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Sri Lanka makes fresh helicopter drop of liquidity as nation fights off Coronavirus

ECONOMYNEXT – Sri Lanka has made another helicopter drop of cash pushing up excess money in the banking system with monetary instability already triggered, the rupee slide against the dollar and more trade controls were promised, as the country fights off Coronavirus.

Liquidity injections not only makes the currency fall, making medical supplies more expensive, excess rupees also generate ‘foreign exchange shortages’ undermining the ability to import food, critics say.

Sri Lanka’s health sector, public health inspectors and the military is making progress seen in few countries in curbing the domestic spread of Coronavirus, implementing a contact tracing strategy, though some gaps have been found, especially in quarantine.

But a yawning gap exists between health and economic policy, critics say.

Politicians are asking people to grow vegetables with more trade controls promised.

The rupee fell below 195 rupees in the one week forward markets Friday, while it was down further in the 12-month trades.

Liquidity injections which pushed down rupee rates and dislocated the dollar credit markets at the same time had reduced interest rate differential and thinned out swap premiums, market participants said, adding to Coronavirus jitters.

When the rupee falls, concerns rise among lenders increase about the ability to repay dollar credit.

Sri Lanka’s Consumer Affairs Authority had also slapped price controls, disrupting activity at economic centres, making basic foods like tinned fish and dhall disappear.

Excess Money

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Excess money in the banking system jumped to 118 billion rupees on April 03, from 68 billion rupees on April 01, data from the central bank shows in the latest helicopter drop style, liquidity shock.

Liquidity shocks generate an imbalance in the balance of payments, triggering more outflows than inflows, at a time when regular inflows from exports and other sources are falling, analysts say.

Sri Lanka’s central bank operates a pegged exchange rate, collecting forex reserves, but also targets a call money rate, triggering currency collapses.

Risks to the economy worsened after the monetary authority started narrowly targeting a call money rate within the policy corridor with excess liquidity, generating monetary instability even when private credit was weak, analysts have said.

At the moment, liquidity injections are being made as tax revenues shrink amid a Coronavirus driven abrupt halt to economic activities, immediate relief given to tax payers and a controversial value-added tax cut made in the name of ‘stimulus’ in January, triggering a widening of the deficit.

While deficits themselves do not cause currency collapses or balance of payments crises, deficits financed by central bank credit (liquidity injections) generate monetary instability and forex shortages.

Liquidity Shocks

Sri Lanka had monetary stability until January 2020. The first ‘helicopter drop’ style liquidity shock, came in the form of a profit transfer of the central bank in the last week of February, which was not mopped up, starting the slide.

On March 13, the monetary authority’s Treasury bill stock a proxy for central bank credit, went up to 128 billion rupees, up from 78 billion rupees, in another liquidity shock, as a second helicopter drop was made. On March 17 over 50 billion rupees were released by a reserve ratio cut.

Due to the Coronavirus crises, there could be a higher demand for cash – an increase in real demand for money. Accommodating a higher real demand for money does not push the exchange rate down as the process is a form of private sector sterilization, analysts say.

However the central bank had issued money enough to generate high levels of excess liquidity, which points to the over-issue of money.

On March 24, the bill stock went up to 178 billion rupees, without a big change in liquidity, which usually points to a reserve outflow, analysts say.

The rupee had already started to fall, triggering uncertainty among market participants.

Nixon Shock

On March 24, day banks borrowed 41 billion rupees from the central bank’s overnight window, up from 4.3 billion rupees a day earlier, and deposited 118 in the excess liquidity window, indicating unwillingness among interbank market participants to take counterparty risks, analysts say.

It was the Monday after the central bank slapped trade controls in a Nixon-shock style move.

President Nixon also slapped trade controls as the US dollar collapsed in 1971, breaking its peg with gold after money was printed leading to the collapse of the Bretton-Woods system of soft-pegs.

The US now has a free floating exchange rate, and there is no export of gold from the Fed.

The central bank also printed money and slapped Nixon-shock style trade controls in 2018 and had done several times in the past. In the 1970s the entire economy was closed around the time of the original Nixon-shock in the US.

Politicians also told people to grow vegetables and yams at the time. Countries in East Asia, which were run by classical economists who did not believe in central bank credit maintained monetary instability and free trade.

Dollar Bonds

In the past the falling rupee and the loss of forex reserves due to liquidity injections had triggered downgrades, making it difficult to re-finance debt.

When foreign investors see the rupee fall, confidence in the ability of a country to service dollar debt falls.

The central bank also barred local banks from buying sovereign bonds, as part of the first Nixon-shock, further undermining liquidity for sovereign bonds and pushing yields up, dealers said.

Sri Lanka’s Treasury Secretary S R Attygalle last week said the government had no intention of defaulting on sovereign bonds and yields of the 2020 October bond fell and the prices recovered.

Sri Lanka has over 7 billion US dollars of reserves and all debt would be repaid, he said.

Sri Lanka has twice repaid maturing sovereign bonds, when markets were jittery or there was domestic political uncertainty. In 2015 a 500 million US dollar bond was repaid and in 2019 a billion US dollar bond was repaid, without going to market.

Sri Lanka also has dollar inflows coming in, including a 800 million US dollars from China, Attygalle said. The World Bank has also given a 128 million US dollar credit.

There are also committed and undisbursed foreign loans balance of over 9 billion US dollars of which over 1.5 billion US dollars are expected to disbursed this year.

Related

Sri Lanka says will maintain zero default record as Coronavirus jitters hit sovereign bonds

Sri Lanka Development Bond auction sharply undersubscribed

Domestic holders of Sri Lanka Development Bonds also undersubscribed and the government has honored the bonds.

Amid the excess liquidity the central bank has also promised another 50 billion rupee Zimbabwe style central bank re-financed credit facility to Coronavirus hit firms in quasi-fiscal move.

Sri Lanka’s central bank stopped quasi-fiscal re-financing in the mid 1990s after central bank re-finance of credit led to steep currency depreciation in the 1980s. (Colombo/Apr05/2020)

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