Sri Lanka loosens policy; signals longer term rates

ECONOMYNEXT – Sri Lanka’s central bank has begun permanently sterilizing forex outflows by outright purchases of domestic assets in a ‘quantity easing’ move, and also begun to signal rates up to 72 days ahead through purchases of government securities, official data show.

Sri Lanka’s banking system has faced liquidity shortages after the central bank effectively tightened monetary policy on March 28, by no longer buying Treasuries outright to offset (sterilize) interventions in forex markets and liming injections to overnight cash.

In another improvement the central bank also refrained from engaging in term reverse repo auctions to inject money, which would have made it easier for banks to give loans with printed money and limited injections to overnight transactions.

Before March, the central bank was driving a balance of payments crisis forward by printing money heavily to buy Treasury bills at weekly auctions keeping money markets flushed with excess liquidity and driving credit beyond the deposits raised by banks.

Validating Reserve Outflows

On November 18 the central bank announced auctions to buy Treasury bills outright with printed money and fill liquidity shortages (sterilize) generated by interventions in the forex market.

After 59 day bills were bought by the central bank with printed money at 8.75 percent, secondary market yields fell, showing that the central bank was signalling rates beyond the overnight market.

Bills maturing in February were quoted at 9.00/25 percent, down from around 9.40/70 before the auctions began, dealers said.

On Friday February bills were quoted wide around 9.00/50 percent, after dealers dumped 650 million rupees of February 10 bills on the central bank at 9.07 percent on Wednesday.

The central bank rejected bids for outright auctions on Thursday after calling bids to sell 15.0 billion rupees of securities for printed money.

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In July Deputy Central Bank Governor Nandalal Weerasinghe said liquidity will continue to be managed through overnight cash auctions and term reverse repo auctions will be conducted only if the "shortfall is deemed to be permanent"

Purchasing bills outright with printed money to sterilize forex market interventions ‘validates’ or make foreign reserve losses permanent, says EN’s economic columnist Bellwether.

So far only around 6.0 billion rupees of bills have been bought outright by the central bank, which is not a big volume to de-stabilize the credit system, according to long term watchers of the central bank’s activities.

Transparency

But outright auctions are a transparent method of loosening policy compared to an earlier practice of buying up undisclosed volumes of Treasury bills at weekly auctions.

Under then governor A S Jayewardene, who sought to avoid money printing and reformed the central bank to some extent, the volumes of bills taken up by the central bank was disclosed at each auction. Later transparency reduced with no disclosure being made.

Purchases of Treasury bills at auction can flush the market with tens of billions of rupees and analysts have called it Sri Lanka’s ‘elephant in the room’ policy measure that is not even formally listed as a monetary policy tool.

The quantity easing measure also signals rates up to 3-months.

At Wednesday’s auction, the central bank accepted only 2.9 billion rupees of bids at the weekly auction after offering 31 billion rupees of securities at the auction.

It is not clear whether most of these bills are already held by the central bank in which case a roll-over will not create new money.

However if the central bank buys bills previously held by banks it will create new money. Settlement of the bill auction is on Friday.

On Thursday banks were short by 23 billion rupees.

Soft-pegs

On Friday the central bank announced a 5.0 billion rupee repo auction to withdraw excess cash. New cash comes to the market either through printing (purchase of domestic assets) or by a dollar inflow (purchase of foreign assets).

Sterilizing forex outflows is the archetypical policy of so-called soft-pegged central banks that de-stabilizes countries in South America as well as others like Indonesia and the Philippines and leads to currency collapses.

Even country that has a budget surplus can collapse due to sterilized interventions.

Sri Lanka has a high inflation, balance-of-payments crises prone central bank.

"Though central banks around the world are thought to have various powers, they in fact have only one power, and that is to print money," explains Bellwether who warned of the coming BOP crisis from late 2014, based on current and past central bank actions.

"This is a crime that ordinary citizens are jailed for. Since Sri Lanka has an inflation and BOP crisis generating soft-pegs central bank, more often than not the policy measures have to be wrong by definition."

"Soft-pegs, which try to control the exchange rate and interest rates simultaneously do not work in the real world, are the most dangerous type of monetary policy authority in existence.

"Dollar soft-pegs were designed essentially by US Keynesian, interventionists like Harry Dexter White, after World War II, to break as stable ‘Sterling Area’ and create a global dollar area through the unstable Bretton Woods system.

"The Bretton Woods soft peg system collapsed, with even the UK getting into a series of currency crises. Among few countries that escaped the ravages of the soft-peg was Germany and Japan.

"Due to the hyper-inflation suffered during two World Wars countries like Germany had a healthy fear of central banks and a distrust for Keynesianism," says Bellwether.

Analysts and economists have called for the central bank to be reformed, or a currency board (hard peg with no money printing powers) re-established to protect the poor from currency depreciation and inflation.

Soft-pegged central banks in countries ranging from the Philippines to Indonesia and Sri Lanka have depreciated currencies, slashed the real purchasing power of worker salaries and driven millions out of the country to work in the Middle East. (Colombo/Nov25/2016)

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