Sri Lanka rupee debt in US$20bn IFR hair cut as economy inflates

ECONOMYNEXT – Sri Lanka government and government guaranteed domestic currency debt broadly considered in debt review has shrunk by a 19.6 billion US dollar equivalent as the economy inflated in the worst currency crisis in the history of the island’s intermediate regime central bank.

Sri Lanka’s central government rupee debt fell to the equivalent of 32.4 billion dollars from 50.5 billion dollars, a phenomenon labelled High Inflation and Financial Repression (IFR).

Sri Lanka had rupee debt of 53.5 billion US dollar equivalent by end December 2021, made up of 50.5 billion US dollars of central government debt and 3.1 billion SOE guaranteed debt, included in an update to creditors on data up to December 2021.

Sri Lanka had 47.3 billion US dollars of central government forex debt with 5.4 billion US dollars of guaranteed state enterprise debt and 3.0 billion dollars of central bank debt included.

In the next six months the rupee collapsed from around 200 to 360 to the US dollar in a float botched with a surrender rule (forced dollar sales to the central bank), sterilized interventions and too low policy rates amid raging domestic credit.

By end June 2022, rupee debt had shrunk to 34.0 billion US dollars equivalent from 53.6 billion US dollars equivalent by end December 2021 in a severe High Inflation and Financial Repression (IFR) or real ‘haircut’ according to the latest update to creditors.

Sri Lanka’s dollar debt considered in the update had also fallen marginally to 46.6 billion US dollars by end June 2022 from 47.3 billion US dollars in December 2021 made up of 5.5 billion US dollars of SOE guaranteed debt and 3.2 billion US dollars of central bank debt.

The Monetary Authority however has more forex debt than included in the update according to other data. Considered in the update was 1.1 billion US dollars owed to the International Monetary Fund (negative SDR position excluded) and 2.0 in external swaps only.

The treatment of Asian Clearing Union deferred liabilities and domestic swaps is not immediately clear.

The wiping out of the rupee debt to 34.5 billion US dollars by June 2022 from 53.6 billion US dollars six months earlier reduced total public sector debt considered in the compilation to 80.5 billion US dollars from 100.9 billion US dollars over the six months.

There are however classification differences between the two updates.

The new update said forex debt was 70 percent out of public debt of 122 percent of GDP public debt in June 2022 compared to 27 percent of 114 percent of GDP public debt in 2020.

Sri Lanka’s economy is expected to inflate to at least 23.8 trillion rupees in 2022 from 16.8 trillion rupees in one of the biggest inflationary blow offs since the 1980s when rupee began to be rapidly depreciated in response to money printing triggering high inflation and social unrest.

An inflating rupee economy boosts nominal tax revenues, bringing automatic ‘debt sustainability’ as long as the public sector is not expanded and wage restraint in maintained.

There are fears that rupee debt will be re-structure hurting banks, pension funds and other debt holders who will in any case pay more tax under contemplated reforms.

Tax revenues were up 25 percent in the six months to June 2022.

Sri Lanka’s rupee collapses due to its intermediate regime central bank which does not have a consistent monetary anchor but practices discretionary and conflicting policy generally known and the impossible trinity.

Over the past 7 years highly discretionary policy was practiced under ‘flexible inflation targeting’ where floating rate monetary tools (open market operations for stimulus) was applied to a reserve collecting peg in policy comparable or worse than the 1980s according to critics.

However in the last decade Sri Lanka had become a market access country and the country defaulted I April 2022 after running out of reserves.

In all previous currency crises coming from flexible monetary policy, debt sustainability was reached with High Inflation and Financial Repression.

At the moment government debt yield are around 31 percent forward with historical inflation running close to 70 percent.

A new monetary law which will subjugate discretion over rule legalizing both a ‘flexible’ exchange rate and ‘flexible’ inflation targeting (a modernized version of attempting to defy the impossible trinity of monetary policy objectives) is to be legalized as a prior action in a deal with the IMF.

Flexible or discretionary policy is a doctrinal foundation of classical Mercantilism (John Law, James Stuart as well as anti-bullionisms and Banking School) which was given a new lease under Keynesianism and forms the foundation of soft-pegs (intermediate regimes).

Washington based practitioners neo-Mercantilism including Robert Triffin (propagation of Argentina style Prebisch-Triffin central banks), John H Williams (key currency), and later John Williamson (basket band crawl/REER targeting) peddled impossible trinity flexible regimes to hapless third world nations without a strong domestic classical doctrinal foundation.

Flexible monetary policy rejects the rule based principles of classical economists such as David Hume, David Ricardo and Henry Thornton outright.

Flexible exchange rates, which are neither floats nor hard pegs also reject modern classicals such as F A Hayek, Milton Friedman, Ludwig von Mises, Bertil Ohlin, Wilhelm Ropke whose ideas drove the Federal Republic and Japan from 1948 in the Bretton Woods era and East Asia and GCC firm pegs and true currency boards.

Similar ideas also drove the US and UK in the ‘Great Moderation’ period from the early 1980s until 2001, and still drive countries with German speakers including Switzerland. Germany itself is now under the ECB which printed money to boost jobs and delayed rate hikes.

The US also fired a bubble with Jerome Powell delaying rates cuts blaming supply chains and ‘transient’ inflation taking refuge in non-monetary explanations.

In Sri Lanka also there are is strong believe that a part of the inflation is non monetary and is used to unleash open market operations to suppress rates and trigger currency crises.

That inflation is non-monetary (supply chain, wages, interest rates, hoarding) stem from ideas of classical Mercantilists such as James Stuart.

That a part of inflation is non-monetary however is an ad hoc idea articulated by persons such as Fed Chief Arthur Burns who broke a three centuries old gold standard in 1971, for which it is difficult to find clear doctrinal originators, according to critics.

In a country with a flexible-policy-reserve-collecting peg, nominal interest rates are high and long term real growth is low due to trade and exchange controls by the soft-pegged central bank which curtail economic freedoms, as well as output shocks.

In an IMF or other Debt Sustainability analysis, low growth and generally higher nominal interest rates have to be assumed with no exit from anchor conflicting flexible policy that has prevailed from 1950 compounded by depreciation from BBC policy from 1980s and market access over the past decade.

In a four to five year Federal Reserve cycle, a flexible policy soft-pegged country will lose about two years of growth due to monetary instability. The compounding effects of low growth (output shocks) have severe impacts on long term growth and prosperity.

In Sri Lanka’s current currency crisis which led to sovereign default, growth is to become positive in 2024 and remain about 3.0 percent until 2027 according to the update creditors. (Colombo/Sept24/2022)