Sri Lanka stagnant for 7 years in output gap, flexible inflation targeting

ECONOMYNEXT – Sri Lanka has experienced 7 years of stagnation triggering three currency crises under “flexible” inflation targeting, a failed attempt to implement a domestically-anchored monetary policy despite a collection peg reserves.

Gross domestic product per capita fell to US$3,815 in 2021, according to data from the national statistics office, after a coronavirus pandemic caused output to plummet to US$3,695 per person in 2020.

GDP per capita in 2021 is lower than the $3,821 recorded in 2014.

Sri Lanka is now in the midst of the most severe monetary instability unleashed in the history of the island’s Latin American-style central bank established in 1950 with embedded peg disputes.

Independent analysts and mainstream economists had warned for several years that monetary collapse and external default were inevitable under an unanchored monetary policy and the International Monetary Fund had also warned of the possibility of an implosion. economy in 2022.

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Unanchored monetary policy

Sri Lanka started following a discretionary or flexible policy where peg disputes explode into currency crises as money is printed in a data driven framework which escalates the peg disputes shortly after 2015.

Under data-driven flexible inflation targeting, rates are cut and money is printed as soon as inflation drops and private credit picks up, which happens about 18 months after the currency crisis. previous one, quickly pushing the credit system into another crisis.

The rate cuts at the end of 2014 were reinforced by the release of liquidity through forward repurchase agreements and outright purchases of Treasury bills.

In 2015, Prime Minister Ranil Wickremesinghe openly admitted the Keynesian stimulus despite the country operating an exchange rate regime pegged to the collection of reserves, with the central bank intervening in the foreign exchange markets in both directions (providing a convertibility of the weak side and the strong side).


Rupee, Sri Lanka, struggling after Keynesian revival

“In 2015, when we formed the government, there was a collapse in aggregate demand,” Prime Minister Wickremesinghe told parliament, when in reality the central bank was injecting liquidity into the money markets from the third quarter of 2014 as the economy recovered from a currency meltdown in 2012.

“In this situation in April, we increased pensioners (state employees) payments by 1,000 rupees, we increased state employee salaries, private sector salaries were increased.

“That way we’re putting more money in the hands of consumers to increase aggregate demand.”

The rupee fell to 152 from 131 in this debacle.

In 2018, rate cuts were applied and an overnight money rate was targeted with a combination of overnight reverse repo injections, forward repo injections and outright purchases of treasury bills and bonds with commercial banks.

The rupee fell to 182 in this crisis.

Targeting the output gap

The “flexible” inflation targeting was supported by the calculation of a so-called potential growth or output gap figure.

Rates are cut or money is then injected rates and money injected to close the “output gap” which is also one for the Keynesian stimulus, which at the time was estimated to be around 5% or more.

In August 2019, the central bank said it was printing money because growth was 3.1%, potential growth 5.0%, and “stabilizing the output gap is a significant concern. under a flexible inflation targeting regime and this again argues for an easing of monetary policy”.

Under the last administration, there was an attempt to usurp the monetary law, to legalize both flexible inflation targeting and a flexible exchange rate, and to compensate civil servants.

Analysts have blamed the International Monetary Fund for peddling flexible inflation targeting to Third World central banks with “fear of floating” and also for teaching Sri Lanka to calculate a potential growth figure that mercantilists can then use it as an excuse to print money and drive the country headlong into balance of payments crises.

Renowned economist WA Wijewardena had said targeting the output gap was against monetary law, which obliges the agency to maintain price and economic stability.


Sri Lanka has corrupt inflation targeting, output gap targeting not conforming to monetary law: Wijewardena

In December 2019, the Department of Finance said it was cutting taxes to close a “persistent output gap”.

“Shifting resources from unproductive government spending to private businesses and individuals will support growth in a context where there has been a persistent output gap,” the finance ministry said in December 2019.

“Higher growth will also have a positive impact on the country’s overall debt dynamics.”


Fiscal stimulus in Sri Lanka to close the output gap

In the first quarter of 2020, the central bank cut rates and reduced reserve ratios, then imposed price controls on bond auctions to print money and prevent the cash freed up by the tax cuts from in the private sector does not come back to the budget through higher interest. rates.

In a hard peg, a tax cut cannot destabilize the exchange rate, because the money lost would have ended up in the budget deficit through higher bond yields, because the money cannot be printed to maintain low rates.

However, Sri Lanka does not have a fixed parity (currency board) and the rest is history. (Colombo/April 17, 2022)

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