By Nasria Naffin, TON Sri Lanka

The World Bank survey found that only 2% of experts thought that balance of payments issues were brought on by conflicts in central bank policy, even as Sri Lanka's rupee crashed once more in 2022 and several South Asian pegs came under pressure.

The survey also uncovered deeply held Mercantilist beliefs among regional policymakers and experts, suggesting that there are no solutions to the region's persistent monetary instability, especially when the US tightens policy and South Asian soft-pegs fail.

Approximately 85% of respondents thought that increasing import costs were to blame for balance of payments deficits. Another 76 percent of experts (who offered a variety of explanations) thought that the reason was a slower growth in exports than in imports.

This is consistent with the general criticism of importers leveled by soft-peggers and others in South Asia (there is a trade deficit). South Asian exporters are simultaneously blamed for soft peggers (this is not an export oriented economy).

Falling remittances through official channels were to blame for another 30%. This is consistent with another group of diligent earners of hard currency who are frequently held accountable by soft-peggers and other people who reject traditional monetary economics.

When liquidity is injected to suppress market rates as domestic credit increases, a reserve-collecting central bank with a policy rate (a non-credible peg) experiences balance of payments problems. In 2021, many central banks in the region lowered interest rates (Bangladesh was one of them), while others (Pakistan and Sri Lanka) established central banks that refinance funds in the style of Zimbabwe in an effort to increase credit. By buying fresh Treasury bills (deficit monetization) or old Treasury bills held by commercial banks and other holders and not rolling them over and purposefully failing bond auctions, liquidity can be added to the banking system.

In the latter stages of a currency crisis, private bank refinancing through liquidity injections to counteract dollar sales (sterilized interventions) in the forex markets picks up as increasing larger volumes of dollars are sold to defend the peg whose credibility has been damaged.

Once the peg's credibility is compromised, there is capital flight, exporters try to postpone conversions, and importers try to settle early. However, capital outflows are constrained in the majority of nations with dubious pegs.

Additionally, new money is created to sterilize outflows in order to maintain the policy rate that is incompatible with domestic policy and to fend off a contraction in the amount of reserves, which would otherwise cause domestic credit to slow down (either inflation or reserve money target).

Shock rate increases will eventually be required to stop balance of payments deficits by limiting domestic credit. By separating the reserve currency from the balance of payments, a flotation could also put an end to policy disagreements.

It is a common misconception that deficit financing occurs in Sri Lanka because such injections, which enable banks to lend without deficits, are categorized as claims on the government (net credit to government). when, in reality, they are claims against commercial banks by central banks.

During the Bullionist-Anti-bullionist debates in the UK in the 19th century, David Ricardo warned the Bank of England against sterilized interventions and referred to them as "fictitious capital."

During that time, currency printing that caused gold exports (or forex shortages in modern parlance) was typically referred to as a "super abundance of paper money."

About 37% of South Asian experts put the blame for the balance of payments problems on capital outflows. After the Reserve Bank of India was nationalized, money was printed to pay for Nehru's five-year Gos-plan-style programs, now generally referred to as stimulus, and Ceylon's currency board was broken in favor of a soft-peg, severe balance of payments problems first appearing in South Asia.

 In the 1950s, B R Shenoy was the only traditional economist to caution India against the general consensus of other "economists" and policymakers against what is now known as stimulus. According to Shenoy under the central bank policies economic freedom and individual liberties will cease to exist and ideologies like communism will develop.

The KMT remnants that fled to Taiwan established one of the world's pegged monetary authorities that consistently practiced deflationary policy (mopping up inflows to under-supply reserve money rather than over-supplying by offsetting outflows with new money), laying a solid foundation for the development of domestic capital.

Exchange controls and import control laws were implemented in Sri Lanka in 1969 after a hard peg was abolished and a soft peg modeled after Latin America was established. This ended economic freedoms and individual liberties and destroyed domestic capital through inflation and depreciation.

In 1966, more than ten years later, Shenoy forewarned Sri Lanka that import restrictions were pointless and that its inflationary central bank policy needed to be changed. At the time Sri Lanka's central bank was engaging in re-financing rural credit, and not systematically mis-targeting rates through open market operations unlike in the past decade.Several pegs which had a degree of credibility in South Asia, including Maldives, Nepal and Bhutan are now under pressure due to ‘monetary policy modernization’.

All blame is usually put on deficit financing in a knee jerk reaction including by the perpetrators of inflationary financing.

However, Shenoy explained that deficit financing simply transfers spending power from the public to the government and cannot add to new demand unless interest rates are suppressed with central bank accommodation.

However, commercial bank funding of the deficit could be inflationary if central bank reserves (a reserve short or window borrowing) were used.