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Wednesday May 12th, 2021
Economy

Sri Lanka rupee in non-credible peg at 199.95 to US dollar

ECONOMYNEXT – Sri Lanka’s banks are offering US dollars at 199.95 to the US dollar in a firmer de facto non-credible peg after being asked not to sell or buy the currency above 200 to the US dollar in multiple meetings with authorities over the last week.

Sri Lanka has been generally running a foreign reserve collecting, a severely unstable sterilizing peg called the ‘flexible exchange rate’ which also lacked credibility due to liquidity injections over the past few years which sent the rupee sliding from 131 to 200 since 2015.

Bank Treasurers are being summoned for meeting from last week in what is now a regular fixture and told not to sell dollars above 200 to importers or buy from exporters above 200 to the US dollar effectively setting the de facto non-credible peg at around 199.95 before commissions.

The meeting have now become regular.

Authorities also summoned bank chief executives last Friday. Assurances were given that inflows are coming.

However the central bank is printing money and there is also excess liquidity in money markets from Treasury bill purchases, which at any time can make outflows of foreign exchange exceed inflows, analysts say.

Banks are now offering dollar both to importers and for telegraphic transfers at 199.95 to the US dollar on their websites.

But with many banks running short positions overnight it is not easy to give dollars to customers as and when they want, analysts say.

In the interbank forex market small spot trades are taking place as big banks try to help out smaller ones in ‘pity deals’, market participants say.

Lost Credibility

Sri Lanka’s peg lost credibility in 1950 after a central bank with money printing powers to artificially manipulate interest rates was established, though the peg was set in theory at 2.88 grains of gold or around 4.70 to the US dollar by a Federal Reserve money doctor.

The US dollar at the time was at 35 to an ounce of gold.

Economist Razeen Sally called the American move a birth defect of the Sri Lanka

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Breaking currency board was early birth defect of independent Sri Lanka: Sally

How Sri Lanka, Latin America was busted by Fed money doctors creating strongmen, anti-Americanism: Bellwether

Fed money doctors set up a series of so-called Prebisch-Triffin central banks in Latin America and Asia which ended up in import substitution and sovereign default and almost permanent monetary and political instability, analysts have shown.

East Asian and South Asian countries including Maldives that got independence in the 1960s escaped the American instability. However Indochina, Korea and the Philippines which got independence around the end of World War II were hit with Latin American style banks, with US influence.

A fully credible peg (Hong Kong, Macau, Brunei) operates by allowing the reserve money to move in step with the balance of payments.

Highly credible pegs such as in GCC countries (currency-board-like systems) or stable fully forex reserve backed monetary regimes such as Singapore (modified currency board) also allow the balance of payments to influence short term rates, and do not print money.

Sri Lanka’s monetary instability, severe exchange controls, trade controls, import substitution and currency crises began after a credible peg or Currency Board was broken under US advice.

Credible Peg

John Exter, the Fed money doctor who prepared a report that helped break the credible peg into a non-credible one explained the then exiting Currency Board as follows.

“Whenever Ceylon is acquiring foreign exchange faster than it is utilizing (i.e when there is a surplus in the balance of payments) the banks purchase Ceylon Rupees from the Currency Board with their surplus exchange,” the Exter Report said.

“The Currency Board pays the banks by drawing notes from its un-issued stocks and it holds the foreign exchange either in Bombay or London.

“..[W]henever the country utilizes foreign exchange faster than it acquires it (i.e. when there is a deficit in the balance of payments) the banks meets the demand for exchange by purchasing it from the Currency Board with rupees,” John Exter, the Federal Reserve money doctor who helped Sri Lanka break peg wrote in his report.

“The Board retires the rupees from circulation and transfers the exchange to the purchasing bank by means of a draft or a telegraphic transfer,” he explained.

When foreign exchange is sold by the agency, liquidity goes down (unsterilized sale), rates go up and credit and imports balance (unsterilized purchase).

“The first process increases the currency in circulation by the amount of the surplus and the second process decreases it by the amount of the deficit,” Exter explained.

The new central bank will also sell forex exchange to maintain the exchange rate he said.

“It will be required, unless it takes the emergency step of suspending payments, to buy and sell foreign exchange in unlimited quantities on the initiative of the commercial bank – just as the Board of Commissioners must now freely issue and redeem Ceylon Rupees…” he said.

“Such a requirement is necessary in order to maintain the par value and free convertibility of the rupee”

Discretionary Policy

But the new central bank on the other hand in a radical departure had the power to buy and sell Treasury bills to add liquidity and carry out domestic credit operations while being expected to maintain the peg.

“The difference is that the Bank’s foreign exchange operations will be compulsory, whereas its domestic operations will be discretionary,” Exter said.

Exter’s “emergency step of suspending payments,” became the norm in Sri Lanka either through exchange controls, import controls or through outright chronic depreciation.

Exter claimed that the previous stable system had “serious disadvantages” to developing countries.

Ironically the claim was made shortly after UK itself – a developed country – suffered a currency collapse by trying to control interest rates and the exchange rate (resume convertibility) at the same time under conditions set by the US and Sri Lanka had trouble converting its foreign reserves to dollars.

Sri Lanka is now trying to enforce a non-credible peg at 199.95 to the US dollar while printing large volumes of money after enforcing a non-credible peg at different levels from 182 to 200 under the ‘flexible exchange rate’ arrangement, where the market participants panic.

The central bank has been providing ‘convertibility’ to the government in particular where printed money had been redeemed with reserves to repay loans falling due after severe instability of the non-credible peg leading to reserve losses.

In March when 75 million US dollars were bought by the central bank from current transactions, forex reserves dropped by around 500 million US dollars driven by financial account defence. (Colombo/May03/2021)

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