Having the peg-policy cake and eating it

The fundamental problem of what, how much and how to produce stuff for everyone is what economics tries to resolve. Be it through any structure, market driven or otherwise, policy makers tend to get hung up on the difficulties of who is producing stuff for whom as well. In foreign trades we try to resolve this with mutual benefits arising to trading countries that is seen in the balance of payments, which summarises the economic transactions of a particular economy with the rest of the world. 

These transactions include exports and imports of goods, services and financial assets, along with transfer payments such as foreign aid. 

A recent World Bank study found that just 2% of experts thought that balance of payments issues was in fact, brought on by disagreements in central bank policy, even as Sri Lanka’s currency crashed once again in 2022 and numerous South Asian pegs came under money pressure. The survey also revealed a fervent belief among policymakers and experts in the region that there are no solutions to the repeated episodes of monetary instability that plague the countries, especially when the US tightens monetary policy and South Asian soft pegs break under pressure.

This is consistent with the typical criticism of importers levelled by currency peggers and others in South Asia. South Asian exporters are simultaneously blamed for soft pegs. Approximately 85% of respondents in this survey cited increasing import costs to blame for balance of payments deficits, while another 76% of experts said that the cause was a slower rise in exports than in imports. Falling remittances through legitimate channels were to fault for another 30%.

When money is pumped to suppress market rates causing domestic credit to increase, a reserve-collecting central bank with a loose peg as its policy rate experiences balance of payments problems. As domestic demand for goods and services increased following the COVID pandemic, many central banks in the area decreased interest rates in 2021, while others such as Pakistan and Sri Lanka established Zimbabwe-style central banks and refinanced money to increase lending.

This means that by buying fresh debt or old Treasury bills held by commercial banks and other holders and not rolling them over, liquidity can be created out of nothing in the banking system. However, the built-up pressure on the local currency would lead to any peg’s credibility being compromised, causing capital flight, exporters postponing conversions, and importers settling early. To prevent this, counterintuitively, capital outflows are constrained in the majority of nations with dubious pegs, as experienced by Sri Lanka years ago.

In Sri Lanka after a hard peg was abolished and a Latin America style soft peg was set up in 1950 exchange controls and import control laws followed in 1969, ending economic freedoms and individual liberties and destroying domestic capital through inflation and depreciation.

In the final phases of a currency crisis, private bank refinancing through liquidity injections to counteract dollar sales, known as sterilised interventions in the currency markets, ramps up as more and more dollars are sold to maintain the peg whose credibility has been damaged. Additionally, new money is kept being created to sterilise outflows in order to preserve the policy rate that is incompatible with the ground situation, to prevent reserve money from contracting and domestic credit from slowing down.

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 might also put an end to policy disagreements. About 37% of South Asian analysts put the blame for the balance of payments issues on capital outflows. In a knee-jerk reaction, everyone, including those who engage in inflationary finance, tends to blame the deficit funding, while the real culprit is confused monetary theory.