ECONOMYNEXT – Sri Lanka’s private credit barely grew in February 2019, though no longer contracting like in January 2019, while new credit to state enterprises was also small and central bank money printing was negative, official data showed, helping harden a peg with the US dollar.
Central bank credit (printed money) to the banking system contracted 4.8 billion rupees in January, ending a streak of money printing that began in September 2018, involving a complex series of policy errors that triggered a second run on the rupee which ended at 182 to the US dollar by the end of the year.
Weak Private Credit
Private credit grew just 7.6 billion rupees in February to 5,560.7 billion rupees, turning around from a negative 4.3 billion rupees in January.
Private credit can fall because exporters are unwinding dollar positions to pay down packing credit taken during a run on the rupee as credibility on the peg is restored. Government settlement of contractors can also reduce private credit, both of which have no negative effects on growth or employment.
The rupee appreciated from about January as private credit fell and capital flight ended. Up to April, the rupee peg has been allowed to rebound to 174 to the US dollar from 182 wtih a strong side convertibility undertaking deployed to collect forex reserves.
In Febuary, the central bank was a net buyer of 29 million US dollars in forex markets. In March, net purchases were 86 million dollars.
Credit to government from the banking system was 46.2 billion rupees in February, down from 110.3 billion rupees in January.
Total credit from commercial banks and central bank to all customers was 57.5 billion rupees in February, slightly lower than 61 billion rupees a month earlier. In September, total credit including CB credit was 278 billion rupees and in October 114 billion, November 135 billion rupees, and Demceber 144 billion rupees amid capital flight sterilization.
However, a January 2019 spike in central bank credit came from a reserve appropriation to part-settle a maturing sovereign bond.
Analysts have pointed out that due to a particular method adopted in settling foreign loans with central bank reserve, the effect is monetary policy neutral and does not involve altering the liquidity of multiple banks and has no effect on either inflation or the peg, unlike sterilized currency defence.
In 2018, the central bank generated a first run on the rupee by printing money and halting mopping up operations from February 2018, which sent the rupee reeling from 153 to about 161 to the US dollar by July.
The central bank then created fresh money and a second liquidity shock through unsterilzed dollar purchases as well as so-called Soros swaps with the Treasury which led to the second run. A legacy central bank swap (which is an explicit forward convertibility undertaking) also matured in September, which was then filled with large scale money printing, filling liquidity shorts at multiple banks.
Forward Convertibility Undertakings
Unlike reserve appropriations, forward convertibility undertakings alter reserve money by injecting cash to multiple banks when neutralized with freshly printed money.
To avoid monetary instability in the future, EN’s economic columnist Bellwether has said that all future swap maturities should be settled in paper with the counterparty bank, giving the central bank an equivalent volume of Treasury bills instead of cash to make the transaction monetary policy neutral.
However, swap maturities (as well as any other risky open market operations) cause less problems when private credit is weak and dollar purchases are mopped up steadily to keep the peg on the strong side of its convertibility undertaking.
In September 2018, however, credit surged.
Balance of payments troubles are primarily caused by credit, as it is borrowers – mostly large investors and the government – who can spend beyond their means.
Pressure on the rupee is created when new loans are financed by central bank credit from its reverse repo, term reverse repo auctions to sterilize interventions or for any other lender of last resort operation or outright purchases of Treasury bills to manipulate bill auctions or provisional advances given to the Treasury.
Ordinary people outside the central bank have no ability to put pressure on the currency. Even capital flight will simply push up interest rates if unsterilized interventions are made or lead to a very temporary fall in the currency if no intervention is made.
Targeting two impossible variables
Sri Lanka’s rupee falls because it is a peg with a series of convertibility undertakings (exchange rate targets) and money is printed to target interest rates after deploying so-called weak side CUs.
Soft-pegged central banks do not seem to realize that deploying a weak side convertibility undertaking and printing money to maintain a base money target (a base or reserve money target is a derivative of an interest rate target) and deploying a strong side convertibility undertaking to contract the reserve money to maintain the target has opposite effects on the rupee.
The central bank seems to believe that its intention in printing money (whether to monetize the debt or engage in LOLR operations to maintain a base money target) could affect the eventual outcomes.
"Reserve Money, which was at Rs. 939.8 billion at end 2017 and at Rs. 1,010.5 billion at end September 2018, was recorded at Rs. 1,020.8 billion on 2 November 2018," the central bank said in November 2018 amid concerns over money printing.
"This is a year-on-year growth in Reserve Money of 11.6 per cent, which is well within the CBSL projections for the year." But a central bank can only control one variable at a time, either the interest rates (through base money) or the exchange rate, and not both simultaneously if it wants to avoid balance of payments troubles.
"…[A] central bank really has only one instrument of policy, i.e. base money," Ross McLeod, a professor at Crawford School of Public Policy at Australia National University said at the Asian Liberty Forum in Colombo.
"Which says they can only control one nominal variable at once: the exchange rate or the price. Not both simultaneously."
Some economists also call it the impossible trinity of monetary policy objectives because central banks then impose exchange controls and/or trade controls to be able to keep printing money.
In 2018, the central bank slapped controls on car imports and other items brining the entire free trade strategy of the current administration into disrepute like other soft-peggers before them. Even the US Fed slapped so-called Nixon shock controls as its soft peg collapsed in 1971 following fancy monetary policy incompatible with its gold peg. (Colombo/Apr16/2019-SB)