ECONOMYNEXT – Sri Lanka’s forex reserves fell by 306.4 million US dollars to 5,549.3 million US dollars November 2020 from 5,855.7 million dollars a month earlier, official data show.
Sri Lanka has been printing unprecedented volumes of money, driving excess liquidity to record levels, with Central Bank Governor W D Lakshman saying ‘modern monetary theory’ allows printing money.
Sri Lanka however has a (soft) pegged exchange rate regime with forex reserves which change according to the balance of payments though dollar purchases and sales.
The central bank’s forex reserves rise when rates are slightly higher than required by domestic credit and the balance of payments (allowing the central bank to buy dollars and mop up inflows) and forex reserves are lost when rates are below the market as required by domestic credit and the financial account payments.
Sri Lanka’s private credit has picked in September and October, though November data is not out yet.
However implied forward premiums have turned negative, indicating that the overall interest rates are out of line with economic developments in the current and financial accounts, analysts say.
Central Bank credit to government (printed money) hit 735 billion rupees in October from 511 billion rupees in February 2020, when money printing began starting with a central bank profit transfer as liquidity.
Though profit transfers as liquidity is not central bank credit by definition, when the liquidity hits the balance of payments, reserves are lost through peg defence or the currency fall if the peg is not defended.
Sri Lanka’s forex reserves are now the lowest since April 2017 when forex reserves fell to 5,048 billion rupees. During the 2015/2016 crisis Sri Lanka had a policy rate corridor to protect the peg to some extent.
However under the Sirisena-Wickremesinghe administration, where full central bank independence was given, a call money rate in the middle of the corridor began to be targeted, a ‘bills only’ policy was jettisoned summarily.
The lack of a policy corridor protection makes currency crises inevitable from a small pick up in the economy and the credit system, analysts have said.
Analysts had warned in late 2019 that Sri Lanka was running out of rating space to continue monetary indiscipline (Sri Lanka needs monetary discipline to avoid further downgrades: Bellwether) and if the credit was downgraded to CCC Sri Lanka would not be able to access capital markets.
“Sri Lanka is a country that had mostly kept monetary stability in the worst years of the war with the help of the ideology then prevailing,” EN’s economic columnist Bellwether warned in late 2019 before the value added tax cut shock came.
“But now each new episode of monetary indiscipline is costing the country one notch in the rating scale.
“Sri Lanka will soon run out of rating space to tap capital markets if the flexible exchange rate/call money rate targeting continues in the next recovery space.”
At the time Sri Lanka’s sovereign rating was ‘B’, there was no Coronavirus crisis and a cyclical recovery of the credit system was expected in 2020.
“The next downgrade will take Sri Lanka to B-. Sri Lanka will probably be able to access credit markets even at that rating,” Bellwether said.
“From two levels below investment grade in 2005, Sri Lanka is now a little above CCC, which is a distressed debt level. It is not a place to take monetary risks in particular.
“If rates are cut further and money is printed, the recovery in 2020 will be short-lived or not at all, and another currency crisis will be generated and downgrades will follow.”
Analysts say Sri Lanka is still at a place where monetary and fiscal corrections can be made, though confidence is sharply down from 2019. (Colombo/Dec12/2020)