the Central Bank. But no such altruism is needed.
Bond market players should use their expertise and market power wisely for their maximum profit and automatically the man on the street, including small savers, will be protected from the draconian 'business' of government.
Even borrowing short in the overnight market and running a 3-month bill portfolio and bringing down rates is perfectly ok, because the government must get that benefit also.
The crazy 12.00 percent reverse repo rate must be used in some way, otherwise short term lenders will lose heavily. However structural rigidities prevent the discontinuous rate structure between the overnight and one month term money being arbitraged away more efficiently. No matter.
Authorities must also realize that primary dealers do not want rates to go up. Rates go up because the government is borrowing too much and ultimately bond holders who hold to maturity (the savers and the insurance companies which represent little people again) push dealers to bid higher.
When dealers advise clients to bid higher, even at the cost of their own portfolio, they are displaying a remarkable professional integrity which is sadly lacking in this country elsewhere, especially in the EPF.
It was really funny to see some dealers getting upset when auction rates went up and the value of their portfolios fell a few weeks back. That is also ok. The market needs different views to work. Aren't markets beautiful?
Remember the forex market last July? (See The Thrift Column – Currency Crisis). The problem of exchange rate depreciation or rate rises is not the fault of the dealers. Heavy handed actions on the part of the authorities will not work if their policies (sterilized intervention, budget deficits) push dealers to act in the opposite way.
It is perfectly legitimate to try to sell bonds outside the auctions on other days especially because money comes looking for homes all the time and not just on the auction date. If the government does not grab it, it goes elsewhere.
But this also shows why bond auction cancellations have proved counter productive in the past. Money not taken is money lost and tied up in a fixed deposit somewhere.
Auction prices go above the secondary market because the Treasury comes into a market between private players. The auction rate also gives early signals to draw new money in.
This is the way markets are expected to work.