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Sri Lanka banks to zero-weight discounted contractor bills for Basel III, count as liquid assets

ECONOMYNEXT – Sri Lanka’s commercial banks could zero-rate for Basle III capital contractor bills due from the government discounted with the central bank to print money and also count them for a liquid asset requirement with a haircut, the central bank said as the implied domestic sovereign has been downgraded to below ‘AAA’.

The ‘Letter of Acceptance of Payment of Outstanding Bills due to Contractors’ issued by the government will qualify as “acceptable credit risk mitigants for credit facilities granted against the same and shall be risk weighted at zero per cent,” on Capital Requirements under Basel III for Licensed Banks, the central bank said.

Sri Lanka’s government credit is no longer rated as ‘AAA(lka)’ by Fitch after the downgrade of the international sovereign rating to ‘B-‘ in April 2020.

The government’s domestic rating is assessed at a range between AA+ to BB+ indicating an implied maximum of ‘AA+(lka)’.

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Sri Lanka’s banks which have large holdings of debt to the government also cannot be rated above ‘AA+(lka)’, but several private companies which are rated higher.

Sri Lanka’s central bank printed money heavily in March and did not adequately defend a peg (did not convert the printed money that came up for redemption in forex markets into dollars) sending the rupee down close to 200 to the US dollar, raising fears over the ability to settle foreign loans.

Sri Lanka’s credit rating was then downgraded to ‘B-‘ one notch above ‘CCC’.

When a pegged exchange rate central bank (a central bank that collects forex reserves) injects liquidity in to the banking system, which turns into credit, foreign exchange shortages result.

After a spike in credit to 100 billion rupees in March, Sri Lanka’s private credit has turned negative in May and June, bringing down interest rates close to the floor rate of the corridor. However, either a spike in private or government credit can boost demand.

Sri Lanka’s Treasury had issued ‘Letters of acceptance’ to contractors who will take it to the central bank and get printed money at 1 percent. The money will be on-lent to contractors at 4 percent for 180 days until the bills are ultimately settled by the government.

As long as the central bank does not defend ‘a fixed pattern of interest rates’ in treasury bill auctions it is possible to sell them down and mop the liquidity to keep reserve money unchanged and stop any pressure on the forex markets.

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Sri Lanka is now under import controls not seen since those slapped after the collapse of the Bretton Woods system of soft-pegs in 1971.

Sri Lanka government is trying to limit spending, to keep the deficit down as much as possible after a tax cuts in the form of a ‘fiscal stimulus’ in December and January 2020, and a Coronavirus lockdown hit tax revenues.

Discounting the bills at the central bank allows contractors to be funded outside the budget.

Analysts have pointed out that similar schemes were used in Germany 1930s called Mefo and Offa bills to bypass both the parliament and restrictions in the monetary law of the Reichsbank to fund contractors and later created foreign exchange shortages. (SB-Colombo/July30/2020)