ECONOMYNEXT – A liquidity shortage stemming from interventions in forex markets made to enforce a soft-pegged exchange rate regime fell by 76 billion rupees to 40.71 billion rupees in the week to March 01, after a cut in the reserve ratio released permanent new cash to the banking system.
The Central Bank had earlier estimated that about 60 billion rupees would be released to the banks from a cut in the Statutory Reserve Ratio (SRR) from 6.0 to 5.0 percent sterilising interventions made mostly in 2018.
The SRR, which is the amount of deposits a commercial bank must hold with the Central Bank, was cut from 7.50 percent to 6.00 percent earlier in 2018 to permanently sterilise dollar sales in forex markets along with a 50 basis point hike in policy rates.
The deposits, helped by the SRR along with notes and coins in circulation, form the base money (M0) in the banking system.
The SRR is an archaic tool that keeps nominal interest rates high.
The liquidity released from the SRR cut gives banks interest-free money to give credit from deposits raised earlier and also allows more loans to be given from deposits raised after the cut.
Banks were borrowing from the Central Bank at rates of around 9.0 percent or slightly lower from various facilities that the Central Bank’s domestic operations departments maintains to print money, so that banks can given credit without raising deposits or buy bonds from fleeing foreigners without a corresponding cut in domestic credit and generate balance of payments trouble.
Bank can now lend up to 95 percent of the deposits raised with the SRR at 5 percent.
Official data showed that the Central Bank had started to intervene on both sides of the exchange rate from January 2018 itself, after major speculative pressure on the rupee eased, raising questions about whether it was too premature.
In the two weeks before March 01, when the SRR cut came into effect, the interbank liquidity short also went up to 117.35 billion rupees by February 22 from 106.15 billion rupees on February 08.
The Central Bank was under an International Monetary Fund program which had institutionalised the contradictions of a so-called ‘impossible trinity of monetary policy objectives’ by giving the agency a forex reserve target which required pegging as well as an inflation target, which allowed it to print money and lose control of the peg.
The Central Bank then slapped trade controls as balance of payments came under pressure from printed money and capital flight was triggered.
Analysts had warned that prolonged liquidity shortages are extremely bad for output and the banking system and whenever such policy errors are made, it is better to allow tight liquidity to permeate through the credit system and float to re-establish credibility in the exchange rate.
After a float is well established, all efforts must be made to keep the peg on the strong side of the convertibility undertaking so that forex reserve can be re-built.
The Central Bank had previously floated the exchange rate with excess liquidity remaining in the banking system. Analysts have called for criminal penalties for such actions.
After the SRR cut, there is still a liquidity shortage remaining in the banking system. Central Bank Governor Indrajit Coomaraswamy told reporters that the liquidity short will buffer any pressure on the exchange rate from the SRR cut.
Analysts have pointed out that as long as there is a strategy to collect forex reserves (in part as a buffer for foreign debt repayments), it is not possible to also have a floating exchange rate and policy rates or domestic operations that are incompatible with collecting reserves.
Sri Lanka’s soft-pegged exchange rate has driven the Central Bank to the IMF multiple times, led to permanent depreciation of the currency from 4.76 to the US dollar to about 180 since the impossible peg was created in 1951.
It had also generated political instability as living standards of the population was slashed by depreciation and inflation and generally kept nominal interest rates higher than required if consistent policy was followed.
In order to target an exchange rate peg (whether a moving target or not), short term rates have to float and M0 has to be generated from liquidity created from expansions in forex reserves.
In order to consistently collect reserves (build reserves faster than M0 growth) as the IMF program requires, short term market rates that impact sterilisation auctions (mopping up) have to be higher-than-a-currency-board or free market rate, to lock up forex inflows. (Colombo/Mar05/2019-SB).