ECONOMYNEXT – Sri Lanka’s forex markets are mired in tight trading restrictions and banks found it increasingly difficult to accommodate customer requests for letters of credit market participants said, as monetary printing and excess liquidity continue to pressure the rupee.
Sri Lanka’s rupee is now in a non-credible peg at 200 to the US dollar with over 100 billion rupees (about 500 million US dollars) in excess liquidity pressuring the peg via potential new credit.
Last week another 22 billion rupees (about 100 million US dollars) were printed to keep Treasury bill yields below 5.21 percent, which is functioning as a de facto ceiling policy rate.
With interbank forex trading coming to a virtual standstill banks are finding it difficult to cover letters of credit obligations in time, forcing them to ration LCs to customers who have access to printed money from the central bank to do business with.
“We cannot accommodate the requests for LCs so we have to ration them,” a banker said. “There is no regulation to say to ration them, but we are forced to do it.”
Bank NOPs were slashed in April as credit demand picked up and printed money hit forex markets.
Then a non-credible peg was imposed at around 200 to the US dollar, making it difficult for banks to cover their positions after providing dollars for customers to cover bills and LCs.
Problems with LCs began to emerge shortly after but has now intensified.
Several banks are now running short (negative) net open positions.
This week isolated forward transactions took at 200 to the US dollar as some banks tried to reduce their negative NOPs, market participants said.
Forward legs at discount in swap market
In the swap market one year forwards are quoted at discounts with domestic dollar yields overtaking the rupee rates kept down by money printing.
The year was quoted this week at 1700/2200 levels or a discount of around 17 rupees.
Banks are mandated to sell to importers around 200 to the US dollar.
However it is not clear whether a similar restriction applies to capital outflows with foreign investors in particular selling out of stocks in bid to protect their money.
Sri Lanka has been following excessively loose monetary policy associated with Sterling crises in the late 1960 and the collapse of the US dollar and the Bretton Woods soft-peg system in 1971, which worsened after 2015.
During the recent past a highly unstable and discretionary external anchor called a ‘flexible exchange rate’ which had zero credibility in the market was coupled with discretionary domestic anchor called the ‘flexible exchange rate’ with predictable consequences.
In 2020, unprecedented liquidity injections were made under so-called Modern Monetary Theory, with pegged exchange rate regime.
Though the peg is now enforced at 200 to the US dollar with multiple controls, there is no monetary policy to back it analysts say as long liquidity is injected.
A US money-doctor set up Sri Lanka’s soft-pegged central bank in 1950 in the style of several set up in Latin America abolishing a currency board that had kept the exchange rate and free trade since 1885.
A false promise was made that that the agency will be able to engage in discretionary credit policy (print money) and also supply foreign exchange in unlimited quantities as the currency board had done since 1885.
Economists and analysts have been calling for the central bank’s open market operations to be restrained, and if not for it to be abolished altogether so that resident of Sri Lanka can get on with their lives without monetary instability.
From 2015 large volumes of liquidity has been released into banks to keep call money rates at the middle or bottom of the policy corridor in a steep regression of policy.
— Steve Hanke (@steve_hanke) September 20, 2015
The China-backed Colombo Port City is to be protected from the soft-pegged central bank through multiple currency dollarization.
Sri Lanka’s Supreme Court has upheld the right of Port City residents to be protected from depreciation.