ECONOMYNEXT – Sri Lanka’s forex reserves dropped 686 million US dollars to 6,493 million US dollars in May 2020 from a month earlier, official data showed, following a 353 million dollar fall in April amid liquidity injections.
Sri Lanka’s forex reserves began to drop after February 2020, in the wake of a pro-cyclical rate cut in January 2020, despite a worsening deficit from tax cuts.
The roots of the current crisis began when liquidity disruptions and injections in the form of outright purchases of Treasuries began in July 2019 halting the ability of the central bank to mop up inflows and the steady build-up of forex reserves ended.
Under then-Governor Coomarwaswmy, a prudential rule set by former Governor A S Jayewardene in the form of purchasing longer term bond to print money was broken, allowing the agency to engage in financial repression further down the yield curve and worsen imbalances, critics have said.
At the time however private credit was still weak as the credit system had still not recovered from a currency crisis in 2018.
A pro-cyclical rate cut in April 2018 and liquidity injections shortly before the policy error triggered the 2018 crises. It was worsened by Soros-style swaps in July/August and a political crisis in October.
In April 2018, at the time the pro-cyclical cut was made Sri Lanka was recovering from 2015/2016 currency collapse.
The pro-cyclical rate that speeded the 2015 crisis was made in April 2018, but liquidity injections started in the last quarter of 2014, when a strong recovery was seen from a 2012 currency crisis.
The gap between currency crises have narrowed due to a combination of discretionary flexible inflation targeting (monetary policy based on a domestic anchor) and call money rate targeting with pro-cyclical excess liquidity while also running an unstable peg to collect reserves (flexible exchange rate).
Analysts had warned that Sri Lanka would run into monetary instability from pro-cyclical rate cuts in 2020. Similar warming about pro-cyclical rate cuts were given in 2018.
In the current currency drop, after which authorities slapped severe import controls up to 160 billion rupees of excess liquidity was printed.
Private credit began to fall in April amid Coroanvirus curfews and consumption had also fallen with retail shops closed. Weak credit allows the currency to halt its headlong fall as demand weakens.
After selling 98 million US dollars dollars to defend the currency against the new liquidity, the central bank had bought 61 million US dollars in May to stop the appreciation of the rupee amid weak private credit, data show.
Gross official reserves also include Treasury dollar assets and they may drop due to loan repayments.
Sri Lanka’s budget had deteriorated in 2020 with at least 850 billion rupees of domestic borrowings expected. Tax cuts for fiscal ‘stimulus’ and forex shortages from liquidity injections had also triggered a rating cut to ‘B-‘.
Generally weak private credit, in the wake of a currency crisis allows the government to borrow more than when the economy is doing well. (Colombo/June13/2020)