ECONOMYNEXT – Reserve related liabilities of Sri Lanka’s central bank has exceeded its net reserves by about 400 million dollars (83.6 billion rupees) by August 2021, data show, placing the monetary authority on an insolvency track, which can lead to large losses and eventual default.
The 400 million dollar negative gap in the dollar balance sheet of the central bank was reported when gross reserves were 3,543 million US dollars.
By September gross reserves were down by another 962 million US dollars to 2,583 million dollars indicating a further deterioration of net foreign assets.
It is not clear how much of the reserve fall came from unwinding swaps, which will also reduce liabilities. Any Asian Clearing Union settlements are already accounted for.
In October the central bank had given more dollars for trade transactions.
The central bank’s net foreign assets as a share of the monetary base or reserve money, or the reserve backing of dollars of domestic rupees have been steadily falling over the past six years and have now turned negative.
Analysts had warned from early 2021 that liquidity injections and failed bond auctions would lead to such an outcome, especially because Fed chief Jerome Powell was printing money and firing a commodity bubble.
Sri Lanka has been engaging in activist, inflationary, monetary policy from around September 2014, bringing the central bank progressively closer to dollar insolvency.
When a pegged central banks injects liquidity into banking systems (inflationary policy) foreign exchange shortages occur, making it difficult for companies or governments that operate in the currency to capture current inflows to repay maturing debt or even make current payments.
The liquidity injections make outflows of foreign exchange exceed inflows.
As a result, foreign reserves are run down. In Sri Lanka when money printing triggers forex shortages, fresh debt is taken to repay maturing dollar debt and also to make current payments through credit lines or suppliers’ credit.
Sri Lanka suffered a 2.3 billion US dollar balance of payments deficit in 2020 and a 2.7 billion US dollars up to July 2021 as net credit to government from the central bank grew amid failed bond auctions.
From 2014 September to August 2021 non-inflationary policy was seen only in 2017 and a part of 2019.
Inflationary policy came from targeting a call money rate with excess liquidity, output gap (mild Keynesian stimulus) targeting and full blown Modern Monetary Theory from 2020 with outright monetization of the deficit.
Sri Lanka is one of several Latin-America-style central banks set up by Federal Reserve money doctors, modeled on Argentina’s central bank. Many of them have collapsed leading to new currencies or dollarization.
These include ones in El Salvador, Ecuador, Korea, Argentina itself and the Philippines, which was re-capitalized. Steep depreciation of a note-issue bank or its collapse has severe consequences on an economy when it has the monopoly on money.
Sri Lanka last faced the full collapse of a note-issue bank when the Oriental Bank Corporation fell on May 03, 1884. The colonial administrators then set up a currency board with a 1 to 1 ratio with the silver Indian rupee which held until the Latin America style central bank was set up in 1950.
The error of equating the value of the currency of a note-issue bank with the economy by neo-Mercantilists that began in the last century was not made at the time, as the Chartered Mercantile Bank was also issuing notes, analysts say.
The Oriental Bank Corporation however had the larger monetary base of 3.2 million Ceylon rupees compared to 921,000 rupees for the Chartered Mercantile Bank.
Over recent months, debt had been effectively transferred from the government to the central bank’s balance sheet through reserve run-downs and dollar borrowings through swaps.
During the money printing periods the Ceylon Petroleum Corporation was also made to borrow dollars instead of buying them from the market, acquiring about 3.0 billion US dollars of borrowings, making large losses each time the rupee falls.
Similar losses would also fall on the central bank when the rupee falls.
Such losses are called quasi-fiscal losses, and the deterioration of the balance sheet will eventually makes it difficult for the central bank to enforce exchange rate and domestic currency monetary policy as well.
In the past with positive net foreign assets, the central bank made book profits when the rupee fell.
Even at the current exchange rate, the gap would widen each time interventions are made to maintain a pegged exchange rate and any swaps would worsen the negative gap and could eventually lead to a default of any dollar debt and the swaps themselves.
If a 1.5 billion US dollar swap from China is used to repay debt, the hole in its balance sheet will widen the negative gap to 300 billion rupees at the current exchange rate.
Sri Lanka’s central bank now has swaps owed to domestic players, the Bangladesh Bank and owe about 1.3 billion US dollars to the International Monetary Fund on account of loans taken on previous programs.
Several central banks that injected liquidity has previously defaulted on IMF loans.
Flexible, un-anchored Policy
Analysts had blamed the IMF for giving technical assistance to calculate an output gap giving the agency the basis to print money to try to close it without doing economic reforms or actual activity.
The US Fed collapsed against gold and the UK pound hit multiple ‘Sterling crises’ with Keynesian output gap targeting.
Te IMF had also institutionalized anchor conflicts in its last program with a high inflation target of 8 percent (domestic anchor which required a floating exchange rate) and giving foreign reserve target which required an external anchor (interventions in forex markets).
The un-anchored monetary policy without a credible domestic or external anchor was known as ‘flexible’ inflation targeting with a ‘flexible’ exchange rate.
Currencies collapse due to a central bank targeting two anchors – printing money to target inflation through low interest rates – while collecting foreign reserves by purchasing foreign exchange by intervening in forex markets.
When the US Fed – which is the anchor currency issuer of a dollar-pegged system – tightens policy amid liquidity injections the pegged country faces capital flight and it can lead to a faster collapse of the currency and sovereign default.
It happens repeatedly in Latin America.
A central bank that collects reserves and intervenes in foreign exchange markets has a convertible monetary base.
When they run out of foreign reserves to exchange for domestic money, rapid deterioration of the currency can be halted to through a clean float of the currency which makes reserve money inconvertible.
A float is a suspension of convertibility. However failed bond auctions which inject liquidity can prevent a float from getting established and lead of further falls of the currency.
A central bank is generally said not to be able to go bankrupt on its domestic monetary base backed by Treasury bills.
The domestic rupee money supply is a liability of the central bank, but through a float it can be made to exist in perpetuity.
However a fully domestic assets based central bank can still make losses on its sterilization activity and deplete its capital and also lose its ability to conduct monetary policy as losses build up.
Quasi-fiscal losses can also come from sterilization costs, though sterilization is ‘monetary policy’ and not a fiscal activity per se.
Sri Lanka’s central bank has also re-financed a Covid loans injecting liquidity in 2020 at around 2 percent, which will have to sterilized or reserves lost until they are repaid.
The central bank using its balance sheet also gave guarantees to Covid-19 loans in a more responsible fashion without printing money, but it can also lead to quasi-fiscal losses through bad loans. By end 2020, the central bank had provided 154 million rupees for credit losses.
Sri Lanka, meanwhile has got into the first stages of a sterilization trap last week as authorities started to mop up money from failed bond auctions, EN’s economic columnist Bellwether says.
As rates are hiked the losses will tend to increase.
The central bank which injected 87 day money at 6.13 percent last month has now started to mop up liquidity from failed bond auctions at 6.00 percent. It is also injecting money overnight at 6.0 percent. The 87 day money was to partially reverse a statutory reserve ratio hike.
In Sri Lanka the SRR is un-remunerated and does not cause costs or losses to the central bank.
Central Bank Governor Nivard Cabraal lifted price controls on bond auctions which had crippled bond markets, but they are still not functioning effectively. There is also no functioning spot market for forex.
It is better to take early action, analysts have said.
Analysts had also warned that while note-issue-banking and changes in central bank balance sheet items are a mystery to most people including rating agencies, they do understand foreign reserves.
When liquidity injections hit foreign reserves or the exchange after going through the credit system, downgrades follow.
Economists have urged authorities to go for an IMF program to restore confidence and avoid outright sovereign default and consider pre-emptive restructuring.
However Sri Lanka authorities do not like to re-structure and are trying to pay back debt.
An IMF program will generally involve raising taxes, cutting spending and raising interest rates. However an IMF program will also unlock budget support loans.
If a country’s debt is deemed ‘unsustainable’ the IMF cannot lend and other development partners including the World Bank and Asian Development Bank also cannot give budget support loans.
Sri Lanka’s current fiscal troubles come partly from ‘revenue based fiscal consolidation’, a reckless strategy followed in the pursuit of a magic revenue-to-GDP number.
In the absence of spending-based consolidation the pursuit of the magic number transferred large volumes of taxes extracted from productive sectors to state workers driving up spending-to-GDP from 17 to 20 percent. (Colombo/Oct09/2021 – Corrected opening para month of August Update IV)