Sri Lanka is heading deeper into balance of payments trouble with the monetary system moving into an active sterilized intervention phase, leaving behind any opportunity for an interest rate defence of the peg.
The central bank has given a firm signal that it will not depreciate the currency and take International Monetary Fund advice to float the rupee.
Rates are also not being allowed to go up and money is being printed to keep rates down via sterilized interventions, fuelling demand and adding to balance of payments pressure.
As mentioned in the last column, the developments in the monetary system in July turned out to be just a dress rehearsal. Now sustained sterilization of the balance of payments has begun.
The central bank’s T-bill stock rose to 42 billion on September 20 and excess liquidity was lower than that level at 31.4 billion rupees. Put another way, all the excess liquidity can be accounted for by freshly injected rupee reserves.
This money is now being re-absorbed by the newly started repo auctions.
Central Bank’s August forex intervention data is now delayed by over two weeks. It is not unusual in Sri Lanka for data to be delayed during a balance of payments crisis.
A back-of-the-envelop calculation, working backwards from available domestic asset data can give some idea of reserve outflows.
Sri Lanka’s monetary base expanded from 413.2 billion rupees in end July to 427.2 billion rupees by September 15. In the same period excess rupee liquidity in banks fell to 29.8 billion rupees from 75.3 billion rupees.
The central bank’s Treasuries stock which represents fresh injections of rupees through direct bill purchases or reserve appropriations by the state, rose from 1.7 billion rupees to 33.1 billion rupees in the same period.
The sum of the net fall in excess liquidity and the net increase in domestic assets in the period is 76.9 billion rupees. Adjusted for the expansion in reserve money, the net change is 62.9 billion rupees.
It points to an approximate reserve outflow of 570 million dollars in six weeks when an average exchange rate of 110.10 rupees is applied.
Assuming no material change in the monetary base, reserve outflows to September 20 amounts to about 640 million dollars. If the monetary base contracted it is higher, or vice versa.
When added to the 416 million dollar interventions in July the total comes to about a billion dollars, over a period of some 10 weeks.
Interest rates are at the moment being held back with an expansionary sterilization cycle. Rates will start to move only when sterilization becomes less than 100 percent.
The monetary authority has started cash auctions and it is for the moment withdrawing excess liquidity which was pumped by its own actions and keeping overnight rates at 7.08 percent.
There was a story where in response to a question from an LBO reporter the IMF mission chief advised against an interest rate defence of the peg. But even at the time it was probably an academic question.
Call market data show that if rates were allowed to move up in June as the system tightened it may have been possible to save the peg.
To some observers the central bank’s defence of the peg by targeting both the exchange rate and interest rate seems inexplicable.
But from the point of view of a soft pegged central bank it is not that difficult to explain.
Even the IMF encourages the central bank to collect large amounts of reserves.
After being encouraged to collect reserves, which after all are supposed to be there to be spent when the need arises, everyone suddenly turns around and advises the central bank not to spend the money.
There is a pithy Sinhalese saying that captures the situation very clearly: Yuddeta nethi kaduwa kos kotannader? It means ‘If the sword is not available for war, is it being kept around to cut up jack fruit?’
Unfortunately reserve collections – far above the monetary base – is a scam that only benefit the governments of reserve currency central banks, principally the US where they are invested.
It is funny that investors actually draw confidence from looking at large reserves. But large amounts of reserves actually encourage Central Banks to defend pegs and keep rates down, leading to predictable consequences.
There is no doubt that a peg is a useful tool. It impersonally acts as an escape valve for periodic build ups of domestic demand pressure, by dynamically adjusting the money supply to economic needs via the balance of payments.
It stops inflation to around the level generated by the anchor currency.
It stops rulers from destroying the real value of salaries of working people and lifetime financial savings of the old and the weak through currency depreciation – which is already being done to a great extent by the anchor currency central bank that is also printing fiat money.
But all this happens only if the monetary authority is prepared to drop policy rates, like in Singapore (with limited sterilization) and Hong Kong (no sterilization).
To build a peg that is sustainable we need to change our monetary laws.
A ‘float’ is similar to what gold exchange standard central banks used to call a ‘lifting of gold convertibility’. Essentially dollar convertibility at a fixed rate is lifted by a float.
The next step may be the start of reverse repo auctions. Some foreign banks are still liquid. They also have limits for local banks. So some amount of excess liquidity can be expected to remain even if reverse repo auctions start eventually.
If some bond holders quit, foreign banks will take paper into their balance sheets and liquidity may also gradually diminish. Bond holders however need not panic, as over the longer term, the peg is likely to brought back to near earlier levels following a float.
Instead of a reverse repo auction, the central bank could continue to buy Treasuries direct and sterilize its effect later.
In the past, the market has seen outright rejections of entire Treasuries auctions, when balance of payments pressures reached crisis territory.
As already mentioned in the last column, higher import taxes could be expected on what authorities quaintly (some would say in a fascist manner) call ‘non-essential’ consumer goods as if they have a divine right to decide for individual citizens what is essential or not.
Though the spot dollar rate is around 110 rupees, in the forward markets rates have moved up. The three month rate is now about 111.10/15, up about 50 to 60 cents over several weeks.
Sri Lanka’s IMF program is “in abeyance” to use a neutral expression. The mission who left with an “uncompleted review” expects to continue discussions.
In July the Central Bank had eight billion dollars in reserves. At the rate of 300 to 400 million dollar losses of reserves a month it will take several months for reserves to deplete to the level of the monetary base, where it can no longer meet its domestic liabilities in dollars.
In a sterilized intervention phase however, state debt repayments can also become net reserve losses.
Treasuries acquired by the monetary authority in place of reserve appropriations in the middle of an expansionary sterilization cycle cannot be sold to the market to dampen domestic demand in the economy and re-build fresh reserves.
All this can at any time be stopped by a float. Unfortunately until the imbalance is resolved market participants will stop their normal growth generating activities and instead watch the BOP.
This is costly for the economy at a time the global outlook is also far from rosy. (LBonline)