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These two regions account for nearly a half of the global output and are well connected to each other as well as to the rest of the world through trade, finance and exchange rate arrangements. Hence, the rest of the world cannot just sit and watch what is happening in an important part of the global economy.
It specifically applies to Sri Lanka which has been a side beneficiary of the Fed’s QE by attracting high interest seeking US investments into its government securities market. This is the view expressed by the Sri Lankan born academic, Lalith Samarakoon, presently Financial Economist and Professor of Finance at the University of St. Thomas in USA through email correspondence with this writer as well as the conversation he had with him on the Facebook.
Samarakoon in the late 1990s and early 2000s supported the Central Bank to train its fund managers attached to the Employees Provident Fund in its modernisation phase.
QE differs from Open Market Operations
Under QE, the Fed started to pump money into the US economy by buying securities from the market in specified quantities. This differs from the normal monetary policy adopted by a central bank known as ‘Open Market Operations’ or OMO wherein it would buy and sell securities to regulate the excess liquidity in the market. QE, in contrast, is one-way and supplies funds to the market on a permanent basis through a pre-announced program of buying securities.
The result of such a program is twofold: it increases the prices of securities lowering interest rates and pumps new money into the system increasing the country’s monetary base – the quantum of seed money available to commercial banks for lending to people by creating multiple deposits and credit. The lowered interest rates and multiple level of credit created in the economy are expected to increase the total demand – called aggregate demand – inducing producers to produce more. In the process, output and employment are expected to move up taking the economy out of economic recession.
US has attained QE targets technically
Both these technical objectives have been realised by the US Fed. Its monetary base which stood at $ 875 billion in August 2008 rose sharply to $ 4139 billion by the end of January 2015. The benchmark 10 year US Treasury securities rates fell from 4.76% as at January 2007 to 1.91% by January 2012. An unintended consequence of the interest rate decline in the US market was the flight of US savings out of the country in search of better interest return elsewhere.
Sri Lanka which had faced a chronic balance of payments problem and depletion of foreign reserves quickly capitalised on these low interest rates and allowed foreigners to invest in government Treasury bills and Treasury bonds which had offered substantially higher rates than those prevailing in US markets.
Accordingly, foreign funds flew into Sri Lanka and, by end February 2015, a total of $ 3.5 billion had been invested by foreigners in government securities. According to an announcement made by US Ambassador to Sri Lanka in February 2013, a bulk of these investments had been of US origin. (available at: http://www.sundaytimes.lk/130210/columns/iran-style-economic-crisis-cwealth-summit-in-balance-32552.html). The total of such foreign funds in the government securities market amounted to nearly a half of the country’s foreign reserves of $ 7.2 billion as at end-January 2015.
Bernanke’s justification of QE
The former Chairman of the Fed, Ben Bernanke, delivering the Josiah Stamp Memorial Oration at the London School of Economics in 2009, explained the rationale behind the Fed following QE (available at: http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm ). According to him, the proximate reason for the financial crisis was the housing sector bubble that had developed in the US but it was an unintended consequence of the low interest rate policy pursued by his predecessor, Alan Greenspan.
When the bubble burst in USA, it soon became a global crisis. The heavy toll it took in terms of loss of output, employment and wealth throughout the globe has therefore been substantial. Though the global economy was expected to recover on its own in due course, the timing and the speed of recovery were not to the liking of the world community. Therefore, the government’s intervention to accelerate the process was called for. Bernanke believed, as he explained in the Stamp oration, that the US Fed still had powerful tools at its disposal to help the US to come out of the financial crisis and economic downturn.
One mistake leading to another mistake
The underlying assumption of this type of policy intervention by the Fed, and also by other central banks, is that central banks, or more specifically the central bank created-money, can boost economic growth.
The reasoning goes as follows: Economic growth comes from the production of a bigger output and continued production of such a bigger output is dependent on the consumers’ ability to buy that output on the one hand and producers’ ability to produce more and more output on the other. When central banks reduce interest rates artificially to low levels, it is believed that consumers make a hard choice in favour of consumption and producers in favour of investments. So, central banks seek to kill two birds with one stone by reducing interest rates. But the reduction of interest rates also leads to shrink the savings flows since people now get a low rate of return on their savings.
When the savings flow declines, banks are unable to lend money to businesses despite the fall in interest rates. To increase the fund-available for lending, central banks start printing money and supplying to the financial institutions. It drives the interest rates further down and dries up savings flows further. Thus, central banks get caught in a vicious trap: They have to keep on pumping more and more central bank-printed money to the financial system in order to keep it alive. Thus, one mistake made by a central bank leads to the making of a series of mistakes.
Unexpected fall in US money multiplier
With this type of money creation, the US would have ended up with an uncontrollable hyperinflation but it had been saved by an unexpected market development. Banks which had already been hit once by the crisis had been cautious about lending and therefore had kept the new money in the form of excess liquidity temporarily deposited with the Fed.
The result was a drastic reduction in money multiplier – the number of times a given unit of monetary base is increased by a bank in creating multiple deposits and credit. Thus, the US money multiplier which stood at 5 – meaning one dollar created by the Fed will eventually end up as 5 dollars – in 2008 fell to a level of less than 1 by end 2013. Thus, for the first time, the US monetary base has been bigger than its narrow money stock. It is a blessing in disguise since the Fed’s QE has not led to monetary expansion and consequential high inflation.
As a result, the US citizens now experience the historically lowest inflation which is below 1%. However, it has inflicted the US economy with a number of macroeconomic ailments: Low inflation, high trade deficit, low economic growth, high unemployment and pressure on the dollar to fall in the international markets. Thus, it appears that Bernanke, having tried to solve one problem, has created so many problems in the US economy.
US has no choice but to give up QE
These ailments take the form of rising interest rates in order to curb inflationary pressures, ending the current QE since the Fed will not be able to continue with liquidity pumping at the same rate and a massive shrink of consumption by US citizens and investment by businesses. It will lead to a curtailment of the output in USA; it will also have adverse impact on several other countries which are linked to the US economy and its financial system.
It has now been the task of Bernanke’s successor, Janet Yellen, to reverse the earlier easy money policy pursued by the Fed. According to the latest reports, the Fed is now seriously considering the tightening the US monetary policy beginning from June 2015 (available at: http://www.wsj.com/articles/fed-leans-toward-removing-patient-promise-on-rates-1426014812).
In expectation of this move, the 10 year US Treasury securities rate accelerated from 1.91% in January 2012 to 2.86% by January 2014. It is therefore likely that the US interest rate structure will move to a higher plateau within the next six to 12 months.
With a new QE being implemented by the European Central Bank at present, funds are expected to move from Europe to USA searching for higher interest rates. As a preliminary for this move, Euro is now falling against the dollar reaching a level of $ 1.05 per Euro as on 12 March. The equality between the two major currencies in the world is expected to take place pretty soon.
Prof. Lalith Samarakoon: ‘Don’t just sit and watch the global developments’
Samarakoon says that policy makers in Sri Lanka as well as in emerging markets should take serious note of these developments. Though the magnitude and duration of US interest rate increases are not known, it is likely that it would take place in a slow and measured phase. At the same time, the decline in oil prices has delivered a positive shock to oil importing emerging economies like Sri Lanka. In that context, according to Samarakoon, these countries have been driven to an unchartered territory making it necessary to predict the net impact as early as possible.
Samarakoon has identified some of the net effects: “The first to be affected are the capital markets. Some of the foreign portfolio investments, particularly the hot money that came to emerging markets and Sri Lanka in search of higher yields and returns into the government bonds and stock markets are likely to reverse gradually as investors find acceptable yields in the US which is a much more stable and liquid market”
Further, he says: “The cost of dollar-based funding will go up and the policy makers must factor this in their desire to float more government bonds in international markets. Definitely, given the drop in Euro and the euro-based interest rates, the government needs to be proactive to diversify its funding sources.”
What Samarakoon says is that Sri Lanka should not postpone the issue of the sovereign bonds in the international markets because US interest rates are to rise after June and EU rates have already fallen. Hence, the proper policy is to make hay while the sun shines.
Need for having a credible domestic bond market
The global developments have shifted the focus to domestic markets. Argues Samarakoon: “The domestic capital market conditions and investors will become more important for government financing. The viability and credibility of domestic bond markets become ever so significant. In that context, liquidity in the domestic fixed income sector is critical. If the domestic liquidity also dries up, then there is going to be more upward pressure on bond yield and general interest rates. The monetary policy will need to be carefully calibrated so as not to raise the interest rates abruptly which will have larger and wide-ranging adverse economic ramifications.”
Given the current scandal eroding the credibility of the bond market, Samarakoon’s assertion that its credibility should be restored should be an eye-opener for Sri Lanka’s policy authorities.
The problem does not end here. Capital reversals could also put downward pressure, according to Samarakoon, on the exchange rate creating a challenging environment for maintaining a fairly stable exchange rate. Of course, the benefits of lower oil prices will be partially offset by any potential currency depreciation. Hence, on a positive side, lower rupee will benefit exports and to the extent the US economy continues to show strength and ECB’s QE program raises growth in the Euro-zone countries, Sri Lanka will further benefit from increased demand for its exports.
Samarakoon says that the decline in interest rates in EU area will not increase hot money flows to Sri Lanka. That is because for investors in EU, USA with its more liquid and free financial and capital markets will offer better investment opportunities. Hence, the developments in USA are to dominate the global scene more strongly in the short to medium term.
Samarakoon: Central Bank should give right signals
In this scenario, how should Sri Lanka design its policies? Samarakoon has several answers to that question. He says that “in the sort-run, the Central Bank and other policy makers will have to prudently manage and balance any risks posed by capital flow reversals, downward pressure on the exchange rate and upward pressure on interest rates. Building a strong foreign reserve position must be considered a top priority to mitigate the risks against any negative external shocks. If external financing becomes too costly and unviable, the domestic money and bond markets should play a pivotal role in government financing.”
But how could that be done? Samarakoon argues that “The Central Bank needs to provide right signals, market guidance and a transparent policy framework to maintain interest rate stability” since higher interest rates coupled with low growth are to worsen the budget deficits.
In this context, says Samarakoon, Sri Lanka should have a prudent medium to long term fiscal policy framework that incorporates “serious revenue and expenditure reforms in multiple areas of the economy. Ultimately, fiscal policy should provide adequate space and flexibility for us to respond to adverse external and domestic events without destabilising the economy and social safety network. Such instability will ultimately lead to social and political unrest, making any meaningful economic reforms more difficult.”
Negative economic shock should be properly managed
What is being delivered by USA and EU is a negative economic shock to Sri Lanka. That shock has to be managed by the country’s Central Bank and the two line ministries involved in the economy, namely, Policy Planning and Finance, through a carefully laid down policy package. This can be done not by increasing lavish expenditure but by prudently managing such expenditure. This is the biggest challenge presently faced by Sri Lanka.
Swap with RBI is good but support from IMF is better
Sri Lanka now faces the risk of the hot money mobilised by the previous government flying out of the country without warning. Any sudden depletion of foreign reserves will bleed the country to an untimely death. It has been reported that the Central Bank has entered into a swap facility of $ 1.5 billion with the Reserve Bank of India to cushion its foreign reserves.
This is only a temporary measure and should not be relied on permanently. A more permanent measure that would require Sri Lanka to implement a comprehensive economic reform program, as argued by Samarakoon, is a Balance of Payments support from IMF that is contingent on policy reforms. Thus, the present negative external shock is the ideal situation for Sri Lanka to present its case with IMF which is, it appears, under a strange belief that Sri Lanka does not need BOP support at the moment.
Hence, Sri Lanka’s policy, according to Samarakoon, should be forward-looking and proactive. In that background, it has no space for a ‘wait and see’ approach.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected]); Lalith Samarakoon is available at [email protected].)
