ECONOMYNEXT – Sri Lanka’s foreign reserves edged up 3.6 percent to 1,717 million dollars in September 2022 from a month ago, the latest central bank data showed.
The reserves rose by 60 million US dollars to 1,717 million last month from the previous month’s 1,657 million US dollars.
2022 after money was printed from 2020 to suppress rates and target an output gap. Eventually Sri Lanka defaulted on its sovereign debt in April 2022.
Analysts who watched with increasing alarm the flexible inflation targeting and output gap targeting (printing money for stimulus with a reserve collecting peg) had warned that external default was inevitable under such an extreme ‘impossible trinity’ regime.
Sri Lanka ran out of reserves around February 2022 but the central bank continued to get some funds to intervene from Reserve Bank of India through deferred Asian Clearing Union dues, putting the central bank deeper into debt.
About 1.5 billion US dollars of the reserves are borrowed from China through a swap. Fortunately China had barred the use of the money if reserves had already fallen below three months of imports.
Sri Lanka lost foreign reserves as printed money was redeemed to maintain the peg which was pressured by the new money. Large volumes of liquidity was injected in 2020 to repay maturing securities from past deficits, held by commercial banks by scuttling bond auctions through yield controls.
As the liquidity turned into private credit, a large part of the reserves were lost to excess imports triggered by re-financed credit.
A part of the reserves were lost to liquidity injections made by purchasing new gilts to finance current year deficits. A large part of the reserves were also lost to debt repayments after monetary stability was lost and the central bank was unable to buy dollars and mop up liquidity.
In the latter part of 2021 when excess liquidity disappeared, reserves were lost to sterilized sales (liquidity injected after interventions to prevent interest rates from moving up, reserve money from contracting and limiting the ability of banks to give fresh credit).
Bank now have large liquidity shortages finance with overnight money borrowed from central bank, in addition liquidity taken permanently from outright sales of gilts to the central bank. Classical economist David Ricardo called such injections made to de-stabilize a peg ‘fictitious capital’.
Sterilized interventions essentially finance private sector activity though it is later classified as deficit monetization because central banks no longer use private securities for open market operations.
Both Bangladesh and India is losing reserves to sterilized interventions.
Sri Lanka now no longer has foreign reserves to engage in sterilized interventions and finance unsustainable private sector credit and imports. Reserves are broadly hovering around 1.7 to 18 billion US dollars.
A country with monetary stability do not need reserves for imports.
However the central bank is buying dollars through a surrender requirement (injecting liquidity banks) and selling for oil imports (again altering reserve money), intervening in both directions of the peg which has lost credibility.
With interest rates now corrected to around 30 percent, private credit is negative and imports falling. Sri Lanka is also seeing capital outflows from banks, in addition to imports. (Colombo/Oct07/2022)