ECONOMYNEXT – Sri Lanka has posted a 2.3 billion US dollar balance of payments deficit in 2020, down from a surplus of 377 million dollars in 2019, official data showed as unprecedented volumes of money was printed under so-called Modern Monetary Theory.
Money was printed in 2020 mostly by rejecting market in for Treasuries auctions and placing price ceilings in an attempt to keep interest rates down despite having a pegged exchange capable of generating a balance of payments deficit by running down forex reserves.
The central bought about 651 billion rupees of Treasury bills in the course of 2021, in blatant debt monetization, which was said to be under MMT.
The injections began in February 2020, witha 24 billion rupees central bank profit transfer conducted as a liquidity injection, in the first of a series of helicopter drops of liquidity that led to a steep fall in the rupee in March and triggered downgrade.
Analysts who are calling for central bank reform or its abolition to preserve monetary stability and allow the country to grow have called for profit transfers to be halted to build reserves or transfers to be done in dollars in the first instance instead of injecting liquidity which is then defended in forex markets.
Where did the liquidity go?
In 2020 the central bank also cut the statutory reserve ratio 2020, but the entire liquidity seems to have been absorbed by an expansion in reserve money.
Reserve money grew by around 28 billion rupees (without excess liquidity) during 2020 to end at 964.4 billion rupees, despite the statutory reserve ratio cuts.
There seems to have been no provisional advances to the government (a type of printed money permanent overdraft that is allowed under Sri Lanka’s Latin America style monetary law) in 2020, amid an expected fall in tax revenues.
By end December 2020, 206.75 billion rupees of excess liquidity remained in the banking system from the printed money, up from 37.9 billion rupees at the beginning of the year, or a net increase of 168.85 billion rupees.
The central bank did not engage in large intervention to defend current account transaction in 2020, amid weak private credit.
Credit surged in March during a severe ‘flexible exchange rate’ episode or (highly non-credible pegging period) and then collapsed amid lockdowns, allowing the central bank to buy dollars for several months.
During a ‘flexible exchange rate’ episode money is printed and peg defence is delayed long enough to panic importers in to borrowing and early covering of import bills, exporters to hold back, and any rupee bond investors to flee.
The March-April, ‘flexible exchange rate’ episode then triggered downgrades, and the fall in confidence worsened outflows through the financial account. Sri Lanka’s credit had been already downgraded after a tax cut was announced in December 2019.
After August 2020 private credit started to pick-up, leading to some defence of the currency peg. Low interest rates from liquidity injections also encouraged forward covering.
But most of the liquidity flowed out through the financial account as government debt was repaid with dollars issued against the liquidity.
Foreign stock investors also steadily sold out, while stock prices rose amid low interest rates and excess liquidity.
Approximately 454 billion rupees had been absorbed by a 2.37 billion dollar balance of payments deficit in 2020, at an average rate of around 190 rupees to the US dollar.
The MMT driven BOP deficit is the highest in Sri Lanka’s history.
However in the third quarter Sri Lanka had registered a current account surplus amid the biggest BOP deficit in history.
“Classical Mercantilists used to focus on the trade deficit,” explains EN economics columnist Bellwether. “The holy grail of modern or neo-Mercantilists is the current account deficit.”
“The current account deficit is simply an outcome of foreign borrowings and foreign direct investment being spent domestically. In countries like Sri Lanka current account surplus occur in severe crises, when financial account turns negative and there is capital flight.
“Because Sri Lanka’s soft peg has created exchange controls, the possibility of current account surpluses occurring in normal times is almost zero.
“In country like Sri Lanka which has a 20 percent domestic private saving rate, BOP surpluses and even current account surpluses can be generated very easily with prudent monetary policy. Sri Lanka is having monetary instability with a peg, due controlling interest rates a final target with money printing.”
“There is no special benefit in generating a current account surplus, it is simply an outcome of savings behaviour. However a BOP surplus is useful to build external confidence and more importantly in the course of creating a BOP surplus the central bank is forced to follow prudent policy.”
Open Market Crises
The previous highest BOP deficit was in 2015, when liquidity was pumped in by terminating term repo deals to create unsustainable credit and imports mostly through the current account.
In early 2015 large volumes of money was pumped in to keep call money rates near the bottom of the corridor.
In 2017, the central bank generated a 2.0 billion dollar BOP surplus, mopping up reserves and selling down its Treasury bill stock as credit contracted after the 2015/2016 currency crises.
In 2018 the central bank began injecting large volumes of money as credit recovered, almost entirely through open market operations, to target the middle of a policy corridor and trigger a currency crisis, generating a 1.1 billion dollar BOP deficit.
In 2019, as credit slowed the central bank again mopped up reserves, running prudent policy and building reserves until July 2019.
By July 2019 there was a balance of payment surplus of 1,490 million dollars.
Policy then reversed as money was printed under a milder version of MMT and liquidity was injected to target an output gap with artificially low interest rates and excess liquidity.
The ‘flexible exchange rate/non credible peg’ episodes that followed then also put bond investors to flight.
The 1.49 billion BOP surplus in July then reduced to 377 million dollars by January after policy reversed.
The tax in December 2019, which triggered an outlook downgrade, reduced tax revenues, triggering more money printing, came amid weakening monetary policy. In early 2020, monetary policy was further loosened. (Colombo/Feb15/2021)