ECONOMYNEXT – The International Monetary Fund, has warned that Sri Lanka’s exchange policy is inconsistent with inflation targeting and it has to stop interventions if it wants to move to a successful inflation targeting regime.
“While the CBSL can retain a role for smoothing excessive exchange rate volatility, it should adopt FX intervention policies consistent with greater exchange rate flexibility under flexible inflation targeting,” an IMF report said.
A technical memorandum added that ‘roadmap for flexible inflation targeting will be completed by October 2017 to establish inflation as the nominal anchor moving away from using the exchange rate as the de-facto anchor.”
An inflation targeting arrangement works when an exchange rate floats and new money is added or withdrawn to maintain a policy rate (monetary policy) through the sale of domestic assets like Treasury bills and only an inflation index is targeted.
When new money is added (through the purchase of dollars) or withdrawn (though the sale of dollars to defend a currency) to target and exchange rate (de facto peg) monetary policy is conflicts with exchange rate policy.
To maintain a policy rate such interventions has to be ‘sterilized’.
Buying dollars and withdrawing rupees that are generated (sterilized forex purchases), which can be done when credit moderates, leads to higher forex reserves and exchange rate stability.
But selling dollars and printing money (sterilized forex sales) when credit demand is high, leads to a balance of payments crises where more and more forex reserves and sold, more and more Treasuries are bought to print money and keep rates down, driving credit ever higher.
Avoiding interventions (floating) generate temporary volatility of the exchange rate but no liquidity injections has to be made to offset sales.
“The authorities also pledged to avoid an overvalued exchange rate at the expense of reserves and shift towards an inflation targeting regime in their 2017 Roadmap, but have yet to demonstrate the commitment to sufficient exchange rate flexibility under external shocks,” the IMF report said.
EN’s economic columnist has pointed out that targeting the exchange rate to ‘avoid and undervalued exchange rate’ is also inconsistent with inflation targeting (Sri Lanka may be heading for a triple anchor ‘inflation targeting’ oxymoron: Bellwether).
“Having a forex reserve target is also inconsistent with inflation targeting,” EconomyNext’s columnist Bellwether says.
“As long there is a reserve target, the central bank has to buy dollars intervening in the forex market. What this means is that if the IMF has a forex reserve target for Sri Lanka, you cannot have inflation targeting at the same time.”
Sri Lanka had an exchange rate which did not conflict with monetary policy until 1951 through a currency board where the interest rate floats and the exchange rate is fixed.
But in 1951 the Central Bank of Ceylon was with money printing powers, where both the exchange rate and interest rate is targeted, generating high inflation and balance of payments trouble.
Such soft-pegged central bankers are said to be suffering from ‘fear of floating’.
However, analysts say Sri Lanka is in good company in its ‘fear of floating’. Even the People’s Bank of China showed unequivocally that it is a pegged currency regime burdened by ‘fear of floating by making massive interventions to defend the Renminbi.
But unlike Sri Lanka, which has a crawling peg, which permanently depreciates robbing living wages of workers and destroying lifetime investible real savings, China currency also appreciates like a floating rate, when US fires loose policy.
For long central bank watchers Sri Lanka’s BOP crises are easy to predict.
The foundations for the most recent BOP crisis was laid in the last quarter of 2014 when repo window of the central bank was cut to 5.0 percent from 6.5 percent for banks that deposited excess money more than three times a week.
The then Mahinda Rajapaksa administration also cut energy prices ahead of the election.
“Energy prices cuts will give more spending power to the people, in the style of a ‘fiscal stimulus’ generating, a recovery in domestic demand,” Bellwether warned in late 2014 writing in the Echelon magazine.
“With higher domestic spending, non-oil imports can go up.”
The column warned that the opposition had “promised massive salary hikes to public servants.”