Tuesday October 23, 2018

Sri Lanka provides dollar backed central bank credit to finance deficit

Oct 05, 2018 07:42 AM GMT+0530 | 0 Comment(s)


ECONOMYNEXT - Sri Lanka's central bank has advanced new rupees to the Treasury against US dollars, shortly before the rupee came under pressure from excess liquidity, in a new method of temporarily financing the deficit by expanding reserve money, it has been revealed.

Deputy Governor Nandalal Weerasinghe said the money was provided against the Treasury's own dollar deposits kept in central bank custody.

"When the Treasury gets money, and they want to use for payment, they leave that money with the central bank," Deputy Central Bank Governor Nandalal Weerasinghe told reporters.

"If they think they don't need foreign currency, but need rupees for whatever purposes, they can swap the US dollars on the short term to use."

"That's what they have been doing from time to time. It's only money that they have borrowed or received in terms of the proceeds of the government. It's not central bank money. It's their own money which they have deposited at the central bank for short term."

The central bank credit had been provided through swaps that had since been reversed, officials said.

If the Treasury sold the dollars in the market to get existing rupees, instead of new rupees from the central bank the exchange rate would not fall (and may even go up, subject to bank net open positions) and short term money markets would be unaffected.

If the central bank is pegging with a forex reserve target it can purchase any excess dollars after allowing the market to strenghten and mop up the rupees.

Dollar Window

But by engaging in a swap with the central bank, the Treasury opens another short term liquidity window which injects cash like a term reverse repo transaction with a different collateral (discounting dollars instead of bills), leading to short term volatility (downward) in interest rates and expansion of the money base.

Central bank credit (printed money) is usually provided to the budget against Treasury bills, or in the case of Sri Lanka against nothing at all in the case of so-called 'provisional advances'.

When a central bank buys any domestic asset - even a house - or pays salaries or pensions, new money is added to the country's circulating stock, which tends to push the exchange rate to the 'weak side' of the peg as imports pick up.

Domestic assets are useless for international payments.

When the currency peg is defended to mop up the money forex reserves (foreign assets) are lost. If interventions are not sterilized with additional purchases of Treasury bills, the system would tighten and the peg would hold.

Sri Lanka's wide policy corridor is useful in this respect at a time of great international volatility, making Sri Lanka's monetary system a bit like Singapore's.

Generally, the creation money through the purchase of dollars is not considered to be 'money printing' because dollars are permanently added to foreign reserves to defend (reserve backing of the money supply), if and when the new money hit forex markets.

But under a 'flexible exchange rate policy' or if the swap dollars are not used for peg defence because the deal would be unwound it a few weeks later, or for any other reason the effect would be the same as advancing money against domestic assets.

Soros Swap

In the East Asian crisis, speculators used Sri Lanka-style swaps to generate local currency and attack many national central bank pegs.

The Bank of Thailand eventually closed its off-shore swap market. Ironically the Bank of Thailand itself was a counterparty to the swaps, generating new Bhats for speculators.

A currency would fall, from new money, regardless of whether the newly minted cash was created against dollars or a domestic asset, if the peg is not defended when it hits the 'weak side'.

Analysts say even if some of the money came from outright dollar purchases, the 'flexible exchange rate' policy would lead to a sharp fall of the rupee, when the peg inevitably hits the 'weak side' after sterilization of inflows (successful pegging) had halted for a few weeks.

By not permanently mopping up at least a portion of excess liquidity generated from the purchase of foreign assets at a steady pace, the central bank itself fuels speculation against the currency, analysts say.

This is one of the reasons Sri Lanka's rupee falls despite having a policy rate of 8.50 percent, leading to panicking bond holders, importers as well as exporter hold backs.

When the currency rebounds, the central bank pegs it at a lower rate based on a real effective exchange rate index.

Last Monday the central bank confirmed that it had bought dollars to stop appreciation.

The realization that the so-called 'flexible exchange rate' does not appreciate but only falls, fuels desperation and panic at each run.

If the Treasury did the swap against a commercial bank rather than the central bank, there would be no expansion on the money supply and no steep falls in interest rates.

But a large swap with a commercial bank, financed with discount window money or term reverse repo money would expand money supply.

This is why classical economists discourage both central bank financing and bank financing of deficits and ask governments to finance the budgets through bonds and short term cash flows through Treasury bills, which does not disturb the money supply.

The current monetary conditions were further complicated by a legacy 379 million dollar central bank swaps with National Savings Bank which matured on or about September 19, which generated massive liquidity shortages and forex reserve losses related to the payment of a 750 million dollar bond.

Bonds vs Bank Financing

In the run up to the current collapse of the rupee, interest rates plunged as excess liquidity rose sharply in money markets, when base money expanded.

The average overnight repo rate fell from a peak of 8.47 percent on July to 7.7 levels in the middle of August, when liquidity went from a short to 58 billion rupees plus on August 08.

The sugar high that the authorities got from the low rates for few weeks, coupled with the 'flexible exchange rate', has now left the country with an exchange rate of 170 to the US dollar and the credibility of a free trade agenda of the administration in tatters as ad hoc trade controls were brought in to fix a monetary policy error.

Market pricing of energy and (at least tax revenues) is also in doubt.

Treasury Bill sales were started in the US in 1929 to partly to avoid getting money from the Fed which tended to expand and contract money supply and cause excessive volatility in short term rates. Auctions were also used replacing subscriptions.

It is not clear what role the US Treasury's practice of dipping into the Fed played in the 'Roaring Twenties' credit bubble which led to the Great Depression.

During World War I, the US Federal debt had ratcheted up rapidly. In the 1920, the US Federal Government had a practice of rolling over bonds, on the due dates of tax payments. But not all tax payments came. There were also gaps in funding between bond sales.

"This schedule forced the Treasury to borrow from the Federal Reserve to bridge the gap between the date it needed to make a maturity payment and the date it actually collected tax receipts—typically several days after the stated due date," explains the Federal Reserve Bank of New York.

"The short-term Reserve Bank loans sometimes created transient fluctuations in reserves available (excess liquidity) to the banking system and undesirable volatility in overnight interest rates."

Unlike in Sri Lanka, where the central bank intervenes in bill auctions to lower rates or reject auctions outright, the Fed at the time loaned money to the Treasury at a rate higher than the market.

In Sri Lanka the central bank was providing credit to the government against Treasury bills and provisional advances without much public criticism for over half a century until from 2004, some analysts, economists like Harsha de Silva (now State Minister), and central bankers like W A Wijewardene spoke against the problem making it a widely understood phenomenon.

The central bank is expected to shut the door on provisional advances in an upcoming change to the monetary law.

Similar prohibitions against swap financing of the Treasury as well as restrictions on monthly bank overdraft facilities are required to prevent liquidity shocks and keep Sri Lanka's rupee and economy stable.

Countries that have sustainable pegs or pure floating rates (where monetary and exchange rate policies do not contradict) tend to have low nominal interest rates and low inflation. (Colombo/Oct05/2018)


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