ECONOMYNEXT – Sri Lanka’s Central Bank has cut its 7-day policy rate at which cash is injected by 50 basis points to 8.50 percent over two weeks, though the overnight rate at which cash is printed is higher at 8.58 percent.
The weighted average 7-day term reverse repo rate has been brought down from 9.0 percent on March 12 to 8.5 percent on March 27.
The 7-day reverse repo rate is being brought down, as the credibility of Sri Lanka’s soft-peg with the US dollar – which has multiple convertibly undertakings – has come back and the credit system is heading into April when real cash demand rises due to the traditional New Year.
Sri Lanka’s Central Bank de-stabilised the credit system in 2018 by cutting rates on April 04 and pumping the system full of tens of billions of printed rupees through multiple lenders of last-resort facilities until excess liquidity soared to 40 billion rupees on April 09.
Soft-currency pegs collapse and Central Bank reserves are lost due to injections from LOLR facilities which follow dollar sales (sterilised forex sales).
Analysts say that in Sri Lanka, April is a risky month to cut rates as there is a seasonal cash demand during the traditional New Year, which then floods back in the banking system from the last week.
In more than one year, the rupee has come under pressure after April rate cuts, long time watchers of the Central Bank say.
It would be a prudent to allow rates to move up in April as banks go short reserve to meet cash drawdowns and cut rates in May after all the excess liquidity has been mopped up, analysts say.
In April 2015, the Central Bank cut rates, triggering capital flights amid continuous releases of liquidity through terminating term repo deals, in the style of Argentina’s central bank repurchasing its own sterilisation securities.
After the credibility of the peg was restored around Augusts 2018, the Central Bank against built up a massive pile of unsterilized excess liquidity which rose to 58 billion rupees, generating a second run on the rupee which worsened after a political crisis.
A part of the liquidity came from Soros-style dollar-rupee swaps generally used by international speculators to bust currency pegs, to which the Central Bank itself was a direct counter party.
However in 2019, the money markets have been kept short, though the rate at which money is printed is has been cut by 50 basis points over the past three weeks.
On September 25, 2018, the Central Bank also kicked out primary dealers, who had access to repo auctions saying they were undermining ‘monetary policy transmission’ by bidding at higher rates and driving rates up.
At the time, a legacy swap involving a foreign loan repayment had matured in the style of capital flight requiring tightening of the system to slow other domestic credit to compensate, if more forex reserves were not be lost.
But by kicking primary dealers out of the term repo auctions, a correction was delayed. After a second run on the rupee was generated, policy rates were hiked 50 basis points in November 2018.
Turkey last week suspended its 7 – day term cash auctions to prevent printed money being used to speculate against the currency through Soros-style swaps sending swap rates soaring.
There is no accountability for monetary policy excesses in Sri Lanka. While ordinary counterfeiters are punished, there is no accountability for monetary policy excesses.
There have been calls for criminalizing some of the more reckless cash injections in a bid to reduce the harm caused to the poor through monetary instability.
The Central Bank is now giving 7 -day printed money at 8.50 percent while overnight money is auctioned at 8.62 percent.
During periods of instability even longer term money has been given at a much lower.
There have been calls to ensure that term money is given at a upward sloping curve in line with interbank offered rates, to reduce instability and make sure that price signal in the credit system is transmitted to banks with less distortion.
There are no criminal penalties for printing longer-term money at lower rates than the overnight rates. On March 27, 14 day money was also given as low as 8.50 percent.
Some banks now have excess liquidity after the Central Bank cut the reserve ratio to permanently fill cash shorts generated during the period of balance payments trouble which were temporarily filled with term reverse repo injections.
Some banks deposited 27 billion rupees in the Central Bank window at 8.0 percent while others borrowed 28 billion rupees at 9.0 percent on March 28.
By accepting all the bids at a term auction, rates can be easily brought down. However, if the lowered rate is far below market, the rupee may come under pressure and the Central Bank will lose the ability to collect forex reserves.
If the rupee is then allowed to fall in line with the cash injections, reserve losses and further pressure can be avoided.
The central bank can also defend the currency and allow the rates to go up. But if the currency is defended, and money is injected to keep rates down, a renewed period of instability may return.
The Central Bank is planning to narrow the corridor, which analysts have warned would further undermine its ability to collect forex reserves and maintain monetary stability as rates will have even less room to move up if convertibility undertakings such as preventing ‘disorderly adjustment’ or Real Effective Exchange Rate Index targeting are given effect.
"The policy corridor should be widened as much as possible to help restore credibility of the peg as quickly as possible and stop making it go to the weak side in the first place," EN’s economic columnist Bellwether has said (Sri Lanka has to reform soft-peg to avoid monetary instability, default: Bellwether).
"About 400 basis points should be a good start. Narrowing the policy corridor will be another disaster in the line of the ‘buffer strategy’ and ‘floating with excess liquidity’. One reason that the April debacle did not produce a full blown BOP crisis is the wide policy corridor. "
The trend in interbank offered rates does not seem to indicate there is a market-driven trend to for rates to fall increasing the likelihood of a policy error unless credit demand falls further.
However in recent weeks, authorities have displayed more willingness for the exchange rate float down as well as up.
At the moment due to bond dealers being out of term repo auctions, banks could also borrow money at 8.50 percent and lend to bond dealers at 9.0 percent.
In a further twist, market participants such as bond dealers are stopped from borrowing real money from each other at rates over the standing discount window rate of 9.0 percent but are pushed to go for printed money from the window even when they are willing to do otherwise, during periods of currency pressure.
Sri Lanka’s policy rate is 9.0 percent when the peg is on the weak side of the convertibility undertakings and 8.0 percent on the strong side CU (forex reserve collecting undertaking), which is still much higher than the US.
Analysts say more monetary stability will come if term repo auctions are either halted or given in line with interbank offered rates for the period. (Colombo/Mar29/2019-SB)