ECONOMYNEXT – As Sri Lanka’s rupee collapsed yet again in 2022 and several non-credible pegs in South Asia came under pressure, a survey by the World Bank has revealed that only 2 percent of experts believed that balance of payments troubles were caused by central bank policy conflicts.

The survey also revealed a deeply held Mercantilist beliefs of policy makers and experts region, indicating that no solutions can be found for repeated bouts of monetary instability that dogs the nations, especially when the US tightens policy and South Asian soft-pegs break.

Usual (Mercantilist) suspects

Around 85 percent of respondents believed that rising cost of imports were the cause for balance of payments deficits.

Another 76 percent (experts could give multiple reasons) believed that a lower growth of exports over imports was the reason.

This in line with the general blame blamed by soft-peggers and other in South Asia on importers (there is a trade deficit). South Asian soft peggers simultaneous blame exporters (this is not an export oriented economy).

Another 30 percent blamed falling remittances through official channels.

This is in line with another category of hard working dollar earning usual suspects blamed by soft-peggers’ and others who have rejected classical monetary economics.

Non-credible pegs

A reserve collecting central bank with as policy rate (a non-credible peg) triggers balance of payments troubles when liquidity is injected to suppress market rates as domestic credit picks up.

Many central banks banks in the region cut rates in 2021 (Bangladesh) as domestic recovered strongly post-Covid, while others (Pakistan, Sri Lanka) set up Zimbabwe style central bank re-financed funds to boost credit.

Liquidity can be injected to the banking system by purchasing new Treasury bills (deficit monetization) or bills from past deficits held by commercial banks and other holders by not rolling them over and deliberately failing bond auctions.

Private bank re-financing by liquidity injections to offset dollars sales (sterilized interventions) in the forex markets picks up in the latter stages of a currency crisis as increasingly larger volumes of dollars sold to defend the peg whose credibility has been lost.

Once the credibility of the peg has been lost, exporters try to delay conversions, importers try to settle early and there is capital flight. However in most countries with non-credible peg, capital ouflows are limited.

Outflows are also sterilized with new money to maintain the incompatible policy rate and resisting a contraction in reserve money preventing a slowdown in domestic credit with exchange rate policy (external anchor) coming in conflict with domestic policy (either inflation or reserve money target).

Eventually shock rate hikes are needed to stop balance of payments deficits by curbing domestic credit. A float could also end policy conflicts by isolating the reserve money from the balance of payments.

In Sri Lanka such injections, which allow bank to lend without deficits, are classified as claims on government (net credit to government) leading to a common mistake that it is deficit finance. when it fact they are central banks claims on commercial banks.

Classical Knowledge

David Ricardo, who warned the Bank of England against sterilized interventions during UK’s 19 century Bullionist-Anti-bullionist debates, called then ‘fictitious capital’.

In the period money printing which led to gold exports (forex shortages in present day terminology) were generally called ‘super abundance of paper money’.

About 37 percent of South Asian experts blamed capital ouflows for balance of payments troubles.

Severe balance of payments trouble began to hit South Asis after the Reserve Bank of India was nationalized and money was printed to finance Nehru’s Gos-plan style five year programs now generally called stimulus and Ceylons currency board was broke in favour of a soft-peg.

B R Shenoy, was the only classical economist around warn India against the consensus opinion of the other ‘economists’ and policy makers in the 1950s against what is now called stimulus.

“To force a pace of development in excess of the capacity of the available real resources must necessarily involve uncontrolled inflation,” Shenoy warned in his ‘note of dissent.”

“In a democratic community where the masses of the people live close to the margin of
subsistence, uncontrolled inflation may prove to be explosive1 and might undermine the
existing order of society.”

Shenoy also warned that individual liberties and economic freedoms will be lost and ideologies such as communism will flourish under central bank policies.

“In such a background one cannot subsidise communism better than through inflationary deficit financing. Probably the greatest enemy of the Kuomintang in China was the printing press,” he warned.

“Alternatively, if appropriate “physical measures”, familiar to a communist economy, were adopted (in an effort to prevent inflation) we would be writing off, gradually or rapidly, depending upon the exigencies, of the plan, individual liberty and democratic institutions by administrative or legislative action.”

Remnants of the KMT who fled to Taiwan, set up one of the pegged mmonetary authorities in the world that ran consistently deflationary policy (mopping up inflows to under-supply reserve money rather than over-supplying by offsetting outflows with new money) setting a strong foundation for growth and formation of domestic capital.

Shenoy

In Sri Lanka after a hard peg was abolished and a Latin America style soft-peg was set up in 1950 exchange controls and import control laws followed in 1969, ending economic freedoms and individual liberties and destroying domestic capital through inflation and deprecition.

More than a decade later in 1966 Shenoy warned Sri Lanka that import controls were useless and inflationary central bank policy must be ended.

“..[T]he Balance of Payments difficulties cannot be solved by intensifying the rigorous of exchange control and import restrictions; nor by extending the schemes for expanding domestic production to
substitute import goods — the so called measures for “economising” on foreign exchange,” he said in a report commissioned by ex-Sri Lanka President J R Jayewardena.

“Intensification of the rigorous of exchange control and import restrictions may reduce the quantum of import goods flowing into the market.

“It cannot reduce the flow of moneys seeking to purchase goods, either for consumption or for investment.

“The remedy to this problem lies in putting a stop to inflationary financing, not in tampering with the normal course of international trade.”

At the time Sri Lankas central bank was engaging in re-financing rural credit, and not systematically mis-targeting rates through open market operations unlike in the past decade.

Several pegs which had a degree of credibility in South Asia, including Maldives, Nepal and Bhutan are now under pressure due to ‘monetary policy modernization’.

All blame is usually put on deficit financing in a knee jerk reaction including by the perpetrators of inflationary financing.

However Shenoy explained that deficit financing simply transfers spending power from the public to the government and cannot add to new demand unless interest rates are suppressed with central bank accommodation.

“No additions to the money supply take place when the savings of the people are claimed by the government to finance its outlays; such operations merely shift moneys from the pockets of the savers into the pockets of the recipients of government disbursements,” Shenoy said.

However commercial bank funding of the deficit could be inflationary if central bank reserves (a reserve short or window borowing) were used. (Colombo/Oct14/2022)