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Sri Lanka excess liquidity down in Rs100bn correction

ECON0MYNEXT – Excess liquidity in Sri Lanka’s money markets, which was driven up to around 20 percent of reserve money, inverting forward premiums and triggering forex shortages has been allowed to fall in January 2021 amid unsterilized forex outflows, data shows.

Excess liquidity which is usually around 10 to 15 billion rupees in Sri Lanka is believed to have been driven up to over 200 billion rupees in a Modern Monetary Theory style exercise.

Excess liquidity peaked at 266 billion rupees on January 01, after falling to 209 billion rupees on December 31.

Liquidity drops when the central bank sells dollars against rupees to the interbank market or to the government to settle loans in an unsterilized transaction automatically tightening the credit system.

In January excess liquidity can also rise due to so-called provisional advances where money is printed and advanced to the Treasury up to 10 percent of projected budget revenues.

Unsterilized Interventions

Liquidity dropped steadily in January 2021 amid (un-sterilized) interventions in forex markets as well as settling dollar loans.

Excess liquidity dropped to 166 billion rupees from 208 billion rupees on January 21 amid the maturity of a Sri Lanka Development Bond.

Last Friday interventions were made around 195.50 to the US dollar in the spot market while the spot next was quoted close to 200 to the US dollar on Friday, market participants said.

The central bank on its own can also withdraw liquidity on its own by selling down its Treasury bill stock to tighten the credit system, without waiting to defend the currency by selling forex reserves, after printed money turns into credit.

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The central bank’s bill stock has fallen from 738 billion rupees on January 01, 2021 to 724 billion rupees by January 22, through sell-downs in two Treasury successful Treasury bill auctions.

The central bank, which also runs the debt office had also announced a bond auction.

Sri Lanka’s extraordinary money printing in 2020, despite the need to conserve forex reserves for debt payments had lowered domestic lowered rupee yields below that of dollars, taking a problem that is usually in the trade account from imports driven by printed money into the financial account.

Exporters have also been discouraged from selling forward due to the interests rates which are out of line with the balance of payments and are instead encouraged to loan out dollars to banks and take rupee credit from printed money in a mis-allocation of resources.

Stocks have also soared.

Over-sterilized

In 2020, whenever excess liquidity dropped from loan payments, new money was been printed to bring it above 200 billion rupees. It is not clear whether more money would be injected now. However there has been no change in call money rates with 160 billion in excess liquidity remaining.

In the third quarter the central bank bought dollars amid a credit contraction to stop the rupee from appreciating, which added liqudity. Mercantilists attributed it to import controls.

Analysts had warned that the rupee would come under pressure from any recovery in economic activity or credit under the current monetary framework whether or not there are import controls. There is a strong belief in Sri Lanka that monetary instability is caused by imports.

Mercantilists are especially fond of blaming the ‘oil bill’, motor vehicle and gold for monetary instability (inflation and depreciation) rather than credit and excess money.

In another twist, within oil, cost-push Mercantilists believe that diesel causes inflation rather than petrol and under-prices or cross subsidizes it.

Mercantilists also believe that the Ceylon Petroleum Corporation causes the rupee to fall, forcing it to borrow dollars to settle oil, further worsening pressure on dollar yields and widening the external current account deficit.

In Sri Lanka any pressure in the currency leads to a so-called ‘flexible exchange rate’ episode, involving rapid switches back and forth between floating and pegged regimes, leading to a slide in the currency, which makes importers take credit and cover bills ahead of time.

Mercantilists had claimed earlier that Sri Lanka’s rupee would stabilize after foreign rupee bond holders exited.

Excess liquidity in money markets topped 164 billion rupees on April 29, 2020 for the first time during a Coronavirus lockdown and the end of a traditional New Year.

Modern Monetary Theory

The record liquidity injections is said to be injected under modern monetary theory. However a milder version of MMT had been followed ever since call money rate targeting began, analysts say.

Under call money rate targeting excess liquidity (from domestic asset purchases) peaked around 60 billion rupees. In late 2015 and early 2016 over 140 billion rupees were released overnight to keep call rates at the floor of the corridor.

The central bank last conducted a repo auction to withdraw excess money on March 19, 2020 when tight lockdowns started, taking out 70 billion rupees after printing 50 billion rupees on March 17, in one of several ‘helicopter drops’ of cash.

Sri Lanka cut taxes in December 2019, hitting the budget.

The rupee collapsed steeply in March, in another ‘flexible exchange rate’ episode involving rapid switching between floating and pegged monetary regimes, with the rupee being allowed to fall amid interventions, triggering credit downgrades.

Sri Lanka has been running partially anchored discretionary monetary policy called ‘flexible inflation targeting’ in recent years, targeting a domestic anchor (inflation index) despite collecting forex reserves by targeting the exchange rate (external anchor).

The framework coupled with call money rate targeting with excess liquidity had led to steep falls in the rupee after the end of a 30-year war.

Dual anchor conflicts which started after 1951 had made the central bank a top customer of the International Monetary Fund. (Colombo/Jan24/2021)

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