ECONOMYNEXT – Sri Lanka’s central bank has spent US$9.8 billion in reserves, including about US$4.48 billion in borrowed money, in the process of keeping interest rates artificially low while exploiting peg collection of reserves, according to the data.
Sri Lanka stepped up the stimulus (output gap target) from 2020, stepping up a policy widely followed under flexible inflation targeting over the previous five years that triggered two currency crises in 2015/2016 and 2018, under a flexible exchange rate or soft peg, which reduced growth (output).
The International Monetary Fund itself had given technical assistance so that the central bank fortunately triggered the calculation of an output gap.
Output Gap Targeting/Flexible Inflation Targeting
In December 2019, Sri Lankan state economists cut taxes saying there was a “persistent output gap” in the fiscal stimulus and followed it up with rate cuts and cash injections. to prevent rates from rising.
In February, liquidity injections began, notably with a transfer of profits from the central bank.
At the time, the central bank had net reserves of about US$5.3 billion and Sri Lanka had gross official reserves of US$7.9 billion, which included borrowings from the International Monetary Fund and any budgetary balance.
In March, the currency fell sharply under a flexible zero-credibility exchange rate, but the peg stabilized during the coronavirus lockdowns and subsequent credit downturn.
Large-scale cash injections were made for a “fuel price stabilization fund” and also to meet a real demand for money during the shutdowns.
The central bank then capped treasury bill auctions, effectively capping policy rates across the yield curve and scuttling wholesale treasury bill auctions.
Large volumes of money were injected to buy back government securities in scuttled auctions under the so-called Modern Monetary Theory and the central bank lost its ability to collect reserves (sterilize or mop up inflows) to repay the debt and its reserves have been exhausted.
As economic activity and private credit picked up, the central bank steadily lost reserves to repay debt.
In 2015/2016 and 2018, the Sri Lankan government and the Ceylon Petroleum Corporation borrowed heavily from commercial markets and banks as liquidity injections created currency shortages.
But after 2020, Sri Lanka lost access to commercial banks. After a series of downgrades, there was also capital flight from the banks.
The central bank then began to borrow more dollars through international and domestic swaps, without allowing rates and liquidity to tighten to stop the outflow of reserves.
Monetary financing of imports
Meanwhile, from around the end of 2021, economists outside the central bank have also called for using the reserves for imports, regardless of the pegged rate.
A central bank with a policy rate that provides reserves for imports then sterilizes dollar sales by adding new money to the banking system to suppress interest rates (soft indexation) effectively engages monetary financing of imports and private sector activity, preventing a tightening of bank liquidity.
In order to maintain the credibility of monetary peg and stability, interventions should be unsterilized or at least partially unsterilized with tightening liquidity and rising rates.
Sri Lanka continues to finance its imports monetarily, securing itself after having “exhausted” its reserves
In December 2021, imports surged to US$2.2 billion per month as interventions of around US$300-400 million per month were made.
Calls to use reserves for imports (soft indexation) continued to grow from economists and others outside the central bank, although as of September 2021 the central bank was using cash borrowed to finance imports.
Those who called for reserves to be used for imports, which necessarily implies a peg to the intervention rate for imports, simultaneously called on the central bank not to peg on unusual monetary irony.
Borrow for imports
Sri Lanka is currently using US dollars borrowed from India under the Asian Clearing Union to intervene and peg 360 to the US dollar.
Sri Lanka’s central bank did raise rates in April, however, in an effort to reduce or end money printing and allow rates to rise and private savings to be channeled into the fiscal deficit after a collapse in the currency from 200 to 360 for the US dollar and 182 since the start of the stimulus.
Maturing debt can also be rolled over in paper form at higher rates.
The collapsing currency and soaring interest rates are referred to as “rawluth ne kendeth ne” (neither the interest rate nor the exchange rate is ultimately saved) by critics.
Sri Lanka’s central bank was about US$4.48 billion in debt as of June, having spent US$9.8 billion since February 2020 to finance imports, finance debt repayment and also to finance imports. further capital flight as investors retreated due to the loss of credibility usually found in flexible trading. rate or soft-peg.
Soft anchors (flexible exchange rates) were built by mainly US-based officials, including Harry Dexter White and John H Williams, during the construction of the Bretton Woods system of failing anchors in the false belief that there was an independence of monetary policy in anchoring to an anchor. currency.
Pegs around the world, which attempt to operate cyclical credit against that of the peg, are now under pressure as anchor reserve currencies as the US dollar hikes rates.
Analysts have called for tight controls on the domestic operations (activity of the issuing department of a note-issuing bank) of Sri Lanka’s monopoly note-issuing bank to maintain monetary and social stability.
However, attempts are being made to legalize flexible inflation targeting with a flexible exchange rate which has led the country peacefully to three currency crises and default with discretionary policy and severe peg disputes.
Currency shortages and currency crises are a problem associated with flexible exchange rates or soft pegs with peg conflicts and are absent from consistent single peg regimes such as clean floats (domestic peg only) and hard pegs (external anchor only). (Colombo/August 1, 2022)