Tuesday July 23, 2019

Sri Lanka to release liquidity from import letters of credit

Apr 11, 2019 08:51 AM GMT+0530 | 0 Comment(s)


ECONOMYNEXT - Sri Lanka's credit system will get more permanent liquidity after cash tied up in import letters of credit for cars is released to the banking system, Central Bank Governor Indrajit Coomaraswamy said while recent dollar purchases have also added new money.

Sri Lanka's credit system runs into liquidity shortages in April, as people draw money out of banks for a traditional New Year holiday season and festivities.

The Central Bank will typically purchase dollars as remittances and exporter conversions increase for salary advances, deploying a strong side convertibility undertaking linked to its highly unstable soft-peg with the US dollar.

Strong Side CU

The Central Bank had purchased about 150 million dollars by deploying a strong side convertibility undertaking from February to April, as private credit weakened, pushing the peg up.

The Central Bank is also expecting liquidity to be released from ending a 200 percent margin on import letters of credit, which was imposed after the credibility of the peg was lost in 2018.

"Margin requirements introduced to curtail motor vehicles and non essential imports last year which was putting pressure on trade account and currency were taken off," Coomaraswamy said.

"That will be releasing 25-30 billion rupees in liquidity," he said.

The Central Bank injects the balance requirement by printing money through its domestic operations windows as banks run reserve shorts to meet cash drawdowns.

The returning liquidity sometimes pressures the currency in May if credit demand is strong.

In 2018, the rupee faced severe pressure after the Central Bank recklessly printed money in April to enforce a rate cut, analysts who closely track the soft-pegged Central Bank have said.

But a combination of short reserves filled by temporary injections, and wide policy corridor which pushed up rates, steadied the currency from around July at about 161 to the US dollar. 

In April, overnight money market liquidity briefly became positive.

Weak Side CU 

Sri Lanka also faced prolonged liquidity shortages after September after pressure on the currency returned following another liquidity shock in August and early September.

A part of the liquidity shock was partly created by currency swaps of the type used by speculators like George Soros to bust East Asian pegs. In Sri Lanka, the counterparties were the Central Bank and the Treasury, not George Soros.

A loss of credibility of the soft-peg by the August liquidity shock forced the Central Bank to defend the currency (deploy a weak-side convertibility undertaking) as it does not have a floating exchange rate.

When a hard pegged monetary authority deploys a weak-side CU, it buys dollars and creates a liquidity shortage, pushing rates up and generates a cascading contraction in credit throughout the banking system slowing credit and preventing the peg breaking.

But a soft-pegged Central Bank will then print money to offset the tightening effect (sterilize the dollar sale) preventing the adjustment from taking place, further increasing pressure on the currency by firing a cascading expansion in credit through the credit system with the newly printed money.

In 2018, Sri Lanka's bank injected money temporarily through its liquidity windows and also cut cutting its reserve ratio twice to offset the effects of weak-side CU deployment.

"Liquidity was affected by Central Bank forex operations," Coomaraswamy said.

"We unwound some swaps, and selling dollars caused a liquidity short."

In September (and perhaps in April) large legacy rupee dollar swaps initiated almost five years ago also matured. A maturing rupee dollar swap with the Central Bank acts like instant capital flight generating a cash short, while Soros swaps injects liquidity to pressure the rupee.

A maturing rupee/dollar swap with the Central Bank as counterparty is also an explicit weak-side convertibility undertaking. It was also sterilized by injections.

Around the time primary dealers who responded to stabilize the country by bidding at higher rates for injections were kicked out of the reverse repo auction system, worsening instability.

The move is strong lesson in for all students of economics who study policy errors of soft-peggers analysts say. Policy rates were hiked later.

Multiple Convertibility Undertakings

Analysts have found a mish-mash of convertibility undertakings within a so-called flexible exchange rate.

This includes real effective exchange rate targeting, where the Central Bank depreciates the rupee in a race to the bottom to follow the worst Central Bank in a basket of trading partners - usually the Reserve Bank of India - but it could be another one on a different economic cycle to that of Sri Lanka.

REER targeting implies both strong and weak-side convertibility undertakings.

In 2017, the Central Bank depreciated the rupee from 150 to 153 to the US dollar, when the rupee was on the strong side of the peg. However, Sri Lanka's Central Bank cannot easily do the opposite as it does not have floating policy rates and sterilizes intervention to target a policy rate.

Sri Lanka, however, has a policy corridor which allows some quick correction. Analysts have warned against Central Bank plans to narrow the corridor, which they say will make it even easier for the Central Bank to generate monetary instability, currency collapses and output shocks.

Sri Lanka also has a strong side convertibility undertaking in the form of forex reserve target set by the International Monetary Fund.


Past depreciations also means the credibility of the peg is easily lost, but it is not easy to restore credibility, which requires higher rates for a short time, or liquidity shortages for a longer period to arrest a complete collapse of the rupee, which tends to generate an output shock.

In the last quarter of 2018, gross domestic growth fell to 1.8 percent, though a political crisis, added to the soft-pegs liquidity problems worsening capital flight.

In 2019, there was no de-stabilizing rate cut from the Central Bank as expected by some market participants, displaying prudence not seen in recent years. An overnight short has also been maintained.

"We don't want to jump the gun," Coomaraswamy said.

"We don't want to reduce policy now and in a month or two to increase policies once more."

Sri Lanka's permanent currency depreciation and monetary instability from the central bank has been blamed by analysts for its high nominal rates, budget deficits, destruction capital available for investment, growth and now debt repayment.

Low nominal rates are found in countries with non-contradictory policy, involving either hard pegging or free floating.

Contradictory Policy

Analysts say if a monetary authority operates convertibility undertakings (a de facto peg) with forex operations altering the reserve money, the balance of payments drives the money supply whether bureaucrats who control rates desire it or not.

As a result, any attempts to expand reserve money by printing money to keep rates below the market rate determined by credit demand as in April and September 2018 will generate balance of payments troubles.

Any contractions of reserve money by slightly higher than the free market rate (higher-than-a-currency-board) required by credit demand will result in a continuous increase in forex reserves.

Another way of saying it is that a central bank can only control one variable at a time, either the interest rates or the exchange rate, and not both simultaneously.

"...[A] central bank really has only instrument of policy, i.e. base money," Ross McLeod a professor at Crawford School of Public Policy at Australia National University said at the Asian Liberty Forum in Colombo.

"Which says they can only control one nominal variable at once: the exchange rate or the price. Not both simultaneously."

McLeod has been studying the depreciation inflation complex of Indonesia's central bank, which had higher inflation than more stable East Asian nations, despite having balance of payments surpluses mostly due to implicit real effective exchange rate targeting.

Sri Lanka's private credit became negative in January due to the monetary corrections, compounded by a political crisis which hit business confidence.

When credit demand is weak, it is easy to collect forex reserves with a convertibility undertaking and keep the peg on the strong side or appreciate the currency.

However if a consistent policy is maintained, and the peg is strong, the absence of monetary instability will result in a collapse of nominal interest rates as happened in China until from 1993 to 2005.

China's monetary stability and interest rates have worsened after it abandoned its firm peg for a 'flexible exchange rate' and the credibility of its reserve backed peg was reduced. (Colombo/Apr10/2019-SB)



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