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Wednesday May 12th, 2021
Economy

Sri Lanka forex market caught between moral suasion and slashed NOPs

THE BIRTH DEFECT: Sri Lanka’s conflicting money and exchange rate policies. The conflict led to a crawling peg or currency crises and output shocks or both.

ECONOMYNEXT – Sri Lanka’s forex market is struggling between slashed overnight dollar positions and heavy moral suasion with bank Treasurers summoned by authorities in a bid to keep the rupee below 200 market participants said, amid unprecedented money printing.

On Tuesday bank treasurers were summoned to the central bank to employ moral suasion directly weeks after several were summoned to the Finance Ministry and given a talking to, market participants said.

The interbank spot market is now largely inactive with dealers quoting one month dollars around 203/206 levels on Tuesday.

There seems to be a preference by authorities to see a rate of around 197 to the US dollar, market participants say.

The central bank was quoting an indicative spot rate of 197.50 in its website on April 27.

However forward premiums have turned negative as money printing pushed rupee yields below dollar yields indicating that shorter end exchange rates should be higher than longer end ones.

Earlier in April bank net open positions (NOP), or the overnight dollar balances kept to give foreign exchange to importers whose letter of credit comes for payment were slashed to around a million US dollars for most banks, market participants say.

In practice many banks are now running short positions which when cleared at a weaker exchange rate will translate into losses.

Banks are struggling to cover LCs market participants said. After repeated downgrades foreign suppliers were already asking for re-confirmation of Sri Lanka LCs by third party foreign banks.

Importers were already paying premiums for such confirmations.

Sri Lanka’s forex markets had been under intermittent controls and spot market has come to a standstill many times over the past five years as authorities printed money to target an output gap.

Critics have pointed out that authorities were using fully discretionary policy involving a ‘flexible’ inflation targeting (no credible domestic anchor) and ‘flexible’ exchange rate (no credible external anchor.

In 2015 authorities printed money claiming inflation was too low driving the rupee to 151 to the US dollar amid unsustainable credit powered by printed money.

In 2017 the rupee was brought down to 153 despite weak credit due amid real effective exchange rate targeting (a downward crawling external anchor).

In 2018 money was printed to target an ‘output gap’ driving the rupee down to 182 to the US dollar.

Around August 2019 money printing to target an output gap resumed and in 2021 output gap targeting was ratcheted up into Modern Monetary Theory injections, according to observers who track the central bank’s policy errors.

Sri Lanka has had currency troubles within two years of a soft-pegged central bank being created by John Exter, a so-called American money doctor ending a currency board or hard peg that had kept monetary stability from the previous century through a Great Depression and two world wars.

Many of the central banks created by Fed money doctors styled after one set up in Argentina by Raul Prebisch where the countries ended up in import substitution, sovereign default or dollarization.

There have been calls to bring laws to restrain the central bank to end monetary instability.

Analysts have traced Sri Lanka’s post independence exchange controls, trade controls and inflation to one sentence in the so-called Exter Report explaining the principle on which money printing central bank was based.

“The difference is that the banks foreign exchange operations will be compulsory, whereas its domestic credit operations will be discretionary,” the Exter Report said in creating the original conflict between money and exchange rate policies.

The central bank created balance of payments crises mainly by purchasing Treasury bills to finance the deficit, through so-called provisional advances as well as expansionary open market operations and re-finance of bank credit.

Related

Sri Lanka to probe forex dealers after printing money

Forex dealers however get the blame when excess rupees created by the central bank against domestic assets come up for redemption against the peg and the authorities no longer have the ability to sell ‘unlimited quantities” of foreign exchange.

Related

Breaking currency board was early birth defect of independent Sri Lanka: Sally

Sri Lanka’s central bank should guard against bankruptcy as Fed lights commodity fires

Economists have called the Latin America style soft-peg a birth defect of independent Sri Lanka.(Colombo/Apr28/2021)

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