Foreigners sell bonds as rupee falls, CB says Sri Lanka has enough forex reserves

ECONOMYNEXT  – Foreign investors sold 13 billion rupees of bonds in the week to August 21, accelerating a weakening of the rupee that began earlier in August, but the central bank said it has enough reserves to defend the currency.

"In recent day we have seen pressure on the fx market," Central Bank Governor Indrajit Coomaraswamy told reporters.

"But the underlying factors do not really explain this pressure. So we think it will be short lived.

"There may be other non economic factors, disturbing the market at the moment. Given the strong underlying fundamentals, we do not see this as a problem that is likely to be prolonged."

The rupee had been weakening from early August though foreigners started to sell heavily only this week. In the week to August 21, foreign investor holdings fell to 123.5 billion rupees, from 136.4 billion rupees.

Reserve Buffer

"We have about 700 mn dollar of foreign investors in the rupee securities market," Governor Coomaraswamy said.

"Even if all of that goes out, which it won’t, we can handle it."

Sri Lanka had about 8.4 billion US dollars of reserves and the authorities were comfortable with about 6.5 billion US dollars, he said.

Deputy Governor Nandalal Weerasinge said of total the foreign bond sales seen over the week, central bank interventions covered only about a third of it, the rest was absorbed by the market.

The banking system can absorb foreign bond sales without the currency falling when credit is weak and not all deposits and loan repayments go for credit, analyst have pointed out.

The rupee fell steeply toward 180 to the US dollar over the week, from around 176 in mid July when monetary policy was generally as prudent and was consistent with the exchange rate policy.

Credit Trend

Sri Lanka’s bank credit has been negative in the wake of monetary instability in 2018, which led to a collapse of the currency, an output shock and a rise in bad loans, though there was positive state and private credit in June.

July data showed that private credit was still negative. Imports had also fallen with weak private credit and slowing economic activity.

No data is available for August, though it is known that the government has ramped up spending through a salary hike..

Foreign investors seen selling bonds also on Friday, dealers said, while importers were also spooked, trying to cover.

in Sri Lanka due to recent collapses of the currency and the central bank’s unwillingness to let the currency appreciate even when credit is strong, importers and bond investors are easily spooked or the credibility of the peg is weak.

"What we said was that as part of an inflation targeting regime, we will not defend any particular rate nominal or real," Governor Coomarasamy said.

"But if there is disorderly adjustment, which is not aligned with the underlying fundamentals, we will intervene in the market.

"There should be no earthly reason why it should be happening other than may be some other factors that have arisen in the last few days."

Until the August instability, the central bank had collected about 350 million US dollars form markets, officials said.

The central bank has been given a forex reserve target by the International Monetary Fund.

To collect dollar reserves the central bank has to sell down its Treasury bill stock to mop up rupee reserves from banks.

Until mid-July, the central bank was selling down its Treasury bill stock steadily mopping up liquidity generated from dollar purchases (sterilizing purchases to create a balance of payments surplus).

The complementary monetary and exchange rate policy allows a soft-pegged central bank to re-build forex  reserves, operating a stable and consistent peg with the US dollar in the process, which analysts have said is tighter than a currency board.

Contradictory Policy

But data shows that the central bank allowed unsterilized excess liquidity to remain for an extended period in July and suddenly started to print up to 20 billion rupees of money from August 07 through its overnight and later other lender of last resort facilities.

The money was printed not at the policy lending rate of 8.50 percent authorized by the monetary board, or near it, but close to the deposit rate of 7.50 percent where excess liquidity from a balance of payments surplus is expected to be removed from the banking system ovenight..

More prnting through term and outirght purcahses also continued in August, data shows.

But on August 16, the central bank suddenly removed about 27 billion rupees of liquidity including part a of the newly printed money and retired bills in its portfolio.  Officials said the Treasury repaid 25 billion rupees in to the central bank.

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It is not clear why such a disruptive repayment was made in one go, when monetary stability and the dollar peg could have been kept tight and more dollars bought if the bills were sold down gradually over two or three weeks, analysts say.

It is also not clear why tens of billions or rupees were printed from a week earlier through lender of last resort facilities at near the policy deposit rate in to the banking system that already had excess liquidity.

Banks deposited 50 billion rupees at the excess window on August 15.

Targets

Governor Coomaraswamy told reporters that open market operations were conducted in August to bring the call money rate to the lower end of the corridor, indicating that the central bank was targeting the rate down systematically.

The central bank is also separately targeting deposit rate deeper into the yield curve through price controls.

More money was also printed up to 316 days through outright purchases far below the 12-month rate, showing that attempts were being made to target the long end of the Treasuries yield as well.

Lending rates are also due to be targeted directly through price controls shortly.

On Friday the central bank cut its policy deposit rate further to 7.0 percent from 7.5 percent.

As the rupee collapsed rapidly towards 180 to the US dollar on Friday another 5 billion rupees was printed overnight Friday at 7.30 percent to take excess liquidity at the deposit widow to 30 billion rupees.

Critics of the central bank has called for what has been dubbed ‘floating with excess liquidity’ to be made into a criminal offence.

Currencies rapidly falls when a soft-pegged central bank injects money to prevent reserve money from contracting after intervening in forex market especially when credit is positive. (Sri Lanka has to reform soft-peg to avoid monetary instability, default: Bellwether).

Another 10 billion rupees of printed money was offered for 7 days but there were takers for only 550 million rupees, which was not given. Whether it was not given to because the rate offered was too high or too low is not known.

One reason for August 23 the rate cut was the recent uptick in the auction rates of Treasury bills, Governor Coomaraswamy said.

Sri Lanka’s central bank is no longer printing money directly through bill auctions to target the long term yield curve to create balance of payments pressure.

Rate cuts earlier in the 2019, were made without printing money, by lowering the floor rate and mopping up money to keep overnight rate abover maket, andabout 20 basis points above the floor policy rate of 7.50 percent.

Another reason lower that floor rate was to target growth and an output gap, Governor Coomaraswmay ssaid under a modified inflation targeting regime.

"We continue to have an output gap where the potential growth is 5 percent and the current growth rate for 2019 is 3.1 percent.

"And output gap stabilization is an important concern in a flexible inflation targeting regime and that again argues for a relaxation of monetary policy."  (Colombo/Aug24/2019)