Sri Lanka private credit negative for second month in June 2020

ECONOMYNEXT – Sri Lanka’s private credit contracted 54 billion rupees in June 2020, extending a 69.6 billion rupee contraction seen in May while the central bank also withdrew liquidity, helping strengthen the currency, but credit to government continued to grow, official data shows.

Sri Lanka’s rupee started to collapse after the central bank printed 164.9 billion rupees in March (not counting reserve ratio cuts), driving private credit to 120 billion rupees, while credit to government rose an unprecedented 269.9 billion rupees.

Sri Lanka’s soft-peg with the US dollar now collapses rapidly due to a so-called ‘flexible’ exchange rate where money printing is not accompanied by dollar sales, when the excess liquidity from call money rate targeting hits the forex markets through the credit system.

The collapsing ‘flexible’ exchange rate then leads of panic among importers who will borrow to settle their import bills, instead of waiting the usual period.

Foreign investors in Treasury bonds also start to sell out which are then fully sterilized to target a call money rate or over-sterilized to generate excess liquidity.

Unstable Peg

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Analysts and economists have called for reform of Sri Lanka’s soft-peg set up under the then-philosophy of the Latin American Department of the New York Fed involving heavy intervention to sterilize the balance of payments.

Most of the soft-pegs from central bank set up by the Fed in Latin America and Asia (as well the central banks themselves in several cases) have collapsed repeatedly analysts say.

In Sri Lanka there is widespread classical economic illiteracy and strong beliefs in Mercantilist doctrine, analysts have said. There is almost no knowledge that currency collapses are driven by credit and liquidity injections that 19the century classical economists called ‘super abundance’ of paper money.

Instead of credit, especially central bank credit, imports are blamed for monetary instability in the form of currency and balance of payments troubles.

Imports or capital outflows driven by credit financed by real deposits cannot cause currency troubles since an equal amount of domestic consumption (or investment) is curbed through changes in short term interest rates.

Sri Lanka is now under severe import controls in a trade lockdown not seen since the 1970s when the collapse of the Bretton Woods system of soft-pegs triggered a closure of the Sri Lanka economy amid fuel subsidies, rationing and price controls.

The extent to which import controls, which hurts a large sector of the economy and how the contracting business activity of those firms and their bad loans works as a negative feedback loop in to the credit system is not clear. But firm with loans backed by stocks would repay as stocks are run down.

After printing 164.9 billion rupees in May another 92.5 billion rupees was printed in April, not counting reserve ratio cuts.

Private credit however started to collapse from May amid Coronavirus lockdowns which put the brakes on domestic consumption.

In June the central bank had withdrawn liquidity by 48.9 billion rupees. Most of the excess liquidity was mopped up by dollar sales to the Treasury to settle foreign loans. It is not known whether the petroleum bills were also settled through dollar sales when money was printed.

Government Credit

In March total credit surged to 426 billion rupees up from 79 billion rupees a month earlier which fell to 144 billion rupees in April and 113 billion rupees in May.

In June total credit was only 78.50 billion rupees. However import controls remain in place.

In May and June positive credit is driven totally by the budget deficit.

In the first six months of 2020 government financing of the budget from the banking system was 794 billion rupees, up from 151.4 billion rupees in 2019.

The deficit went up partly due to a so-called ‘stimulus’ involving a sudden reversal of tax policy in the earlier three years under an International Monetary Fund program by slashing value added tax.

The IMF program however did not contain limits on central bank credit, leading to a collapse of the currency in 2018 within the program. The central bank also practiced real effective exchange rate depreciating the currency wantonly in 2017, despite weak credit.

In 2020, the currency is now at 185 to the US dollars and the central bank has bought dollars amid a private credit contraction in what is suspected to the more de facto REER targeting to boost profits of exporters at the expense of economic stability and real wages of all workers.

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