Sri Lanka BOP episode update: Bellwether
ECONOMYNEXT – Sri Lanka’s BOP episode moved into a second stage where liquidity gradually reduced as the Central Bank reduced its money printing activities, and overnight rates spiked in August, which has led to the start of overnight injections of money.
Until that time large volumes of excess liquidity were in money markets as forex sales were sterilized 100 percent or more with term repo deal terminations until June 2015, and with fresh outright purchases of Treasury bills thereafter.
But after excess liquidity fell to 30 billion rupees on August 20, the Central Bank started reverse repo auctions to inject money. Money is now injected overnight at 6.2 percent, which is a slightly better practice than buying bills outright as banks will start to put the brakes on credit.
In forex markets a daily intervention rate is now indicated to market participants, a legacy practice that was abandoned in 2001.
In past BOP pressure episodes the following events have taken place.
a) Oil bill payments are delayed, which helps fire credit some more as the Ceylon Petroleum Corporation borrows. Taxes are raised on imported goods, restrictions are placed on letters of credit especially for cars. Oil prices are raised. Forex forwards are curbed.
b) Reserve ratios are cut, releasing more cash in the system and increasing the ability of banks to lend.
c) The rupee is allowed to fall a few cents or a rupee or two and then interventions are made at each new rate with liquidity injections (sterilization) also taking place firing credit with newly created cash. If sterilization is less than 100 percent rates will move up. But full intervention will keep the rate steady at each new level the exchange rate falls. During this time corrections will take place to the banking system where credit will be curtailed and deposit rates raised. Rates may also be hiked. Excuses such as China and India currency falls may be given. The current global turmoil may be good excuses for policy makers to take corrective action.
d) At one point the exchange rate will be floated. With excess liquidity down to 30-40 billion rupees, it is now possible to float the currency. If rates are not raised beforehand to slow credit before the float, the exchange rate will fall further than if rates were raised. Sri Lanka has little experience of this type of floating without a rate hike.
e) If the float is allowed to take hold, both interventions and liquidity injections will stop and credibility will be restored. The rupee will fall, overshoot and will bounce back somewhat if no further liquidity injections are made (hump). In the past floats have taken place only after rate hikes except during an incident in September 2006, where the build-up was not as strong. Excuses will be given that a weaker exchange rate is good for exports. If external demand is weak however exports will fall like in 2012 but nobody will question this Mercantilist dogma.
f) In the past the Central Bank has tended to move in to a phase after the float is attempted where interventions are partial but sterilization is full through reverse repo auctions or through outright purchases of bills instead of allowing the float to take place. During that phase the rupee will fall steadily with no end in sight until interventions and injections stop.
The ‘partial intervention full sterilization’ phase is the most dangerous for the rupee, where the exchange rate deteriorates rapidly. It can be called the ‘asai-bayai’ phase, where the Central Bank wants to float, but is fearful and intervenes, from time to time, injecting rupees at different levels validating the fall. It can stop when credit slows or imports are too expensive and people’s spending power is exhausted. If policy rates are not raised and the credit system slowed, the entire correction will fall on the exchange rate.
This column is based on ‘The Price Signal by Bellwether‘ published in the Septmeber 2015 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.