ECONOMYNEXT – Sri Lanka’s net monetary forex reserves had fallen to around 33 percent of the monetary base by April 2021, one of the lowest levels seen in over a decade, as activist monetary policy intensified, official data show.
Net reserves are usually bought against rupee notes (reserve money).
However the central bank has also borrowed ‘reserves’ from the International Monetary Fund and swaps, which are effectively encumbered and cannot be exchanged for rupees.
Under a currency board arrangements net reserves have to be above 100 percent of reserve money (usually 115 percent as a buffer against risks).
After the credit contraction that came after Sri Lanka’s 2011/2012 soft-peg crisis, net foreign assets of the central bank as a share of base money rose to as much as 148 percent of reserve money.
However injections began in September 2014 to keep rates down, quite independent of any budgetary process. In September net foreign reserves as a share of monetary base was as high as 148 percent.
By January 2015, when the so-called ‘Yahapalana’ administration came to office, NFA as a share of base money (reserve backing of the note issue) was already down to 106 percent.
Large volumes of liquidity was then injected to keep call money rates at the bottom of the policy corridor as the budget deteriorated under the ‘100 day program’ of the so-called Yahapalana administration.
The 100 day program was a ‘policy-making by manifesto’ strategy without white papers, green papers or wide discussion.
Monetary policy deteriorated rapidly after that, with call money rate targeting coming into play to trigger the 2018 currency crisis.
Unlike a policy ceiling, at which liquidity shortages take place, squeezing the ability of banks to lend, ‘call-money-rate-targeting’ of the middle of the corridor leads to excess liquidity and a complete loss of control of reserve money, analysts have shown.
Call money rate targeting intensifies dual anchor conflicts involving targeting an external anchor (peg) and inflation (domestic anchor), analysts had pointed out.
In 2018 output gap targeting, a policy that led to the collapse Bretton Woods system, and the end of a gold standard which had operated for around four centuries, was also used and so-called stop-go policy cycles intensified.
The International Monetary Fund also gave technical assistance to Sri Lanka to calculate the output gap, despite the central bank being a top customer which had got into currency crises due to anchor conflicts.
Under a ‘flexible exchange rate’ an unusually unstable soft-peg, the currency collapsed quickly before the expected ‘Barber Boom’ from output gap targeting got properly took hold. A ‘barber boom’ was last seen in 2011.
Sri Lanka got into a currency crisis in 2018 while having a significant loan from the International Monetary Fund.
In 2019, taxes were slashed in another ‘policy-making by manifesto’ operation (echoing Anthony Barber), outdoing the ‘100 day program’.
“Manifesto making is political,” explained Rohan Samarajiva, a regional policy specialist in Arthashastra his column in EconomyNext (Sri Lanka’s misguided state priorities and how to reset them).
“Experts or those who are perceived as experts may be called in to contribute, but the principal criterion is not expertise, but trust.”
“Those who have been involved in manifesto making will testify to the opacity of the process, wherein what is accepted one day can disappear the next and new clauses and conditions can mysteriously appear even after ‘finalization’.”
Forex reserves then deteriorated sharply as rates were cut, reserve ratios were cut as the budget deteriorated.
Analysts have pointed out that Sri Lanka’s monetary policy deteriorated sharply after Deputy Central Bank Governor W A Wijewardena retired from the central bank.
When foreign reserves fall to very low levels, rates are usually hiked and the exchange rate is floated. By raising taxes and cutting state spending, the rate hikes can be capped to some extent.
Central banks that do nothing may end up in dollarization.
The fall in net reserves comes as policy at the anchor central bank is also deteriorating. Inflation in the US hit 5 percent in May 2021, in line with forecasts made by classical economists.
Analysts had warned that the central bank had to guard against a runaway Federal Reserves.
Sri Lanka’s first balance of payments crisis in the early 1950s also took place as the Fed printed money to target the yield of ‘Liberty Bonds’.
When oil prices rise Sri Lanka usually tries to fix oil prices losing tax revenues and driving up domestic credit, under a policy popularized by current industries Minister Wimal Weerawansa called ‘removing the World Bank plug’.
The rising domestic credit triggers more money printing under a policy rate targeting exercise (Colombo/June11/2021)