Sri Lanka forex interventions rise to US$72mn amid credit pick-up in Jan 21

ECONOMYNEXT – Sri Lanka forex market interventions to defend a soft-peg with the US dollar had picked up to 72.25 million dollars in January 2021 from 22.5 million dollars in December as domestic credit started to pick up, official data showed.

Sri Lanka’s rupee has fell close to 200 to the US dollar in the one week forward market in February amid excess liquidity in money market mainly from Treasuries failed to be sold under a price controlled sale which was previously a multiple price ‘auction’.

Sri Lanka’s central bank wants to keep the exchange rate at 185 to the US dollar.

“There is a policy aim (prathipatthi aramunak) to bring the exchange rate to that rate,” Governor Cabraal told reporters at the last press conference of the monetary authority.

“Due to certain reasons the level of 180 to 185 (to the US dollar) has several advantages. A clear advantage is in the repayment of debt in converting from rupees.”

In 2020 the rupee fell close to 200 to the US dollar in March, under a so-called ‘flexible exchange rate’ where the monetary regime flips rapidly from a floating to pegged exchange rate multiple times with the same trading day.

However the central bank intervened (sold dollars) around 195 to the US dollar under a so-called disorderly market conditions rule (DMC), and strenghthened the rate after allowing the currency to fall rapidly and panicking importers into overdrawing banks to settle bills early and exporters to stay away.

“In the first instance we did it,” Governor Lakshman said. “In the second instance we could not because there was no required asset exchanges (wathkam maruweem).”

Analysts had pointed out that the central bank was able to not only defend the currency, but prevent an appreciation beyond 183 levels as private and state enterprise credit collapsed after April 2020 amid lockdowns.

State enterprise credit in particular which are used to subsidize Ceylon Petroleum Corporation, Ceylon Electricity Board of SriLankan Airlines losses, directly hit the forex market, while private credit also hits the forex market eventually.

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Sri Lanka started injecting liquidity to the banking system from around February 2020, initially with a central bank profit transfer after cutting taxes in December 2019 and then outright purchases of Treasury bills from failed bill auctions.

In March 174 million dollars were sold to defend the peg against the liquidity injections and ‘flexible exchange rate’ panic or lack of credibility of the peg. In February 2020, when the profit transfer was made as liquidity Sri Lanka had foreign reserves of 7.9 billion US dollars.

The excess liquidity, which turns into credit, has to be redeemed in the forex market through dollar foreign reserves sales (interventions) to prevent the exchange rate from collapsing below 185 to the US dollar.

By January 2021, forex reserves were down to 4.8 billion US dollars.

Keeping the exchange rate at 185 to the US dollar involves maintaining an external anchor for monetary policy or a ‘credible peg’ for which the call money rate has to fluctuate based on the liquidity changes driven by interventions (reserve money and interest rates float).

Most East Asian nations in the their fastest growth phase and the period of strongest monetary stability stopped printing money and avoided targeting short term rates.

Hong Kong, Singapore, GCC nations to a greater degree and several other stable East Asian nations to a lesser degree follows such policies.

However if liquidity is injected through Treasuries purchases it is not possible to maintain the peg.

In 2018 Sri Lanka broke the peg by injecting liquidity to target a call money rate purely through open market operations, buying bills and bonds from banks and other holders (monetizing past year deficits), at a time when taxes were raised to reduce the deficit and state salaries were frozen, analysts have said.

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After July 2019, similar actions were taken instead of using a slowdown in credit (and imports and economic activity) to build up a reserve buffer, critics have said.

In January 2021 the central bank ordered banks to surrender 10 percent of converted remittances (at broadly market rates), the central bank, taking the dollars away from the forex market and creating more liquidity.

“If the central bank wants to keep the peg, it has to be either ready to sell the exact quantity of dollars in bought, or mop up the liquidity created by the remittance purchases through a sell down of CB-held Treasuries,” says EN’s economics columnist Bellwether.

“However there is a much more liquidity in money markets from failed bill auctions to target the call money rate and various points of the yield curve which dwarfs the pressure from remittance purchases.

“Import controls do not help, since credit will turn to an area that is not under controls.”

Analysts have said targeting the call money rate with excess liquidity is the most significant economic risk to the country after the end of a 30-year civil war, which put the country on the path of Latin America.

Falling reserves usually forces a correction of the rate and the abandonment of the rate targeting exercise.

Unlike in 2011, 2015 and 2018, where liquidity injections mostly generated imports through the current account and only some capital flight in rupee bonds, in 2020 and 2021, a loss of confidence from earlier ‘flexible exchange rat’ episodes is triggering financial account outflows in government and bank debt cross border debt.

The liquidity injections are adding to the reserve losses and taking away reserves that could be used for debt repayments. (Colombo/Feb19/2021)

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