ECONOMYNEXT – Sri Lanka’s central bank swap transactions with market participants and others to borrow reserves have surged in 2020, official data shows as rates were cut and historic volumes of money was printed under modern monetary theory turning forward premiums negative.
Sri Lanka ended monetary stability from around January 2020 cutting rates despite a tax cut and then injecting liquidity from around February 2020, with a cyclical credit recovery due from a 2018 currency crisis.
In March a Coronavirus crisis hit the country and a ‘flexible exchange rate’ panic drove the rupee towards 200 to the US dollar before interventions began, earning a credit downgrade.
Outstanding central bank swaps which were down to 357 million dollars in December 2019, then started to climb as more reserves were borrowed.
Gross reserves hit 7.9 billion dollars (7.4 billion without swaps as) in February as a central bank profit transfer was made in the form of liquidity in the first of the so-called ‘helicopter drops’ of liquidity bombshells into the credit system.
By November gross reserves were down to 5.5 billion US dollars and reserves after swaps were 4.1 billion US dollars. Information of Asian Clearing Union balance is not available.
By end November excess liquidity was 185 billion rupees which if turned into credit would result in another billion dollars in forex reserves to defend to keep a peg with the US dollar. In December more money was printed and reserves had also been appropriated, data show.
Meanwhile swap premiums turned negative as a confidence shock worsened with further downgrades to ‘CCC’.
Rates are now at historic lows with money printing, and the failing reserves show a drain through the financial account which is indicative of interest rates out of line with the balance of payments. Stock prices are soaring.
The Catbird Seat
In late 2020 forward premiums, which were progressively narrowing amid money printing and weakening confidence, turned negative. In the past the forward cover was given at a premium.
But under the current extraordinarily loose policy which is said to be following modern monetary theory, domestic dollar yields are higher than rupees, swap premiums have turned negative.
In effect analysts say market participants are in the unusual position of being paid to buy forward cover. It is also discouraging exporters from selling forward.
Analysts had warned in the past that central bank swaps, instead of borrowing outright represented a serious risk for the agency as it represented a forex risk to the agency and that many soft-pegged central banks including the Bank of Thailand and Bank of England (during ERM soft-peg) had suffered massive losses while giving ammunition to speculators.
If swaps mature during a crisis, liquidity is usually injected to maintain policy rates.
Analysts have warned that any credit pick up from a stronger economic activity would further pressure the currency regardless of whether there are import controls or not, but early corrective action could also turn the situation around.
Central Bank purchases of dollars have also eased as credit recovered.
With most imports wanted by economic agents – which are anyway taxed at high levels – being controlled, imports deemed bureaucratically desirable are allowed in. They are taxed at a lower rates depriving revenue requiring more money to be printed.
In the recent past Sri Lanka abandoned both a policy corridor and started call money rate targeting, which analysts say is perhaps the biggest economic risk the country since a civil war, and also jettisoned a ‘bills only’ policy buying longer term bonds to create money.
However both in 2017 and 2019 swaps were unwound, strengthening bought reserves, despite operation twist style activity combined with a flexible exchange rate undermining monetary stability.
Sri Lanka has a central bank set up by a Federal Reserve money doctor in the style of several set up in Latin America inspired by the creator of the Argentina Central Bank Raul Prebisch. However at the time reckless open market operations were not envisaged. (Colombo/Jan12/2021)