ECONOMYNEXT – Sri Lanka’s central bank has made large helicopter drop style liquidity injections, despite the lack of a freely floating exchange rate regime, data shows, and the credibility of the island’s soft-peg has been severely undermined despite weak private credit.
As the credibility of the peg was weakened the central bank slapped import controls but no effort was made to withdraw liquidity.
Sri Lanka had monetary stability up to January 2020, despite foreign selling in rupee bonds, mostly helped by weak private credit.
But on January 30, the central bank cut rates, in a risky move as fiscal policy had deteriorated with a series of tax cuts, especially value added tax and budget deficits were set to worsen, and private credit would go through a cyclical recovery.
Analysts had warned that Sri Lanka’s obsession with short term rates would lead to monetary instability.
In late February 2020, a 24 billion rupee central bank profit transfer was made to the Treasury as a liquidity injection in a relatively small helicopter drop which was not permanently sterilized, mopped up.
Analysts had earlier advised that profit transfers be halted to boost reserves and if they are done, to transfer foreign reserves, recognizing up front that the rupee would have to be defended against the liquidity injections.
On March 13, the central bank’s Treasury bill stock went up from 78 billion rupees to 128 billion rupees as a 50 billion rupee ‘helicopter drop’ was made, which was not formally disclosed to the market, despite global uncertainty.
Excess liquidity in money markets jumped from 30 billion rupees to 74 billion rupees.
On March 16, the following Monday rates were cut and a statutory reserve ratio (the share of deposits that banks have to place at the central bank) was also cut by 100 basis points, potentially releasing another 50 billion rupees in liquidity with effect from March 17, despite global uncertainty.
On March 17, excess liquidity jumped to 118 billion rupees.
Chillingly, markets were told more liquidity would be given.
With low rates and excess liquidity, domestic banks also started to buy Sri Lanka dollar bonds, some of which were trading around 30 percent below par, while exporters and importers were also concerned, leading to a deterioration of the credibility of the peg.
Sri Lanka’s dollar bonds began to yield higher than rupee bonds.
The central bank then imposed trade controls and banned banks from buying dollar bonds. In Sri Lanka there is a strong belief that monetary instability and currency pressure is related in some way to imports (trade) and not liquidity.
In forex markets the gap between spot and forward rates narrowed and the forward premiums almost disappeared.
Mercantilists have also put forward an idea that the 2018 monetary instability came from sales of rupee bonds, conveniently forgetting that the rupee had been busted from 4.70 to the US dollar when Sri Lanka’s soft-peg was set up, to around 110 to the dollar, solely due to money printing and loss of credibility of the peg, when there were no foreign investors in rupee bonds.
In the 2011 and 2012 the balance of payments crisis, foreign investors in rupee bonds largely stayed put.
Pegged countries that do not inject liquidity recklessly in times of uncertainty, and maintain monetary stability and the credibility of the peg, are able to benefit from low global rates and monetary easing in the anchor currency (USA) and raise money abroad and roll-over debt at very low rates.
Analysts had warned the central bank not to inject liquidity because it leads to loss of foreign reserves when the newly minted money turns into imports and the peg is defended, or if the peg is not defended the rupee falls. Usually both outcomes occur in Sri Lanka.
When liquidity is injected on a net basis the central bank loses the ability to collect forex reserves by sterilizing the current account (mopping up in flows) undermining the country’s ability to settle dollar loans and a rapid deterioration of reserves, which then leads to a downgrade.
Analysts had warned that Sri Lanka did not have enough rating space to narrowly target a call money rate with excess liquidity which had been identified as a key risk to the economy.
“Sri Lanka will soon run out of rating space to tap capital markets if the flexible exchange rate/call money rate targeting continues in the next recovery space,” an analyst warned in December when value added tax was cut, even before the Coronavirus crisis.
“If rates are cut further and money is printed, the recovery in 2020 will be short-lived or not at all, and another currency crisis will be generated and downgrades will follow.”
Unlike in the US, when liquidity injected by the Fed moves out of the country to fill dollar liquidity shortages in the world, sometimes pushing up the US dollar against other currencies, the opposite happens in a soft-pegged country where the domestic money is not in demand overseas.
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