ECONOMYNEXT – Sri Lanka’s is holding the first Treasury bill auction without price controls Wednesday that crippled the bond markets and led to liquidity injections that ravaged the rupee and pushed the economy in to a monetary crisis triggering the worst balance of payments deficits in history.
The price controls on bill and bond auctions progressively discouraged investors from longer term bonds and 12-month bills and trading in the secondary market dried up.
Crippled Bond Auction
On Tuesday a solitary 2024 bond was quoted at 8.35/45 percent up from 8.25/40 levels Friday dealers said.
The central bank is offering 39.5 billion rupees of 3, 6 and 12 month bills.
There were no secondary market quotes for 12-month bills.
Sri Lanka’s 3, 6 and 12 yields flattened as price controls and liquidity injections continued over the past year and a half, a telltale sign that signals currency crises.
When bids are rejected and the central bank prints money to buy bills, rates remain rock steady week after week giving a ramrod straight curve over time until the currency collapse.
In times of monetary stability however the is a gap of around 100 basis points or more between 3 and 12 month bills.
The ramrod anomaly continues until delayed corrections are made to stabilize the rupee.
Then the gap between 3 and 12 month bills widen steepening the yield curves.
As stability comes back, credit slows after rate hikes the rates fall. If the currency is allowed to bounce back rates fall faster. At the moment however Sri Lanka’s forex markets are also dysfunctional.
Newly appointed Central Bank Governor Nivard Cabraal ended the price controls last week.
There is a high degree of uncertainty among market participants.
“Bids may be on the high side,” a dealer said. “We are not sure whether they will be accepted.”
The interbank money market is now 200 billion rupees short following a hike in the statutory reserve ratio as well as some foreign exchange interventions in September. The short is filled with printed window money at 6.0 percent.
It is not clear why the statutory reserve ratio was raised before the crippled bond auctions were allowed to work.
In order to fill the liquidity with foreign asset purchases after the liquidity injections stop, the interbank forex markets where the net internally unmatched dollar balances are traded among banks must also work work.
Hobbled Forex Markets
In addition to crippled bond markets, Sri Lanka forex markets are also hobbled under a series of controls. There is no spot market and forward cover is banned.
The exchange rate is decreed at 203 to the US dollar but there is no monetary policy to back it as long as there are liquidity injections to enforce artificially low interest rates.
Despite the peg being weakened by liquidity injections and low rates, more liquidity is being pumped in to the system through exporter forex surrenders worsening pressure on the exchange rate. Similar cascading policy errors had been seen in the past, analysts have shown.
In order to maintain a stable exchange rate (a credible peg) the monetary authority has to allow interest rates to move so that no money is printed to keep rates down artificially and interventions have to be unsterilized, or mostly unsterilized so that the credit system tightens and overnight rates move up.
Social Unrest Exchange Rate
Sri Lanka is following a so-called ‘flexible exchange rate’ a highly unstable pegged regime involving two conflicting anchors operated with inflationary policy to keep rates down until the currency peg collapses.
“This is new fangled words to describe highly unstable post World War II third world crawling or soft pegs without a credible monetary anchor which trigger currency crises, social unrest and sometimes civil wars,” says ENs’ economic columnist Bellwether.
“Social unrest flexible exchange rates have previously also been known as dirty floats or managed floats.”
Importers are now buying dollars at 230 to the US dollar or higher in the over-the-counter market as low rupee interest rates have incentivized exporters to keep dollars instead of converting them.
In the absence of liquidity injections any dollar hoarding should have driven up rupee rates and crowded out domestic credit, keeping the external sector in balance.
However liquidity injections permit dollars to be kept at low cost and also for domestic credit to expand unchecked triggering imports.
Sri Lanka’s policy rate is still 6.00 percent at which all interventions are sterilized.
The central bank has effectively halted convertibility (floated) the rupee for trade transactions leading to the rupee falling to 230 or weaker.
A float however does not work if liquidity continues to be injected either through failed bond auctions or sterilized interventions.
Credit expansion, monopoly, price controls
Sr Lanka is now mired in trade controls, price controls and forex shortages as the inflated reserve money supply undermined and de-stabilized the market, while import substitution oligopolies are fleeing the public under cover of trade controls.
In parliament, on Tuesday ruling party legislators called for demonetization of rupee notes and controls over kerb market operators in the style of many money printing European governments in the last century as Marxism and Keynesianism spread like new religions.
“European governments and parliaments have been eager for more than sixty years to hamper the operation of the market, to interfere with business, and to cripple capitalism,” Economist Lugwig von Misses wrote.
“They have blithely ignored the warnings of economists. They have erected trade barriers, they have fostered credit expansion and an easy money policy, they have taken recourse to price control, to minimum wage rates, and to subsidies.
“They have transformed taxation into confiscation and expropriation; they have proclaimed heedless spending as the best method to increase wealth and welfare.
“But when the inevitable consequences of such policies, long before predicted by the economists, became more and more obvious, public opinion did not place the blame on these cherished policies, it indicted capitalism.
“In the eyes of the public not anticapitalistic policies but capitalism is the root cause of economic depression, of unemployment, of inflation and rising prices, of monopoly and of waste, of social
unrest and of war.” (Colombo/Sept22/2021)