ECONOMYNEXT – Sri Lanka has recorded a balance of payments surplus in September 2022, official data show, after rates were hiked to reduce private credit, allowing money printing to be phased out and the agency also ran out of reserves options to borrow and engage in sterilized interventions.
Sri Lanka’s central bank started to lose the ability to collect reserves and run BOP surpluses from around August 2019 as liquidity injections to target the yield curve began.
From December 2019 taxes were cut and from around February 2022 large volumes of money was printed and Treasury bills issued to finance past and current deficits were bought to mis-target rates.
In the 9 months to September Sri Lanka recorded a BOP deficit of 2,927 million dollars, down from 3,035 million US dollars a month earlier, indicating a monthly surplus.
Though a BOP surplus implies a rise in central bank foreign reserves, repayment of reserve related liabilities can keep gross reserves unchanged.
A pegged (intermediate regime) central bank which runs inflationary policy either by injecting liquidity outright to keep rates down or by filling liquidity shortages after defending the peg (using reserves for imports and re-financing private sector activity) to mis-target rates will trigger forex shortages and a BOP deficit.
Sri Lanka’s central bank stopped mis-targeting rates around April 2022 and allowed market rates to go up, helping reduce domestic private credit, drive more money to the deficit and reduce money printing, which is causing forex shortages.
Sri Lanka also hiked taxes and raised utility charges to reduce public sector borrowings.
However the Reserve Bank of India gave deferred Asian Clearing Union dollars to Sri Lanka until June to continue to create BOP deficits by sterilizing interventions with borrowed money. (Sri Lanka owed US$1.9bn to Asian Clearing Union by June 2022)
However after India halted ACU deferements, the central bank lost the ability to run BOP deficits.
Related Sri Lanka’s BOP deficit creating ability wanes
A central bank which runs deflationary policy and reverses money printing will build up reserves and run a BOP surplus.
In September net central bank credit to government fell marginally. However reserve money has also fallen.
Sri Lanka Central Bank credit negative in Sept 2022
Sri Lanka key current inflows exceed imports for fourth month in Sept
Sri Lanka is now operating a peg around 360 – 370 to the US dollar, intervening in both directions with the 3-month rate around 30 percent.
At least 8-10 basis points of the rate may be due to flaw in a debt re-structuring framework where there is uncertainty whether domestic debt, which has already in a steep in an IFR hair-cut, will suffer a default and second re-structuring, according to some analysts.
Classical economists and analysts had earlier urged the central bank to float the currency after hiking rates as it bring backs confidence at a lower corrective interest rate than if a peg with lost credibility is continued. (Sri Lanka has to hike rates, tourism recovery will not help end forex crisis)
A float involves isolating reserve money from the balance of payments and halting all interventions (suspending convertibility) in forex markets whether to buy or sell dollars.
Sri Lanka’s float in March failed due to low rates which were driving credit and forced dollar sales (a surrender requirement or strong side convertibility undertaking) of dollars to the central bank which pushed the peg down further.
A float restores confidence in the exchange rate and encourages dollar holders to sell, exporters to convert early and importers to delay import payments to pre-crisis levels and bring down interest rates faster.
The central bank was a net buyer of foreign exchange from commercial banks in September and October as private credit contracted and imports reduced.
Under an International Monetary Fund program, a float is a prior action. The exchange rate is then re-pegged to collect reserves. IMF money is disbursed after the BOP is turned around and ‘reserves for imports’ are no longer required.
An IMF program will impose a net international reserve target where the central bank will run deflationary policy which is tighter than a currency board to re-build reserves and sell down its Treasury bill stock.
When reserves are collected under deflationary policy (dollar purchases are sterilized), it is possible to appreciate a currency peg as credit is weak and rates are higher than the required market rate.
However due to a belief in (basket, band, crawl policy) peddled by theoreticians living in more stable single-anchor regime nations, and lack of a doctrinal foundation in sound money in countries with intermediate regimes, currencies are not allowed to bounce back unlike a floating regime, tipping people who have partially crawled out of poverty back into the abyss and triggering social unrest, in one of the most merciless post-1931 Mercantilist strategies.
In a shocking revelation, a World Bank survey found that only 2 percent of policy makers it surveyed in South Asia knew that currency troubles were caused by central banks.
Forex shortages and BOP deficits (as defined) is a problem related to soft-pegs or intermediate regimes. They are absent in floating regimes and hard pegs without a policy rate where interventions are unsterilized. A central bank is the only agency which can create forex shortages and BOP deficits and also the only agency that can stop them.
Under an IMF program it is not possible to operate a clean floating exchange rate as there is a NIR target. As a result it is also not possible to run orthodox inflation targeting regime.
Under the IMF program, flexible inflation targeting where liquidity was injected for stimulus, mis-using the central bank’s its statutory obligation to maintain stability would be legalized in a new monetary law.