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Monday May 16th, 2022

Sri Lanka forex reserves down to US$1.6bn in November

ECONONOMYNEXT – Sri Lanka’s official reserves have dropped to 1,587 million US dollars in November 2021 from 2,269.2 million US dollars in October, official data showed amid low interest rates and sterilized interventions.

Forex reserves are now about one month of imports.

Sri Lanka also has a 1.5 billion US dollar undrawn swap with the People’s Bank of China. As of October there was another 160 million swapped to domestic banks, which is not considered a gross international asset.

Sri Lanka’s forex reserves are now the lowest since May 2009, when reserves hit 1,435 million US dollars.

Sri Lanka reserves hit 1,272 million US dollars in April 2009, when the rupee was floated.

A float, completely suspends convertibility taking place through a non-credible stops sterilized interventions (intervening to maintain a non-credible peg and injecting liquidity to maintain policy rates, which triggers further credit and imports), and gets the spot market to operate.

Liquidity injections made to offset interventions in a peg that had lost credibility, makes outflows exceed inflows.

Analysts however have said Sri Lanka’s current policy rate of 6.0 percent is too low for a safe float and has to be hiked.

A floating exchange rate does not need forex reserves to “manage” the exchange rate unlike a reserve collecting peg. However interest rates have to be sufficiently high to limit or contract liquidity injections through open market operations.

Following a successful float, the currency can be re-pegged provided domestic private credit is curtailed and bond auctions are successful.

Sri Lanka’s bond markets are now functional. Successfful bond auctions are required to channel private savings to to the deficit.

Sterilized forex sales are part of a so-called ‘Latin America clause’ found in central banks set up after the Great Depression and Keynesian dogma to try to operate counter-cyclical policy (sterilize the balance of payments) despite running a peg.

It eventually led to the collapse of the gold standard and subsequently the Bretton Woods system of soft-pegs as well.

For more information on the difference between floats and pegged regimes and why intermediate regimes fail is explained in this Q and A by EN’s economics columnist : Why Sri Lanka’s rupee is depreciating creating currency crises: Bellwether


Q: What is a hard pegged exchange rate? What is a currency board?

A hard pegged exchange rate is the simplest form of monetary system that one can imagine. This is where some institution takes a foreign currency or gold and issues paper in exact proportions. This is like writing cheques against a current account.

As long as cheques are written with a balance the cheques always realize (can be exchanged for dollars). This is a currency board and they never depreciate and are never dishonored. This is because the owner of the cheque book is prohibited in the first instance by law from writing cheques which bounce.

This is called a monetary anchor. The cheques are firmly anchored to the available balance of the account or reserves or a bank. As long as what is the reserve does not inflate, the cheque also will not inflate.

Digressing a little, this is why central banks generally discourage undated cheques from passing from hand to hand.

If the Federal Reserve does not inflate the dollar, Hong Kong dollar issued under currency board principles will not inflate and certainly the parity will not change. If Singapore dollar does not inflate, Brunei currency board dollars will not inflate. And Singapore dollars will exchange in parallel.

Thomas Cook traveller’s cheques are currency board like notes. Amex traveller’s cheques are also currency board notes. They never defaulted and broke the one-to-one parity like the central bank depreciates the currency.

As many readers may be aware there used to be unsigned travellers cheques that used to circulate like money, especially when there were tight exchange controls.

Amex and Thomas Cooke never broke the parity but they also replaced stolen travellers cheques. This was done using the invested returns of deposits taken from Amex customers to issue the travellers cheque, which is like the interest earned from foreign reserves of a currency board or central bank.

The Tether cryptocurrency (a so-called stable coins) is supposed to operate like a hard pegged exchange rate to the US dollar. Whether the promise will be kept no-one knows. A currency board will transparently publish its balance sheet every month to back up the promise.

When people with fixed exchange rate paper use it for imports, the total outstanding (reserve money) reduces as the monetary authority exchanges the bills for dollars.

That automatically stops further imports. If a system of banks uses this money, interest rates in all the banks will go up and credit will contract. In practice these changes are very small.

That is how the Ceylon rupee held a one-for-one parity with the Indian rupee until 1950 the Latin America style central bank was set up, and Bhutan still does.

Under such a system, the rupee notes outstanding also called the reserve money or monetary base is fully CONVERTIBLE to the foreign reserves.

Maintaining the exchange rate limits money issue and it is the ‘anchor’ that preserves the value of the currency. There is absolutely no problem with maintaining a fixed exchange rate as long monetary policy – the rule for printing money – supports it.

What is a soft-pegged central bank?

A soft pegged central bank is like a conventional bank where a customer (The Monetary Board) can write cheques without having the required full cash balance in the bank in the hope that it will not be presented for redemption. However as soon as credit picks up these notes come up for redemption creating forex shortages.

The old gold standard central banks were also soft-pegged central banks. They could issue notes or interest free cheques without having gold in the bank. This phenomenon is also called fractional reserve banking.

However if large volumes of notes were issued without taking in gold in the economy into the bank, the value of the notes depreciated (gold price went up). Because Sri Lanka is supposed to issue dollars against foreign reserves, if money is issued against Treasury bills, the value of dollars will go up.

This in fact is what has happened to Sri Lanka now. In fact it has happened to many other countries. It does not happen to Bhutan or Singapore because there is a law which says money cannot be issued against Treasury bills.

The original Monetary Law Act of Ceylon in 1950 contained elaborate measures to stop the over-issue of money except for short periods – usually about 270 days – which was expected to keep the peg intact.

The IMF is trying to ‘modernize’ monetary policy in many countries which have good central banks. When it succeeds, these countries will have severe social unrest. They are trying harm Vietnam and Cambodia with the same ideology that destroyed Sri Lanka. These two countries will become like Laos if they follow the IMF.

Why do soft-pegged central banks run into currency crises?

Soft pegged central banks run into currency crises because when notes are first exchanged for dollars in the reserves, the outstanding note issue does not contract unlike in a fixed exchange rate and rates do not rise. Reserve money is re-expanded by injecting money through standing lending facilities, overnight reverse repo auctions and term reserve repo auctions to stop rates falling. This prevents reserve money from adjusting to the outflow or transfer of wealth and the currency collapses.

The value of the note does not collapse due to ‘overvaluation,’ or the real effective exchange rate, due to the lack of tourism revenues or other myths.

The currency collapses due to liquidity injected to sterilize or fill the rupees lost due to the intervention. If the intervention was unsterilized and rates were allowed to go up – even partly – it is possible to hold the currency. This is what Dubai, Qatar, Saudi Arabia and Oman do.

Is it possible to run a monetary system where money is created against something like Treasury bills which has no inherent value?

Yes. To a great extent. That is exactly what a floating exchange rate is. In a floating exchange rate reserve money is not convertible. This is called inconvertible paper money. The central bank is not obliged to give dollars in exchange for inconvertible paper money.

People exchange these money among themselves like undated cheques.

Because no dollars are sold to defend the exchange rate, no rupees have to be injected to stop the rates from going up.

When we say the Bretton Woods collapsed, President Nixon closed the gold window, the Bank of England suspended gold convertibility, or the Sri Lanka rupee floated, what we actually mean is the convertibility has been suspended.

Therefore outflows of foreign exchange matches inflows, just like a hard pegged exchange rate system.

But under this system, there has to be a rule also to limit the creation of money to make the floating exchange rate strong.

In the short term therefore note issue does not grow or contract due to foreign exchange defence or purchases, it can go out of ATM withdrawals and banks may also be tempted to get money from the central bank window and lend.

The notes outstanding will also change when pull money out of ATMs which will also be filled by the central bank to keep rates fixed. However they may come back to the banking system in a day or two.

The danger is that money reserve money will grow simply through open market operations to maintain the interest rate as happened in the Greenspan-Bernanke bubble and the current Powell bubble with asset price bubbles and commodity bubbles.

If there is no external anchor to control reserve money in a floating rate, and there is no gold as an anchor, what keeps a floating reserve money in check?

To limit the growth of reserve money in a floating rate also an anchor is needed. Margaret Thatcher and Alan Walters first tamed the floating rate Bank of England with money supply targets. In 2008/2009 Sri Lanka also did that when Deputy Governor W A Wijewardene devised such a program. IMF programs in the past typically used to have them. Bangladesh still does it. But it also intervenes in the forex market and collects reserves.

One consistent system developed by Sweden and New Zealand independently was to target inflation directly with interest rates, ignoring money supply changes in a pure floating exchange regime. A low inflation target of around 2.0 percent has been shown to work.

That is to say when inflation goes up, regardless of what reserve money or broad money or any other indicators such as economic growth or jobs is, rates are raised to slow the growth of reserve money and credit and which in turn tends to strengthen the currency. The US Fed fails due to its dual mandate as well as Mercantilist (John Law style) ideology which resurface like a bad penny.

Floating exchange rates are extremely strong. As a last resort when soft pegs collapse, a float will stabilize the system following a bungee jump.

Has Sri Lanka had a floating exchange rate?

No. Sri Lanka has had very short periods of floating when foreign reserves had run out and the credibility of the peg has been completely lost. But these periods can probably be measured in days or weeks. Sri Lanka then goes back to a dollar buying peg.


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