Sri Lanka prints over 200 billion rupees, generating BOP pressure
ECONOMYNEXT – Sri Lanka has printed 200 billion rupees in the past four months to October 2015, to finance a budget deficit, accommodate debt repayments, resist market interest rate rises and contraction in the monetary base and credit, official data show.
At last week’s Treasuries auction, the Central Bank rejected bids for maturing bills, and bought them with printed money, allowing the previous holders to generate excess demand in the economy with the newly created money.
The money can also be used by banks or the previous holders of bills to buy cars, build a hotel or factory, eat food or purchase Treasury bonds, which the government will then pay out as salaries or other expenses.
When excess money is created in a country which is not self-sufficient or an autarky, imports go up to prevent inflation and demand pressure.
When the printed money ends up as imports, the Central Bank has to pay out its foreign reserves to prevent the rupee from falling against foreign currencies.
By rejecting bids at the Treasuries auction and printing money, the Central Bank actively defends at least a 3-month interest rate, going beyond its mandate to defend only an overnight policy rate. In practice however the Central Bank is also defending rates higher up the yield curve.
Already there is a large gap between the 12 month yield and the two year yield.
Even before outright monetization as conventionally defined, began after June, the Central Bank has been releasing excess liquidity tied up in term repurchase transactions, driving credit and imports higher.
While excess liquidity has come down from 362 billion rupees at peak reserves of 9.1 billion US dollars in August 2014 to about 60 billion rupee this week, Treasury bill stock has risen from zero in June to 200 billion, totalling about 500 billion rupees or 3.7 billion US dollars at an average exchange rate of 136 rupees to the US dollar.
Up to July Sri Lanka’s entire budget deficit of 532 billion rupees has been financed domestically.
"What this means is that there has been little or no crowding out of domestic credit by the budget deficit," says EN’s economics columnist Bellwether.
"Instead the shock has been taken by the foreign reserves and domestic private credit is growing unhampered. We have been living on reserves."
Foreign reserves have fallen from 9.1 billion US dollars in August 2014 to 6.8 billion by end September 2015 or which is a loss of about 3.8 billion US dollars when a 1.5 billion dollar swap from India is counted in.
In addition to so-called ‘reserve pass through’ transactions involving domestic liquidity, forex reserves also fall due to repayments to the International Monetary Fund and they go up due to profits from reserve investments.
Meanwhile foreign investors also began to sell rupee bonds after a rate cut in April, after buying back some bond sold in the last quarter of 2014.
Fiscal Monetary Links
Currencies fall when budget deficit go up, because a central bank buys up government debt with printed money. But in Sri Lanka the Central Bank is also banker to the government and it also repays foreign debt.
Analysts point out that when large volumes of money is monetized and excess liquidity is high the Central Bank is also unable to sterilize foreign exchange purchases to generate resources to pay regular foreign debt, in addition to premature exists from rupee bonds.
Though rupee bond sales have featured in the 2008 and 2015 balance of payments crises they were not a feature in pre 2007 crises as foreigner were not allowed to hold rupee bonds.
In this crisis, only about a third of the reserves lost or about 1.3 billion US dollars (173 billion rupees) were accounted by capital flight from bond markets.
In the 2011/2012 crisis, foreign investors held tight giving time to raise energy prices and interest rates, but the crisis was generated with the Central Bank indirectly accommodating energy subsidies through sterilized forex sales.
Authorities have now imposed controls on cars as predicted earlier by EN’s economics columnist Bellwether, who also warned that liquidity releases and the Central Bank’s reluctance to raise rates was likely to generate a balance of payments crisis.
On September 04, Sri Lanka attempted to float the rupee, but the rupee is now showing signs of being re-pegged at 140 to 141 to the US dollar levels.
"As float work best when there is a cycle of sterilized foreign exchange sales, where liquidity shortages that are generated from peg defence are filled by barely enough or less than necessary (sterilization below 100 percent), generating tight monetary conditions," explains Bellwether.
"This time however liquidity has been heavily in excess, which is equal to 100 plus sterilization and is reflective of outright monetization of debt."
Sri Lanka’s Central Bank has denied that there is "rampant monetization," and said monetary growth is within target.
But analysts say Sri Lanka has soft-peg to the US dollar and its money supply is therefore anchored and is determined by the balance of payments.
Attempts to resist a contraction in the money supply and a rise in domestic interest rates when credit drives imports higher generates a balance of payments crisis.
Analysts in addition to fleeing bond holders, domestic banks who have foreign loans may also find it difficult to roll them over and especially if rating agencies – who are usually late in spotting problems starts creating noises.
Other than Fitch who has made warning noises, rating agencies have generally made positive noises. The current administration has a lot of international goodwill.
Observers who watch trade deficit or current account deficits, through an extended Mercantilism without understanding the nature of soft-pegs and domestic operations of a central bank and its sterilization activities, may miss vital warning signs, as monetization can cause forex reserve losses even when imports and current account deficits narrow.
Current account deficits widen when inflows through the financial account such as foreign borrowings and foreign direct investments come in. A so-called current account deficit causes BOP trouble only when widened by excess demand from monetized debt.
When inflows fall or reverse, imports and current account deficits can narrow, but the overall balance of payments can still be steeply in deficit and currencies can fall. (Colombo/Oct13/2015)