Sri Lanka forex forwards upside down amid money printing, downgrades
ECONOMYNEXT – Sri Lanka’s forward foreign exchange rates have inverted with unprecendented money printing pushing down rupee interest yields and sovereign credit was downgraded as foreign reserves continued to erode, data shows.
In the interbank market US dollar interest rates have risen amid as banks found it difficult to raise dollar loans abroad as Sri Lanka’s sovereign credit was lowered, market participants say.
When sovereign ratings are downgraded, foreign banks do not renew loans or credit lines and they have to be paid back on maturity.
Some counterparties who have long relationships with Sri Lanka banks have also been forced to cut exposure limits, market participants said.
Analysts say Sri Lanka’s interest rates which are kept down with money printing is out of line with the balance of payments (or financial account), which is seen by the erosion of forex reserves, though a private credit contraction sharply cut current account flows as imports fell for several months after lockdowns.
Implied forward rates are usually determined by the interest rate differential between rupees and dollars.
In countries with depreciating soft-pegged depreciating currencies, domestic interest rates tend to be higher than countries with hard pegs or true floating central banks which do not have contradictory policy.
Sri Lanka as a result usually has positive forward rates, which reflects the actual cost of a bank to offer a fully covered forward position to a customer.
Sri Lanka’s rupee rates have now fallen, amid excess liquidity, though a part of the fall is due to a cut in reserve ratios.
Three and six month dollar rates have moved to around 5 to 6 percent, market participants say with higher yields at longer tenors.
Sri Lanka’s one year Treasury bill rates are around 5 percent, kept down with money printing and price controls.
As a result Sri Lanka has not been able to fully roll-over maturing debt as debt and paper securities are being turned into reserve money (Sri Lanka fails to sell 80-pct of Treasuries at auction), which are exchangeable for dollars, analysts say.
Authorities have suggested that unlimited volumes of money could be printed under ‘modern monetary theory.
As a result forward rates have inverted.
Banks also hold Sri Lanka sovereign bonds which have yields in excess of 20 percent. As dollar credit lines are cut, banks try to generate dollars through the swap market or borrow, which has elevated dollar yields.
Exporters also prefer to lend at 6 percent plus than sell forward with negative premiums.
The central bank last week against restricted the purchase of sovereign bonds by banks.
Sri Lanka’s sovereign bonds are anyway expected to be paid out of reserves, and the early purchases by commercial banks would make the credit system adjust to the payments through the interest rates and curb domestic credit, in the absence excess liquidity from money printing, analysts say.
Analysts had warned from last year that Sri Lanka’s obsession with low rates would lead to downgrades and at CCC Sri Lanka would not be able to access capital market.
With a cyclical recovery in the credit system expected in 2020, analysts warned in late 2019 to avoid monetary indiscipline.
..[E’each new episode of monetary indiscipline is costing the country one notch in the rating scale,” EN’s economic columnist Bellwether warned.
“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.
“From two levels below investment grade in 2005, Sri Lanka is now a little above CCC, which is a distressed debt level.
“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.”
“The next downgrade will take Sri Lanka to B-. Sri Lanka will probably be able to access credit markets even at that rating.”
At the time Sri Lanka’s rating was at ‘B’. All the major rating agencies have now downgraded Sri Lanka to CCC or CCC+ level. Standard and Poor’s also raised concerns over excess liquidity which is now around the equivalent of 1.2 billion US dollars.
Sri Lanka has seen severe financial repression currency trouble especially after 2016 as Sri Lanka abandoned a policy corridor, jettisoned a bills only policy for monetary policy and also engaged in ‘operation twist’ style exercises to manipulate rates as the economy barely recovered from previous currency crises.
The central bank then descended to using price controls for deposit and lending rates.
The actions have raised concerns that the interest had become a final target and not an intermediate target under a so-called ‘flexible inflation targeting’, a type of highly discretionary monetary policy regime.
Under the regime foreign exchange targeting labelled ‘flexible exchange rate’ was backed by a discretionary disorderly market conditions rule (DMC) or convertibility undertaking.
In March 2020 shortly after money printing started (Sri Lanka makes helicopter drops of new money despite soft-peg), the DMC was deployed a little under 200 to the US dollar after allowing the market participants to panic. Critics also fault the International Monetary Fund for advocating post-panic DMCs instead of placing rules to stop prevent liquidity injections.
Critics have faulted the last administration for giving full independence to the central bank to conduct discretionary monetary policy and engage in real effective exchange rate targeting. It is not clear where the REER was also a final target. (Colombo/Dec14/2020)