Fussbudget was particularly happy to see the coal power plant being set up and central bank paying back t-bills as foreign reserves continued to flow in and inflation fell.

But by May it has all changed. A balance of payments problem is developing, inflation is rising and last but not least the country is officially at war with itself, albeit at a 'low intensity'.

Weak Point

A war is not necessary to create a balance of payments problem because our economic policy framework, particularly the fiscal side, is capable of doing it all by itself, thank you very much.

Weak fiscal policy and fiscal dominance of monetary policy (the treasury taking away central bank independence and forcing it to print money) is enough to destabilize this island economy, as our experience in 2004 so graphically showed.

So what exactly is happening now?

In May, Sri Lanka started to lose official foreign reserves on a net basis. Though the numbers are not out yet, we can infer this from some of the data that is available.

Reserve Money

The first hint that something was wrong came from the way, excess liquidity was disappearing from the inter-bank market in mid-May.

To understand what is happening, it is first necessary to explain how the monetary system in the country works.

Two variables (net foreign assets of the banking system and net domestic assets of the banking system) drive the country’s money supply.

Rupees are fundamentally generated in two ways, when the Central Bank buys dollars, and adds them to its reserves (foreign assets), and when it buys t-bills (the largest component of domestic assets) and gives printed money to the treasury.

See The Thrift Column – Print Job for details on how this happens.

The impact of these two variables is directly felt in reserve money, a very narrow measure of money supply.

There are also other factors that affect money growth such as commercial bank credit creation and Central Bank direct advances to government - which is another form of printed money.

Central Bank will try to limit the growth of reserve money to keep inflation down. If lots of foreign dollars come, it will sell t-bills it has in stock, or issue its own securities and suck liquidity out, like China does now. This is called sterilizing capital flows.

Look at it in another way. Rupees are backed either by dollars (foreign assets) or by t-bills and central bank advances.

In a country with a currency board - like Sri Lanka before independence, Hong Kong or even Singapore - local currency is basically backed 100 percent by foreign reserves (see The thrift column - Invitation to Disaster and ‘Why a currency board’ a speech by a former Finance Minister of Singapore).

True Central Banks however issue money against t-bills and have the power of ‘independent monetary policy’. This power is usually taken over by the treasury in countries like Sri Lanka and Zimbabwe and we have runaway inflation.

This is called fiscal dominance of monetary policy and is a chronic sign of countries with weak macro-economic management.

In order to sell down t-bills, and contain reserve money growth, there has to be capacity in the country to buy them. That depends on the interest rates in the country.

The central bank will automatically print money, if it has to keep interest rates low by buying treasury bills. This is what happened in 2004.

In November 2003, when President Kumaratunga took over the ministries Central Bank had sold down all the t-bills acquired during the Pariwasa and pre-parivasa money printing binge and was issuing its own securities to sterilize capital flows.

By that time the Sri Lanka rupee was almost fully backed by dollars except for Central Bank advances.

Respite

In 2005 when foreign aid and debt relief came, the treasury did not need to print so much money.

When capital inflows came, the Central Bank was even able to sell down some of the t-bill stock. If rates had been higher (or if the borrowing requirement had been lower) central bank would have been able to sell down t-bills faster and slow the growth of reserve money and therefore inflation.

That said however, when the economy is growing, reserve money has to keep pace, otherwise the economy would be strangled for want of liquidity or money.

Developing Scenario

Now we come to the present situation.

In May liquidity suddenly went off from the system. See the 'Liquidity Crunch' graph.

Banks which were parking excess money at Central Bank through the repurchase mechanism was suddenly borrowing on a net basis through the reverse repo auctions.

The first that anyone would think is that, ‘Great! Central Bank has finally come to its senses and has started to do its job by tightening monetary policy, especially since the inflation has started to spike up.

Monetary Comedy

Earlier Central Bank was engaged in a silly type of monetary policy.

It first prints money by purchasing t-bills in the auctions.

Then, usually after the government spends it and creates demand in the economy, takes it out of the system by what it quaintly calls ‘aggressive open market operations’ in the monthly monetary policy statements.

Isn’t that cute? Really, really, laughing - gas funny?

This is like closing the stable door after the horse has bolted.

This is good competition for the monetary policy of the Reserve Bank of Zimbabwe (point to point inflation moved over 1000 percent in Zimbabwe in April and the Zim dollar has fallen to 100,000 to the dollar now), but it doesn’t get us anywhere except more inflation, bad lending and problems in the banking system later.

Emerging Problem

But a close look at the numbers show that it is not central bank that is draining liquidity from the system.

The graph below show how economic fundamental have changed in the past few months.

Sri Lanka recorded a balance of payments surplus of 151 million dollars by end March. Central Bank was steadily selling down its t-bill stock at the current interest rates.

This means there was fiscal space to do so. All well and good. By April, the t-bill stock and reserve money was rising again.

In April and December, Central Bank usually pumps in lots of money to accommodate festive spending.

This year it seemed unusually good.

Sure enough after the holidays money came back to the system and both reserve money and the t-bill stock tumbled.

Central Bank said the balance of payments surplus climbed to 197 million dollars and official reserves to 3-billion dollars by end April.

But in May, you can see in the graph, that reserve money is steady, but the t-bill stock is rising.

Going the other way

In May the two variables started to diverge. It is the opposite of what happened from January to March.

You can estimate the loss of reserves by deducting the t-bill stock from reserve money and assuming that the balance is the foreign reserve figure.

This is not strictly correct as foreign reserves are much higher, becuase dollars given by the IMF for example, do not show up in reserve money.

Also other variables affecting net domestic assets can also change. Fuss-budget assumes that in a country with profligate fiscal policy and weak monetary policy (interest rates are flirting in negative territory again) it is highly unlikely to happen.

The ‘Backdoor Calculation’ graph shows that we may have lost close to 85 million dollars by end May.

Even if all of the reserve money loss was not due to falling foreign assets, and assuming only half of it was due to reserve loss, we should have lost about 50 million dollars at least on a best case scenario.

Going by past experience, other domestic assets tend to rise, not fall. If so, the reserve loss would be greater not smaller.

Hot and bothered

Last Friday the markets panicked and the rupee fell almost to 104 against the dollar after the sudden resignation of Central Bank Governor Sunil Mendis.

Central Bank officials quickly announced that the government would raise 300 million dollars by what it calls a development bond issue.

Most of it would go to pay back maturing debt. This would be raised from local banks and there would be no new dollars coming into the country.

But to the extent that any new bonds are issued, there will be a transfer of dollars from private reserves to official reserves when the government spends that, and the central bank buys it.

Of course if the government uses that money to pay for subsidized imports like oil or subsidized fertilizer, the forex would go out of the country.

So all this depends on to what extend we implement Mahinda Chinthana or not.

The Bank of Ceylon is also reported to be raising dollars again. The BoC is always used by the government to raise money abroad when there is a balance of payments crisis.

Can we ride it out?

Can we ride out the current problem by resorting to commercial borrowing? That depends on the causes of the problem.

If this is a temporary problem, we can ride it out. Central Bank has responded fairly well by allowing liquidity to drain out and not pumping in more money like in did in 2004.

But if the problem persists, Central Bank will have to allow the system to tighten and raise rates and allow the market to go short some more.

In that case, it could be that too much money is being pumped in, even now.

Fundamentals

But if the causes are more fundamental, then short term fixes cannot work.

This column has warned several time that Sri Lanka’s rupee was overvalued in real effective exchange rate terms, because of Rata Perata inflation and tsunami rupee appreciation (see The Thrift Column - Great escape - and The Thrift Column – Debt Reduction).

Export growth fell to single digits in 2005 and then fell in absolute terms in the first quarter of 2006. In April there was a slight upturn.

That means the rupee has to depreciate. Lots of export companies, especially high value added ones like Hayleys are suffering. Hayleys just got downgraded.

But exports do not respond quickly. However, depreciation may help stop us losing orders.

Immediate demand management measures are needed.

We need to bring back automatic fuel price adjustments and also stop overpricing petrol and subsidizing diesel.

Again it is a question of whether we change Mahinda Chinthana or not.

Meanwhile the trade deficit is now at over a billion dollars. This is a lot of money. If you extrapolate it, that means a 4-billion dollar deficit at the end of the year. Can we really bridge that kind of resource gap?

The debt relief is also not there this year. We had a party on the generosity of the international community, but now it is ending.

That means a burden of about 250 million dollars on the balance of payments as well as the fiscal front, compared with last year.

War drums

Whether the war continues or gets worse also depends on the Mahinda Chinthana.

Continued denial of a federal state to the Tamil people or using Karuna faction to hit the LTTE will intensify the war.

Of course the people who drive the country towards a war and kill more people, may just want to import arms because it is good business, and may not really go to war.

But the import of arms will be a burden on the balance of payments, even if it can be delayed by getting credit.

The war is already affecting tourism earnings. Investments will also be deterred.

Originally the government was going to borrow a billion dollars through a rated 7-year bond issue and use it to finance fiscal excesses.

But with our sovereign rating outlook being downgraded with the war drums beating louder, this might be difficult.

This is what this column said in the The Thrift Column – Purrs and Whimpers in December 2005;

"So now the Tigers have 'elected' Mahinda Rajapakse as the President. His manifesto would of course be attractive to the Tigers because it will weaken the economy. The more subsidies you have, the bigger the pressure on the country's public finances and that means higher interest rates, printing money, cuts in capital spending AND less fiscal room to fight a war."

We need to change our policy on the ethnic question and also move towards benign economic policies that do not foment crises, and hurt the poor.

Its policy, stupid

Some good signs are there.

The treasury has released some numbers on subsidies, and tried to educate people. But it is not easy to convince people after singing a different tune earlier.

The Central Bank’s has also done a lot of plain speaking in this year’s annual report.

Its director of economic research had gone on record in public talking of the problems the country has to guard against, at the risk of being branded a traitor by the JVP.

The JVP seems to have turned its guns on 'foreign forces invading the motherland,' as its latest vote catching gimmick, and allowed the government to do some things that are good for the country and the poor.

Its silence on fuel price rises has been telling, as has been the response of the good-for-nothing leadership of the opposition.

A weak opposition like we have in Sri Lanka will not only allow the executive to destroy independent commissions without raising a hum, but it will also allow the government to implement economic and political measures that is good for the country and the poor, without too much political cost.

Postcript__________________________________

This is your corner so if you have comments please send to fuss-budget@vanguardlk.com or click the comment icon at the bottom of the page.

I am featuring a comment from a reader who watches the economy very closely and has responded to The Thrift Column Expensive Plug on the money wasted on fuel subsidies by the government and the way it taxes petrol heavily and use the money to subsidize diesel, which is the fuel used in the super luxury vehicles of politicians and top bureaucrats.

Here goes;

"In you recent column on fuel prices, it may be worth looking more closely at the situation and questioning the government's language in how they have presented this.

Essentially what has happened is that the govt. has let the rise in international petroleum prices erode part of their tax base -- in this case the high indirect taxes on petroleum products, including import tariffs, excise and VAT; and who knows, the Treasury may also have an import cess as well?

The fact is that fuel prices have remained well above world prices, but not by as much as would have been the case if the govt continued with the automatic fuel price adjustment tied to international prices. The notion that the Treasury has been doling out large amounts to keep prices low looks to be untrue.

Money has been 'lost' only if one adopts the view that the taxes forgone by not raising prices in some way belonged to the Treasury and not the taxpayers buying fuel. It is misleading to think of this as a subsidy, at least in the way this term is ordinarily used (e.g., as with the fertilizer subsidy).

And if this view is correct, the recent price increases amount to nothing more than yet another thinly disguised tax increase, such as the introduction of 'import cesses'. Maybe it can be argued that the govt should have raised taxes --especially given their perennial high budget deficits. And maybe increasing the taxes on fuel make good sense in terms of the distributional impacts.

As you have correctly pointed out, the great bulk of fuel purchases take place in the WP. But at least such a move should have been presented as such.

You are completely right about the distortion that has persisted between petrol and diesel prices. I suspect that the underlying mis-allocation of resources is greater than many expect to be the case."