Rate Signals

by Fuss-Budget, LankaBusinessOnline, July 4, 2007

A big question in everyone's mind these days is where interest rates are going, and whether rates will ease towards the end of the year with falling inflation as foreign bond buyers were originally led to believe.

The country needs a rate at which the budget deficit can be bridged without printing money, if inflation is to be kept at bay and a balance of payments crisis avoided.

Obviously it is not the Central Bank or even the finance ministry that actually determines the interest rate, but the cabinet through its budget deficit. This was shown last week by how treasury efforts at revenue collection were undermined by tax waivers.

Central Bank policy rates no longer have any meaning except in so far as to take back excess liquidity.

Fiscal Signals

The effective 'signal rate' in Sri Lanka is now the 3-month Treasury bill rate, which is above 17 percent. It will only come down if fiscal management improves. But the fiscal situation looks as horrible as usual.

On the positive side there is the 'elimination' of fuel subsidies. There is also talk of public private partnerships to revive state institutions that have been run to the ground. Others presumably will have to wait for their turn to be run to the ground.

On the negative side is the jumbo cabinet, 20,000 new public sector recruitments, a high flying Mihin Air, foreign junkets, high profile arms deals, tax-free cars to public servants, foreign aid suspensions and supplementary estimates and assurances that electricity prices will not be raised.

An attempt by the Treasury to adjust interest rates of public servants to recover some of the costs were vehemently opposed by public sector unions, which, Shylock-like, demands subsidized loans while every ordinary man borrows at high rates and pays taxes.

More than half the taxes collected from the people are already going to pay government salaries and wages. No content with getting tax free salaries and tax free cars state workers are fighting over each others' salaries, which they call 'salary anomalies'. This is really amazing.

To find 'fiscal restraint' and 'discipline' in this mess you will have to import a scanning tunneling microscope. Does it look as if rates can come down?

These signals are enough to make foreign investors or even a fuss-budget shudder. True, foreign bond buyers have piled into government bonds. But then foreign bond buyers bought into Argentinean bonds too, until the government defaulted.

Sri Lanka has never defaulted. Fortunately the JVP has not suggested that we do. If they do, we will probably be downgraded pretty fast, because rating agencies have seen earlier how fast the JVP's pet rants, like fuel subsidies, became government policy here.

Foreign View

According to Fitch we have been already rated too high at BB- compared to the parlous state of our budgets. Chronic fiscal deficits that financed wasteful spending have pushed our national debt to 93 percent of GDP, when other countries with a BB rating only have national debt of 30 percent of the economy.

Fitch said the 'negative' outlook of the BB- rating would be upgraded to 'stable' only if there are "clear signs of fiscal consolidation, a reduction in inflation" and a fall in fiscal risks from the conflict.

This is what the CALPERS, one of the largest pensions funds in the world, said when they finally dumped Sri Lanka from the list of countries they were watching earlier this year. Remember CALPERS is in for the long haul. They are not the speculative buyers of government bonds who are hoping to make fast buck if rates fall.

"Last year, Sri Lanka fell below the 2.0 threshold and was granted a one year “cure period” to improve its score before exclusion from the universe," CALPERS said.

"While Sri Lanka’s 2007 score improved, it is still below the 2.0 threshold and will now be excluded from the universe."

In their fiscal transparency report there was more.

"The move away from liberal economic policies that began when a new coalition government was elected in April 2004 has been reinforced by the presidential elections in November 2005," the report done by Oxford Analytica said.

"Privatisations and efforts to streamline the civil service have been halted or reversed, and public enterprise reform has stalled, particularly in the electricity and transport sectors."

The report also said that budget deficit and debt targets under a fiscal management responsibility law have been missed.

In terms of monetary policy CALPERS was less negative, though they did not see an improvement for two years. While their fiscal policy score was 3.0 (last upgraded in 2003) the monetary policy score was 3.5.

"The appointment of a new Central Bank governor on 1 July 2006 was controversial, because his family firm was reportedly linked to a company associated with pyramid schemes in Sri Lanka," the report said.

"However, this has not affected his overall competence as a Central Bank governor."

This column has made no secret that it is impressed by Governor Nivard Cabraal's monetary policy stance for the past few months.

It is monetary policy and Ashantha de Mel's efforts at raising fuel prices, that has so far kept our foreign reserves intact while tourism receipts fell as oil prices went up and the budget deteriorated.

Hangover vs. Drug Habit

Balance of payments crises, just like inflation, are caused by money printing, not high oil prices. At the moment the budget is battling several enemies; the Tigers, the public sector and subsidies.

Many countries have lost wars by economic collapse because monetary policy was weak, which means printing money to finance expenditure. We saw this happen in 1999/2000 economic crisis here.

In 2004, the treacherous anti-national policies under Rata Perata paid subsidies to oil sheiks brought the economy to its knees even without a war, in a classic Zimbabwe fashion. This was repeated in 2006 (The Thrift Column – Monetary Plunder).

In 2005, a sharp downturn was avoided with foreign tsunami aid. In 2006 the Central Bank came to the rescue with prudent monetary policy.

In 1999 the government printed about 21 billion rupees. In 2000 it printed 49 billion rupees increasing the speed of the suicidal express train without cutting government expenses and driving up 'growth'.

The economy was brought to its knees and foreign reserves fell to dangerously low levels as the Tamil Tigers hit the economy from another front. To stabilize the economy from two years of excesses was very painful and we had negative growth in 2001.

If the central bank had printed money in 2007 as well, we would not know where the economy would have ended up with the rupee probably touching 115-120 to the dollar by now easily.

The country was feeling the effects of the withdrawal of the 'punch bowl from the party', as Deputy Governor Wijewardene and Assistant Governor Thenuwara said on several occasions.

Even if we have 4, 5 or 6 percent growth its better than a complete collapse which you will see if money is printed for a couple of years in a row. The more you print, the harder you fall.

An overnight hangover is nothing like the pain of kicking a heroin habit.

Warning Signs

If oil prices are adjusted quickly and if monetary policy is tight the economy will be stable. But when the speculative capital that came into rupee bonds to make a fast buck tries to leave, we will have a problem.

If we try to hold the rupee and supply dollars and then hold reserve money at the normal also we will have trouble if the volumes are big. Terrorizing forex dealers will only be a short-term fix.

In the last few days, (this column is open to being corrected) we seem to have lost a couple of hundred million dollars. Bond buyers were probably only partly responsible, but the bulk may have been government debt repayments.

A downward spiral will start if the central bank tries to sterilize the effect of outflows by buying domestic assets and not allowing reserve money to contract to account for at least a part of the reserve outflow.

If the government wants to repay foreign debtors, it should borrow from the public and pay the central bank for the dollars in their reserves. This way imports will slow and we will be able to manage with the reserves that are left.

You cannot pay for it all the time with rupees from the central bank and expect nothing to happen. Terrorizing dealers is simply a short-term option.

Remember Ricardian equivalence? . Add BOP to the equation and you have the picture (The Thrift Column – Balancing Act) . This column has pointed out several times that sterilized intervention simply does not work.

This is a small island economy. The government should perhaps build up a sinking fund in an offshore account over a few months to meet bi-annual debt payments instead of messing with the central bank to do that and de-stabilizing the monetary system.

At the moment 5-year bond auctions are cancelled and policy rates kept low probably to pacify foreign bond buyers. But unless fiscal restraint comes, we need high real interest rates. Obviously it will be better to have high real interest rates than a BOP crisis.

Wars and Printing

Good monetary policy is essential for a country at war. Countries like Germany have collapsed during wars because they printed money.

Zimbabwe is now collapsing spectacularly with no war, under the strain of chronic money printing and dangerous Rata Perata style economic policies which had destroyed the balance of payments.

There have also been many near misses. Take the example of the US in 1951.

A decisive battle was fought between the Treasury and the Fed that year which ultimately led to independent monetary policy through what later came to be known as the Fed Treasury Accord of 1951.

Principled Fed officials fought Treasury Secretary John Snyder and President Truman with the Korean War and even the prospect of another World War on the horizon. It was fought over exchanges of letters, in Congressional testimony and ultimately over newspapers with the New York Times and the Washington Post playing a decisive role.

It was in this period that a Fed Governor, Mariner Eccles, said the following;

We are almost solely responsible for this inflation. ..the whole question of having rationing and price controls is due to the fact that we have this monetary inflation, and this committee is the only agency in existence that can curb and stop the growth of money. We should tell the Treasury, the President, and the Congress these facts, and do something about it.

In Congressional testimony, Eccles was heckled by populist Representative Wright Patman, a US equivalent of a JVP member. He tried to make out that the Federal Reserve men were traitors to the United States just like the JVP did to the Central Bank in 2004, and may yet do again.

Patman: Don’t you think there is some obligation of the Federal Reserve System to protect the public against excessive interest rates?

Eccles : I think there is a greater obligation to the American public to protect them against the deterioration of the dollar.

Patman : Who is master, the Federal Reserve or the Treasury? You know, the Treasury came here first. And, ...You are sabotaging the Treasury. I think it ought to be stopped.

Governor Mariner Eccles maintained that the Fed was not a 'bureau' of the Treasury. Eventually the Fed won and America survived to tell the tale without degenerating into a Venezuela or Zimbabwe.

The man who made it possible was deputy treasury secretary William McChesney Martin, who later became Fed Chairman and made the now famous statement about removing the "punch bowl from the party".

In fact America had a similar experience much earlier with a fiat dollar, the 'Continental'. From 1775 to 1779 millions of Continentals were issued to finance the American revolutionary war. By 1780 a gold dollar was worth 40 continentals.

But the Congress stopped the press in time, because there were a few sane men to put the brakes with the stability of the gold dollar in parallel saving the nation from collapse.

Ten years later remaining Continentals were redeemed at the rate of 100 to 1, in government bonds. By that time most were thrown away as worthless paper, giving rise to the term 'not worth a Continental'.

The confederate currency during the American civil war was another case in point. It was these experiences as well as the problems during the Second World War that made Fed officials resist Treasury move to lower interest rates in 1951.

During the French Revolution from 1789 onwards, the revolutionary government printed a paper money called the Assignat based on real estate, despite heavy opposition from sane representatives of the National Assembly.

The finance minister Necker, a renowned banker, resigned in protest. But the Assembly went ahead, appointing another in his place and promising only a single issue of notes.

But the seduction of paper money proved irresistible, and like the JVP is seduced now, the revolutionary government of France was gripped by its power to pay for state expenses with nothing, and gain political power at the expense of the poorest of the poor.

The Assignats soon became a flood and it corrupted an entire society, leading to the deaths of many innocent players in the economy who were simply responding to economic forces.

Eventually inflation and food shortages became so acute (it was compounded by price controls like in the 1970-77 era and Zimbabwe now) that there were food riots in Paris with printing presses running 24 hours.

Traitors and Patriots

But this was one instance that the instigators of the plunder paid the supreme price.

They could not escape like the JVP does now by heaping misery on the working classes by devaluing their salaries by over 40 percent over three years, undermining the national currency from 96 to 112 and still coming out like lily white saviours of the poor.

The people behind the fiat money scam in France were guillotined by their own colleagues, who realized what happened. The printing presses were burned in public.

From the ashes of this experience emerged Napoleon who not only was against printing money, but who also abhorred increasing the national debt.

Obviously it was not Governor Eccles of USA nor Finance Minister Necker who were the traitors. And neither is it Governor Cabraal of Sri Lanka, his thoughtful advisors or critics of money printing that are the traitors.

Unless the runaway government expenses can be halted, and the avarice of the politician and the public servant can be tempered at least a little together with impractical ideology, the economy is heading for a problem.

The savings of a nation is even now being diverted from gainful investments to finance the fiscal deficit which is mostly current expenditure, through the mechanism of high real interest rates.

Keynesian Stimulus

A Keynesian stimulus or deficit spending always causes inflation. When money is diverted from private citizens who would otherwise have spent it on something that gives the best return to government current expenditure, there is no way that growth will increase.

Government is a bad allocator of even capital expenditure, let alone current expenditure. Mihin Air and the Moragahakanda project are good examples.

Our foreign lenders, who generally fall over themselves to fund good capital projects, would not touch this dam with a barge pole. So we have to spend our own valuable tax rupees on this low return project, just like we did for fuel subsidies.

The only way economic activity can be boosted with a rising budget deficit (like in 2006) is for the private sector to continue to spend while government adds new spending by money printing. This is why a Keynesian stimulus is always inflationary.

In the absence of foreign aid (the Keynesian model is a closed one) a deficit budget will be financed at the expense of productive private investment (crowding out) and printed money (inflation).

This inflation is paid for by the blood of the wage earners, savings deposit holders and the pension funds, while businesses thrive. This year growth will fall because the boost from tsunami aid in 2005, and the stimulus from printed money has run out.

This column has stayed in the sidelines of the debate about whether last year's growth of 7.4 percent was over-stated or not because it was more concerned about how the government was plundering the poor via an indecent state sanctioned larceny of an 'inflation tax'. (Read The Thrift Column Monetary Plunder).

This column will say one thing, however. The 2007 growth will be understated because of a statistical effect.

The way the economic activity is deflated in national income accounting, to arrive at the 'real' growth has short comings in the nature of a lag effects. Where price-volume data is not readily available statisticians use index numbers to deflate production estimates.

There is an averaging effect in the method used, which tends to delay the impact of a sharp rise in inflation. This year's growth numbers will show a sharper downturn than the 'actual' growth, coupled with the so-called base-effect.

But this does not really matter statistically because over two years the errors will probably cancel each other out. Last year the government crowed about high growth. This year the opposition will crow about low growth.

This year the economy is more stable, though suffering from a serious hangover, though new problems are now cropping up.

Transparency

One last word about interest rates. If the Central Bank publishes the cut off rates, more money will come to the Treasury markets and help ease the cash crunch. The bank has already started advertising the average rates, which is good but not enough.

The Central Bank stopped releasing cut off rates about ten years ago. Why, no one really knows. It probably wants to hide rates from the market. But dealers, who talk among themselves soon after a Treasury auction, know the cut-off rates.

It is the larger investing public that does not know the cut offs, resulting in information asymmetry. If they knew they would be willing to put more money into treasuries and eventually more money will flow into them.

The rates are now hidden under the proverbial bushel. Price discovery, remember, is what makes markets efficient.

But the real solution is to reverse fiscal profligacy, cut down the foreign trips, stop hiring people into the public sector and bring some semblance of fiscal discipline back.