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Sri Lanka overnight window borrowings spike amid reserve outflow

ECONOMYNEXT – Sri Lanka’s commercial banks have borrowed 10.5 billion rupees from the central bank’s overnight window amid reserve outflows, the highest volume seen since June 2020, official data showed, amid drop in the still-high level of excess inter bank liquidity.

Over the past week the aggregate overnight balance of the banking system had dropped from 181 billion rupees to 132.7 billion rupees, which is usually indicative of reserve outflows.

The level of non-borrowed excess reserves rose sharply to over 100 billion rupees in March 2020 when modern monetary theory style injections began, expanding from a policy reversal that began around July/August 2019.

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Sri Lanka has been printing large volumes of money, buying Treasuries outright through auctions, through administrative issues and also though failed bill auctions since around August 2019, triggering the current balance of payments episode.

In 2020 the central bank was hit by a 2.3 billion US dollar balance of payments deficit.

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Liquidity goes out of the banking system when a central bank sells dollar for capital flight, debt repayments or current transaction to maintain the exchange rate peg after printing money.

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Since around March 2020, over 100 billion rupees in excess liquidity has been maintained by printing money in a pegged exchange rate, requiring banks to rarely borrow liquidity from the central bank.

The 10.5 billion rupees borrowed on March 18, is the highest since the 10.87 billion rupees borrowed on June 12.

The overnight repo rate spiked to 5.00 percent on March 17 and 4.95 in March 18 from around 4.68 percent last Friday.

A soft-pegged central bank triggers a balance of payments deficit by injecting cash to inflate the monetary base and keep rates down, resisting the self-correcting mechanism of a hard peg, triggering monetary instability in the form BOP deficit, currency depreciation and inflation.

When injected liquidity is borrowed and used by banks, a currency peg is pressured.

Historically it is state banks that borrow and cause forex reserve losses by financing the government or state energy enterprises, analysts who study monetary policy errors in the country say.

Sri Lanka’s large foreign banks and largest private banks usually lend less than they collect in deposits and are net depositors in central bank windows.

As a result they are incapable of putting pressure on the currency.

The private sector as a whole are also net savers generally accounting for annual savings of about 20 percent of gross domestic product or over and live under their means.

The government which runs a current account deficit and state enterprises which run large losses usually ‘live beyond their means’.

When such borrowings are financed with central bank credit there is a balance of payments deficit and the currency may also fall if the central bank is unwilling to give dollars in exchange for the newly printed rupee that comes to the forex market to be redeemed.

State banks which are obliged to finance the budget or state enterprises off budget spending or inefficiencies then end up borrowing printed money from liquidity windows.

On March 18, when some banks borrowed 10.5 billion rupees, other banks were plus by 143 billion rupees.

When the borrowings from the window persist, the central bank will buy Treasuries outright, inject money and ‘validate’ the balance of payments deficit.

This week, a 45 billion rupee Treasuries auction was undersold.

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(Colombo/Mar19/2021)

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