Sri Lanka’s credit is now slowing (compared to total deposits raised), allowing the central bank to easily purchase dollars and mop the rupees created in the process (sterilized forex purchase) by selling its Treasury bill stock down, and built up forex reserves.
The more Treasury bills are sold down, more credit (compared to total deposits and inflows) creating a virtuous cycle.
The more Treasury bills are sold down, the more credit will be restricted (compared to total deposits and inflows) creating a virtuous cycle.
The central bank if it wants can now allow the exchange rate to appreciate, and stop creating high levels of new inflation. But under its current policy of creating a ‘competitive exchange rate’ it has not done so.
This is as good as it gets, at least BOP wise.
It is now that the first policy errors that will help create the next balance of payments crisis cum currency collapse will be made. The central bank should guard against this.
Policy Error Cycle
Sri Lanka’s balance of payments crises are not due to insufficient exports, excessive imports, oil or any other real-economy problem, but simply policy errors by a soft-pegged central bank, which has been making them now for 57 years.
Simply put, when domestic credit demand goes up (due to budget deficits, due to subsidizing imported energy or simply stronger private credit) the central bank instead of allowing rates to go up, prints money to keep rates down, driving credit and imports to unsustainable levels.
The resulting pressure on the exchange rate, when seen by dealers, eventually drives foreign investors to sell bonds, generating capital flight, while exporters to hold back dollars and take further rupee credit.
As the central bank intervenes in forex markets, selling dollars, and then prints more money by purchasing Treasuries to keep rates going up (sterilizing the forex sales), and a vicious cycle of is generated. If dollars were simply sold (unsterilized sales) reserve money will shrink driving rates up and rebalancing the system as it did before 1951.
The Treasury bill stock of the central bank (domestic assets) the goes up, and foreign reserves go down, in vicious cycle in a sterilized forex sales, which does not end until rates are raised and the currency is floated.
The 2015 crisis was interesting in that the central bank tried to float the currency from mid-2015 without raising rates and made another policy blunder, of a type it had not made in earlier recent cycles.
However eventually rates were raised in this cycle – too late as usual. Banks also responded on their own, raising deposit rates, getting more savings to finance loans, instead of getting printed money by selling their Treasury bill holdings to the central bank.
Virtuous Cycle Begins
Looking at the Treasury bill stock of the central bank, it can be seen that money printing started to tail off in the first quarter of 2017.
By the second quarter, the central bank was actively selling down its domestic asset stock and building up foreign reserves.
Though the purchases of dollars tends weaken the exchange rate, the mopping up of liquidity tends to reduce the total credit and allow the exchange rate to strengthen and appreciate if the central bank allows it.
However compared the 2009 or 2011/2012 crisis, this time the rupee is continuing to fall even with sterilized forex purchases. This is because the Central Bank is targeting a Real Effective Exchange Rate (REER), in the mistaken belief of creating a ‘competitive exchange rate’.
Deliberately weakening the currency in this fashion will alter the price structure of traded goods (exports and import) and eventually non-trade items as well, pushing up inflation.
Even if policy rate are raised, it may not help, other than slowing growth and consumption further and increasing foreign reserve collections.
Whether or not there is real pressure on the exchange rate can also be seen by the money market rates.
When money market rates move towards the lower end of the policy band, banks are raising deposits and not giving out all in loans (but are buying Treasuries previously held by the central bank), credit is slowing, allowing foreign reserves to be collected.
In contrast, when the money market rates move toward the upper band, credit pressure is rising.
The central bank creates the balance of payments crisis, by enforcing the upper rates (reverse repo rate) by printing money with Treasury bill purchases.
All this indicators now shows that Sri Lanka’s credit system is stable and in fact rates can be cut if needed.
As long as the exchange rate does not depreciate, there will not be much more inflation than is generated by the US Federal Reserve at this point. But with the REER targeting that expectation is doomed.
Policy Errors to begin?
The Central Bank’s Treasury bill stock fell to about 20 billion rupees by the last week of November, from around 40 billion rupees at the end of September. Excess liquidity is around 20 billion rupees.
By end December- if the central bank keeps up mopping up liquidity – it will run out of Treasury bills to mop up liquidity and build up reserves.
This is where the central bank will start making the first of its policy errors that will lay the foundation for the next BOP crisis and credit surge.
The US architects of soft-pegged central banks in South America, Philippines and Sri Lanka created central bank securities to mop up liquidity and lock-up foreign reserves over and above the domestic monetary base.
Unlike the British Colonial currency boards, this practice made the newly created dollar pegged central banks to keep policy tighter for longer than necessary (dampening growth) and buy more and more US Treasuries with the foreign reserves collected.
The political motivations of-pegged central banks that drove the US Treasury and State Department after World War II (for which J R Jayawardene fell hook line and sinker) and central bank securities are complicated.
But whatever the motivations, the practice brought more stability, than Sri Lanka’s recent actions of short term mopping up of liquidity.
In the last decade the central bank stopped issuing its own securities (which used to be issued for 6 -month or more) and instead started mopping up liquidity through term repos, using borrowed bills from the Employees Provident Fund.
Compared to central bank securities this practice is riskier and contributes to instability.
Several years ago domestic analysts warned early on, against the practice of buying dollars through swaps and forwards, when baby steps were made. Their warnings were ignored.
The International Monetary Fund and others sat around until the swaps/forwards built up to billions of dollars before requiring them to be wound down.
All these seems to be coming from a weak understanding of soft-pegged central banking in general and Sri Lanka’s peculiarly risky monetary practices in particular.
The risky practice of short term mopping up, in a central bank that is prone to push up credit by sterilizing interventions at the drop of a hat, has not much been talked about.
In order to reduce currency and BOP risks the central bank should immediately start selling CB Securities again. At first it can sell 3 to 6 months securities but go up to one year as soon as possible, if general market rates fall further.
The importance of ending the practice of temporary, short term mopping up to build up unstable reserves cannot be over-emphasized.
All impediments regarding taxes or liquidity that made banks reluctant to buy CB Securities a few years ago have to be cleared.
The central bank should take another important step.
The monetary authority should make the CB securities the only instrument which will be accepted for open market operations.
By this single act – provided term auctions and other operations are also conducted against CB securities – or US government securities even – the risks of balance of payments crisis slashed or eliminated in Sri Lanka.