ECONOMYNEXT – Sri Lanka has run a balance of payments deficit of 2.755 billion US dollars up to July 2021, official data show, a record high, as historically high levels of liquidity was injected to expand unsustainable credit, boost imports and also sterilize debt repayments.
In 2020 Sri Lanka ran a balance of payments deficit of 2.373 million US dollars, the highest annual deficit in central bank history up to the time, operating so-called ‘alternative’ or ‘modern monetary theory’ policies to keep interest rates down.
Sri Lanka has had balance of payments or liquidity injections trouble even since a Latin America style central bank modeled on the one in Argentina was set up by a US money doctor in 1950.
US money doctors set up similar central banks with sweeping money printing (counter cyclical) powers to suppress interest rates, leading to chronic currency collapses, followed by sovereign default and ultimately dollarization usually.
The full year 2020 BOP deficit has now been exceeded in the first seven months of July 2021. A part of the BOP deficit in 2021 (closet to billion US dollars) was triggered from liquidity injections left over from 2020 due, which were used up as private credit picked up.
The BOP deficit is approximately the fall in net international reserves, which are progressively drawn down as outflows of foreign exchange exceed inflows (foreign exchange shortage) due to new money pumped into the banking system and the budget.
Banks may loan the money (from maturing bonds which are bought by the central bank after rejecting bids or new bonds bought to make coupon payment) to borrowers who in turn will trigger imports when they are invested.
Any new bills or bonds purchased by the central bank or standing deposit window money given to re-finance state bank overdrafts to the Treasury, will be paid as salaries to state workers who will use the money to buy goods in the marketplace, creating a foreign exchange shortage when importers replenish the stocks.
In the 1970s when Sri Lanka was mired in multiple trade and exchange controls the knowledge that Treasury bill purchases from failed auctions triggered BOP deficits had been known to at least one classical economist within the bank.
“The responsibility of absorbing the unsubscribed portion of the Treasury bills fell on the central bank,” the classical economist wrote in the 1975 anniversary publication of the monetary authority.
“A major drawback in financing of budget deficits with central bank credit is that while the process involves an expansion in the money supply, it is not necessarily accompanied by an expansion by a corresponding increase in national product,”
“Consequently, increased demand emanating from central bank financing of budget deficits had to be satisfied by increased recourse to foreign supplies with resulting pressure on the country’s external payments.
“Thus, though the Government fiscal problem and the balance of payments deficits were two distinct problems, they were nevertheless inter-related, in that the balance of payments deficits and loss of external assets arose partly out of the method by which the government sought to finance its deficits.
When liquidity is injected and bond auctions fail, the government is also unable to generate real resources for itself (by curtailing domestic credit) leading to foreign reserves appropriation to repay foreign debt. The reserves are released against T-bills in a book transaction.
If no liquidity was injected (and bond auctions do not fail) the central bank would later be able to sell down the Treasury bill taken to sell reserves to the Treasury, curtail domestic credit, force a foreign exchange surplus and buy the dollars.
However when liquidity injections to keep interest rates down pressure the currency peg, market participants also bet against the peg and or try to cover themselves against further currency falls.
These include exporters who pile up dollar deposits and borrow rupees made cheap by failed bond auctions and old people and pensioners who stock up on medicines fearing that they will not be imported in the future.
In Sri Lanka according to social media, some member of the public are also stocking up on jockstraps and other underwear after import restrictions were slammed by outgoing central bank Governor W D Lakshman.
In the stock market inflationary expectations were also raised by the liquidity injections and currency instability, firing an exporter or ‘dollarized asset’ frenzy.
Sri Lanka last ran two successive years of deficit where the second year deficit was bigger than the first in 1999 and 2000.
Usually policy corrections are made to reduce liquidity injections after a BOP deficit emerges in the first year.
The central bank hiked policy rates in August, but it failed to bring the desired results as price controls on bill and bond auctions triggered more liquidity injections as auctions failed.
Currency Crisis Tools
Over the past two decades the central bank has created liquidity injections or balance of payments crises in several ways, analysts have shown.
In 2004 and 2008, liquidity was injected by rejecting real bids at bill auctions.
Prior to that liquidity had also been injected by failing to roll-over maturing central bank securities, which analysts say is the preferred BOP crisis method of Argentina’s central bank (failure to roll-over Leliq and Lebac sterilization securities).
In 2011 the liquidity injection crisis was created by failure to roll-over term repo deals (which is similar to failing to roll-over sterilization securities) as well as rejecting bids to bill auctions outright and keeping ramrod straight fixed bill yields over several months.
In 2015 and 2016, when bond auctions were not sold outside auctions, liquidity was injected by initially failing to roll-over term repo deals and keep overnight rates near the floor corridor.
“Because the usual tool of rejecting bids at auction was not available to inject liquidity, authorities devised other methods to trigger monetary instability,” explains EN’s economic columnist Bellwether.
“After term repo deals ran out the currency peg was slapped with reverse repo and term reverse repo injections to generate excess liquidity until the rupee collapsed.
“Then bills were bought outright from banks. Later the ‘bills only’ policy of A S Jayewardene was jettisoned and bonds were also bought outright to inject liquidity, monetize past deficits and manipulate rates deep into the yield curve.
“Rejecting bids for bond auctions also manipulates rates directly beyond overnight and discourages the financing of the deficit with real private sector savings.”
In 2018 in addition to slamming the rupee peg with overnight injections and term repo injections, a dollar rupee swap was also used around July to create liquidity when the budget deficit was brought down.
By purchasing long bonds outright the central bank also bought bonds outright and monetized past deficits turning existing securities in banks into reserve money so that the paper turned into liquidity and imports.
In 2020, bonds were bought outright outside of auctions, auctions were failed with price controls and also a Zimbabwe style private credit re-finance program for Covid-19 hit businesses, and a Mefo bills style contractor bill re-finance programs were started to inject liquidity.
In 2021 the BOP deficit came mostly from mostly failed auctions, left over liquidity from 2020, and there were also sterilizations of reserve appropriations such as the July bond repayment.
The liquidity injections in 2020 and 2021 were so severe that the central bank is now running out of net foreign reserves and its reserve liabilities are going up. (Colombo/Sept14/2021)