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ECONOMYNEXT – Sri Lanka’s exchange rate regime, which involves ad hoc interventions and has so far remained stable, providing a solid foundation for the resumption of economic activities amid a largely deflationary monetary policy, has been classified as ‘other managed’ by the International Monetary Fund.

Particularly after 1978, when the IMF’s Second Amendment to its Articles of Agreement deprived members of a credible monetary anchor, countries found themselves in various exchange rate regimes. These collapsed due to conflicting monetary and exchange rate policies, leading to high inflation, social unrest and political upheaval.

De facto

“The de jure exchange rate regime is classified as freely floating, while the de facto exchange rate regime is classified as otherwise managed,” the IMF said in its latest economic report.

The de jure regime is usually the one that is reported to the Fund by a country’s authorities. The de facto regime is what IMF staff typically observes after watching a currency behave for six months or more.

An independent central bank does not intervene in the market and does not build up foreign reserves, nor does it lose them or sterilize them in any direction.

Sri Lanka now has a reserve target under an IMF program, so the rupee cannot float freely. The central bank has to intervene in the forex markets in a kind of pegging operation to buy dollars, with new (printed) rupees.

The moment or moments when an IMF-sensitive central bank intervenes in a country with monetary instability or a soft peg is a source of confusion for outsiders struggling with high inflation and currency devaluation as they try to discern a consistent rule.

Intervention policy

“What is the policy framework that is being used to make interventions,” Dhananath Fernando, Chief Executive of the Advocata Institute, a Colombo-based think tank, asked a central bank forum earlier this year.

“Today we buy, tomorrow we buy, what time do we buy… Can you explain how you use the policy framework to decide this?”

“The central bank does not pre-determine an exchange rate and does not intervene in any way,” Governor Nandalal Weerasinghe explained.

“In the past, banks were told to keep it at 203. Now that is no longer the case.

“It’s called a flexible exchange rate because we’ve allowed it (to move) based on supply and demand. Also, we know that the reserves have been lost.

“There is a need to rebuild the country’s reserves to a stable level.

“We have agreed with the IMF to build up reserves steadily every year.

“Our policy is that there is supply and demand on the market. On some days there is supply but no demand. On those days there can be big fluctuations if we let the market determine the price alone.

“If a lot changes in one day, there can be some uncertainty and it is difficult for market participants to determine the value. So we buy the surplus and give rupees.”

Buying Dollars for Non-Circulating Media

Fernando also asked where the central bank gets the money to pay the US dollars.

“As with all central banks, there is no limit to the rupee we can spend,” Governor Weerasinghe said.

“We can issue rupees against treasury bills or foreign currency.

“On the other hand, we conduct open market operations, where we focus on longer-term interest rates.”

However, the central bank does not ‘own’ the foreign currency it has bought for its banknotes. This increases the monetary base and pushes down interest rates.

The original owners of the banknotes (exporters or relatives of foreign workers) spend the banknotes on real goods, some of which are imported.

Because the reserve money supply grows slowly, depending on the demand for real money, almost all of the rupees created are eventually imported, depreciating the currency unless dollars are later exchanged.

To prevent the rupees from being withdrawn again, the central bank must clear them out (clean them up) by giving any asset held by the central bank that is not in circulation to the original or subsequent owners of the banknotes.

Construction reserves

This absorption or ‘sterilization’ of the inflow requires that interest rates remain slightly higher than necessary to keep the exchange rate unchanged and the balance of payments in perfect equilibrium.

The sale of domestic assets by the central bank to banks to reabsorb the rupees created by the purchase of dollars, leading to a reduction in potential domestic investment by the same amount.

The transaction creates a ‘surplus’ on the balance of payments of the same amount, which effectively leads to an eventual transfer of wealth from the banks to the central bank. It also creates an imbalance on the foreign exchange markets, which causes the exchange rate to rise, in a virtuous circle.

If a central bank that collects reserves wants to lower interest rates through open market operations and pump money into the banks, there will be a surplus of domestic investment financed by money created by purchasing Treasury bills.

This leads to pressure on the exchange rate and a loss of reserves if prices of domestic trade goods are not pushed up by depreciation, leading to social unrest.

As long as the policy rate is suppressed through open market operations, reserves will be lost and social unrest will remain limited.

Modern central banks that are sensitive to the IMF inject money to lower the policy rate (to generate inflation, as in Sri Lanka) or to achieve a specific level of reserve money, as in Bangladesh.

The effect of targeting a policy rate via OMO injections after interventions also opposes a shrinkage in reserve money and is a de facto targeting of reserve money. It leads to the build-up of foreign reserves as long as there is too little reserve money.

Consistent

Countries that successfully tackle inflation do not intervene in the currency markets and do not accumulate reserves, so that outflows are limited to inflows. They do not go to the IMF to manage their balance of payments, because there are no currency crises.

The exchange rate is then determined by monetary policy. This policy typically strengthens the rate against commodities or other currencies in another cycle, as monetary policy becomes ‘tighter’ and attempts are made to reduce domestic credit and reduce inflation.

Countries that successfully leverage exchange rates (rather than interest rates) also succeed in making inflows determine outflows, with foreign reserve growth limited to net expansion of the reserve money supply and to small, temporary purchases and sales of foreign currency on a consistent basis.

They also don’t need to go to the IMF, because there are no foreign currency shortages or currency crises.

Dollar countries similarly limit outflows to inflows.

The intermediate regimes or soft pegs can collapse at any time, when exchange rate and balance of payments stability are subordinated to domestic objectives (anchors), either with respect to inflation or with respect to reserve money or even ample money supply.

The intermediate regimes face large fluctuations in the foreign and domestic assets on the balance sheets of the banknote-issuing banks and trigger crises when the policy rate is lowered.

The IMF now divides exchange rate regimes into four broad categories, apparently based on the behavior of the exchange rate and not necessarily on the balance sheet of the central bank, which is linked to the issuance of banknotes.

One major category, the so-called “hard pegs,” consists of actual currency councils with legal restrictions against exchange rate mismatches and dollarized regimes, which are called “no separate legal tender.”

Soft pins

The IMF has divided soft pegs into separate categories, known as conventional pegs. These include arrangements that resemble currency councils, where the interest rate is not targeted in practice (the operational framework) and the exchange rate has been credibly fixed for decades.

Examples of this are Dubai and Denmark. Monetary laws in such countries usually have loopholes through which money can be printed, unlike a true currency board, according to economists in the classical tradition.

The IMF has classified other crisis-prone regimes as ‘pegged exchange rate within horizontal bands, stabilized arrangements, crawling peg and crawling arrangements’. According to analysts, all these regimes appear to have open anchor conflicts.

The last category is ‘Residual’ and concerns ‘Other managed arrangement’.

Sri Lanka has now also been included in this category.

In the IMF’s 2022 annual report on exchange rate arrangements and exchange rate restrictions, Sri Lanka was listed as one of the countries with a ‘crawling arrangement’ rather than a ‘floating’ arrangement.

According to the report, the residual category (other managed arrangements) generally increases with increased uncertainty in the economic environment.

Regardless of what the current category of ‘other managed arrangement’ is called, the central bank has provided Sri Lanka with a solid foundation for stability and growth, while also undershooting its 5 percent inflation target, which has seen repeated currency crises over the past decade. (Colombo/11 Aug 2024)