ECONOMYNEXT – External liabilities of Sri Lanka’s central bank exceeded its assets by US$4.0 billion or 1.2 trillion rupees as liquidity injections made to keep rates low triggered the worst currency crises in its history. history, according to official data.
Net foreign assets, which were negative at US$3.65 billion in February 2022, increased by around US$376 million in March as borrowing increased and reserves were used to repay debt or fund debt. excess private sector imports triggered by liquidity injections.
Using reserves to live beyond means
Sri Lankan economists had actively encouraged the use of reserves (central bank credit) for imports in a bizarre move, helping the country live beyond its means, on a deep descent into commercialism.
Using reserves for imports is also a procyclical activity and a type of central bank credit-driven stimulus.
The central bank now mainly borrows from India through the Asian Union Clearing Mechanism to finance imports and also to repay multilateral debt.
Central bank debt includes swaps with India, Bangladesh, ACU deferred liabilities and International Monetary Fund debt from the latest program.
While using reserves or borrowing for imports and increases net debt with higher consumption, paying down debt with central bank borrowing (or central bank reserves) does not imply any further increase in national external debt.
Bad targeting of interest rates
Usually, reserves are lost in a pegged exchange rate system when money is injected through open market operations into banks, to artificially keep rates low, a five-person committee mistargeting the market interest rate and triggering cascading loans.
When foreign exchange reserves are used to finance imports, liquidity injections follow the sale of reserves (sale of sterilized currencies).
The poor targeting of interest rates and the resulting conflict of monetary policy and exchange rate are then covered by a depreciation of the currency.
Poor interest rate targeting by the rate committee is then blamed on imports, trade deficit, exogenous shocks, diesel, vehicles, gold or other conveniently non-monetary phenomena after the peg was put under pressure.
People who are net savers are repeatedly accused of importing (private savings make up about 20% of GDP in Sri Lanka), rather than central bank credit which triggers excessive outflows in a peg.
Targeting the output gap
Sri Lanka engaged in aggressive open market operations under a highly discretionary policy (flexible inflation targeting) after September 2014, notably allowing monetary and exchange rate policies to easily come into conflict and breaking the exchange rate peg (flexible exchange rate).
After 2015, money was printed for targeting the output gap (monetary stimulus) despite the anchoring of foreign exchange reserve collection, triggering currency crises in 2015/2016 and 2018 that reduced growth because monetary policy came into conflict with the peg.
In December 2019, taxes were also cut (fiscal stimulus), indicating that there was a “persistent output gap”, triggering the worst currency crises in the history of the 72-year-old loosely pegged central bank.
After 2015, net foreign exchange reserves did not recover to match reserve currency and foreign exchange reserves as a share of reserve money supply in rupees (monetary base or M0) fell steadily below 100 % and slipped into negative territory in August 2021.
In order to restore monetary stability, domestic credit and economic activity must be wiped out by high interest rates and replenished reserves, which reduce growth. Raising taxes helps reduce state credit.
A float (full suspension of convertibility) accomplishes the task at a lower rate by ending further intervention and liquidity injections.
Sri Lanka attempted a float in March but with a buy-back rule (the central bank forced purchases of dollars for fresh money) which pushed rates further down (strong sideways convertibility) or up.
The rupee rose from 200 to 299 rupees during the month in jolts and not in a rapid flutter as it successfully happened in 2001 and 2012.
Key rates were raised in April to slow credit, but shortages persist in May with the currency around 265 to 280 to the US dollar. At the sidelines, a peg is defended with ACU dollars. (Colombo/May 29/2022)