ECONOMYNEXT – Sri Lanka’s central bank has sold down its Treasury bills stock for the second week, taking its holdings of Treasury bills purchased to trigger monetary instability in March and April to 296 billion rupees on Friday from 303 billion rupees a day earlier, official data show.
The week earlier the central bank also sold down its Treasury bill stock taking the stock down by about 8 billion rupees to from 311 billion rupees.
Over the past two weeks the central bank had sold down about 14 billion rupees of Treasury bills and withdrawing liquidity from money markets potentially saving about 75 million US dollars in forex reserves that would otherwise have been lost.
A soft-pegged central bank can withdraw excess liquidity either by selling domestic securities (Treasuries or its own sterilization securities) or defending the peg with dollar reserves (an unsterilized dollar sale) to reduce forex shortages.
When domestic credit is strong, a soft-pegged central bank will however print more money to target a short term rate after selling dollars (sterilized forex sales) re-inflating reserve money to the previous level, resisting correction in the credit system.
Data showed that in the current bout of monetary instability the central bank has sold about 1.3 billion US dollars unsterilized mopping up part of the 400 billion excess liquidity injected to inflate reserve money, since February.
In 2018 Sri Lanka’s central bank triggered monetary instability by injecting liquidity to target a call money rate below the ceiling policy rate, without any fiscal dominance or political pressure, analysts have showed.
Analysts also warned in November and December 2019 monetary instability as well as credit downgrades was likely as the credit system recovered unless there was monetary reform.
Last week the central bank conducted the Treasuries auction before a policy corridor was cut by 100 basis points to 4.50 percent (floor) and 5.50 percent (ceiling).
Before the rate cut amid excess liquidity injected earlier the overnight interbank rate was already touching 5.50 percent. After the cut the overnight rate again fell to 4.50 percent.
In May the central bank had bought 61.5 million dollars in interbank forex markets amid private credit in April and lockdown which hit consumption as well as import controls, and in June 69 million dollars were bought and 9.25 million dollars were sold.
In May private credit picked up from April lows data showed.
Before the rate cut the central bank had allowed some term reverse repo deals without rolling them over, withdrawing more liquidity and potentially saving forex reserves.
An overnight rate hitting the floor of the corridor generally points to weak domestic credit, though now large amounts of the excess liquidity had come from domestic asset purchases (printing money) to pay state salaries and meet expenses as well as cuts in statutory reserve ratios.
Excess liquidity hit a high of 224 billion rupees on June 17 with a reserve ratio cut. Reserve ratio cuts themselves structurally lower interest rates by reducing inefficiencies in the banking system.
Excess liquidity which fell to 160 billion rupees on Thursday rose to 166 billion rupees on Friday despite the bill sell-down.
The central bank is also re-financing loans from commercial banks creating more money, but by selling down the Treasury bills stock it can neutralize part of the negative effects and reserve losses.
Liquidity had also been created with dollar rupee swaps with commercial banks.
Classical economic analysts point out that the Bank of England during the ERM crisis and the East Asian central banks like the Bank of Thailand during the crisis also gave ammunition (domestic currency) to speculators through such deals.
In general when a auctions of domestic government bonds (or roll-overs of sterilization securities) fail and the central bank purchase part of all of the securities to inflate the reserve money supply, a country will run into forex shortages and could also default on foreign debt.
Classical economists have tried to explain to Mercantilists and neo-mercantilists in the Keynesian tradition in particular that balance of payments troubles comes from inflating reserve money and credit and not debt repayment or imports.
The mis-understanding is generally referred to as the ‘transfer problem‘.
Until it is understood, balance of payments problems as well as import controls, import substitution, price controls and rent seeking will persist in a country as policies are directed to ‘save foreign exchange’ instead of stopping the injections of domestic currency.
“The truth is that the maintenance of monetary stability and of a sound currency system has nothing whatever to do with the balance of payments or of trade,” explained Austrian economist Ludwig von Mises, who tried in vain to show that John Maynard Keynes was wrong in the so-called ‘transfer problem’ in relation to German war reparations.
“If a country neither issues additional quantities of paper money nor expands credit, it will not have any monetary troubles,”
“An excess of exports is not a prerequisite for the payment of reparations. The causation, rather, is the other way round. The fact that a nation makes such payments has the tendency to create such an excess of exports.
“There is no such thing as a ‘transfer’ problem. If the German Government collects the amount needed for the payments (in Reichmarks) by taxing its citizens, every German taxpayer must correspondingly reduce his consumption either of German or of imported products.
“Thus collecting at home the amount of Reichmarks required for the payment automatically provides the quantity of foreign exchange needed for the transfer.”
While the pre-war Weimar Republic collapsed with monetary instability, the Federal Republic of Germany which operated on Austrian classical principles (Ordoliberal), started with central bank reform and repaid all pre-war and post war debt and also paid reparations including to Israel which did not exist before the war.
“Stability may not be everything,” one time West German Economic Minister Karl Schiller said. “But without stability everything is nothing.” (Colombo/July13/2020)