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Friday July 1st, 2022

Sri Lanka rupee dollar swap discounts jump amid forex crisis

RATE IMBALANCE: Steeply rising domestic assets of a pegged central make downgrades likely.

ECONOMYNEXT – Sri Lanka’s rupee-dollar foreign exchange swaps, which are going at discounts despite forex shortages deepened sharply in this week after a credit downgrade from Fitch further tightened dollar liquidity in bank funding books, market participants said.

The spot/1-month swap was quoted around negative 550/400 cents up sharply from -170/-150 in the second week of December.

Swaps and forward dollars started to trade at discounts instead of a premium as is usual for a weak currency due to artificially low interest rates enforced by money printing.

Under Keynesian dogma taught in some Anglo-American universities particularly after the 1933 float of the Sterling pound, currency weakness is blamed on fixed exchange rates, but currency pegs collapse due to fixed interest rates enforced by liquidity injections.

Dollar interest rates overtook rupee yields in 2020 as sovereign bond yields went up and accelerated after a credit downgrades in late in the year, as cross-border banks reduced risk limits to their Sri Lanka counterparties.

After the latest Fitch downgrade to CC limits were cut further and banks found it even more difficult to renew their funding lines, market participants said.

The central bank had earlier put caps on domestic dollar deposit rates instead of allowing rupee rates to rise as dollars were sold in the market and liquidity tightened. In another cascading soft-pegging policy error dollar deposits of residents earning salaries were also banned analysts have said.

At the moment interventions are sterilized with printed money at 6.0 percent injecting non-deposit rupee reserves into the banking system to spur credit and create more forex shortages.

Spot/1 month business was done around minus 530 cents this week showing that the 1-month forward rate implied in the transaction is 194.70 rupees to the US dollar and the receiver is generating dollars above 30 percent, depending on the funding cost.

Spot/3 month swaps were quoted at -1450/-1300 cent and business was done at 1,400, indicating the 3 month rupee/dollar forward is at 186 rupees, despite continued foreign reserve losses.

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Two weeks ago spot/3 months was quoted -500/-400.

There were no firm quotes for 6 or 12 month swaps, after the sovereign downgrade by Fitch to ‘CC’.

Moody’s had in October downgraded Sri Lanka to Caa2. But Fitch had earlier confirmed the ‘CCC’ rating, despite continued money printing pushing up domestic assets of the central bank which automatically triggers more reserve losses as convertibility is provided for the new rupees.

“Rating agencies do no really understand soft-pegs, money printing and liquidity injections, after all their staff also went to the same universities like Harvard, Yale, Cambridge or Oxford that peddle money printing and stimulus and Western financial media lionize them,’ EN’s economic columnist Bellwether explained earlier this year. (Sri Lanka’s monetary meltdown will accelerate unless quick action is taken: Bellwether)

“But they do understand the opposite side of a central bank’s balance sheet – foreign reserves – which fall when liquidity is redeemed against dollars.”

Sri Lanka’s dollar borrowings started to go up sharply after call money rate targeting de-stabilized the monetary regime.

From 2015 to 2021, Sri Lanka was able to pay back dollar debt with current account flows only in two years, 2017 and 2019.

In all other years, liquidity injections under a highly discretionary ‘flexible’ inflation targeting and ‘flexible’ exchange rates created forex shortage making it impossible to repay foreign debt with current inflows (sterilized inflow).

Instead the central bank sterilized outflows buying securities into its balance sheet and borrowing abroad.

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As a result the net accumulation of foreign debt was greater than the foreign financed budget deficit in all years with inflationary central bank policy.

A the moment outflows are sterilized. A float is required to end sterilized interventions. Consistent or hard pegs (currency boards) interventions are unsterilized.

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Sri Lanka overnight injections top Rs400bn amid sterilized interventions

In countries which maintain stable exchange rate, a wide policy corridor reduces sterilized forex sales and allows overnight rates to go up quickly and slow credit, before the credibility of the peg is completely lost. (Colombo/Dec23/2021)

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