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Wednesday October 20th, 2021

Sri Lanka rupee non-credible peg at 203 to dollar drives dollar rationing, rates rise

ECONOMYNEXT – Sri Lanka’s non-credible peg with the US dollar at 203 is driving dollar rationing, market participants said, as an attempt to ration rupee production by the monetary authority is driving market rates up, but is yet to be fully successful.

Banks prioritized the supply of dollars to food imports in recent days especially items like milk where the Consumer Affairs Authority created a shortage with its price control gazettes.

Importers including LP Gas and some building materials are crying for dollars and banks are trying to help, market participants say.

Sri Lanka’s central bank has been printing large volumes of money, triggering credit and driving outflows above the total inflows to the country and shattering the credibility of a dollar peg. In August private credit on the rupee books of banks was 104 billion rupees.


Sri Lanka private, state credit surge in August, CB credit up 187-pct

There had been the off-market settlement of dollars at rates up to 230 to the US dollar, but the activity reduced following a central bank order which led to more intensive dollar rationing.

However some off-market settlements are taking place among friendly parties, at around 215 to 220 to the US dollar, trading sources say with the central bank not providing full convertibility for the rupees it is creating, despite wanting to maintain the parity at 203 to the US dollar.

A surrender rule further undermines the peg which is weakened by liquidity with negative convertibility creating more liquidity, analysts say. However many third world central banks with unstable currencies including that of Zimbabwe has done it, analysts say.

Partial Convertibility

A central bank cannot maintain a peg without providing convertibility to the currency it creates. However, some convertibility had been provided, to importers of food over the past week following an order by Prime Minister Mahinda Rajapaksa.

Sri Lanka has had external problems ever since a Latin America style central bank was set up in 1950, abolishing a credible peg that had kept the country stable through two World Wars and a Great Depression.

Sri Lanka (then Ceylon) had some trouble with depreciation (against the gold Sterling) only when the silver price started to fall from the ‘panic of 1893’ but the peg still held, analysts say.

When the credibility of the peg is undermined by artificially low-interest rates, steep spikes are required to restore confidence in the soft-pegged currency. The ‘better’ the economy is doing (stronger private credit) the more difficult it is to restore credibility.

Central banks that operate credible pegs are able to provide stability to those who use the currency which eventually results in low inflation (capital preservation) and low-interest rates.

Sri Lanka current troubles and loss of credibility of the rupee came from extreme stimulus and suppression of rates throughout the yield curve through price controls, despite the widening of the budget deficit through tax cuts and unemployed graduate hires in the midst of a pandemic.

As long as money is printed to buy bonds from failed auctions, problems with the rupee will persist, analysts have warned.

“A partially failed bond auction is as good as a fully failed bond auction because both result in liquidity injections which undermine the peg,” EN’s economics columnist Bellwether says.

“Failed auctions will also lead to a sterilization trap where the central bank is forced to mop up through repo auctions that it creates through failed auctions.

“However a float (full suspension of convertibility) also will not work if bond auctions fail or the Treasury borrows from state bank overdrafts which are re-financed with window money.”

On Tuesday bond yields spiked as the government tried to roll-over maturing bonds and meet a coupon payment in an auction of 100 billion rupees.

A 2023 bond that was auctioned at an average yield of 9.36 percent is estimated to have a cutoff of 9.80 percent. The bond was quoted at 9.50/10.00 levels on Wednesday.

A 2017 bond that had an auction average of 11.14 percent and a 2030 bond which hand an auction average of 11.23 percent are estimated to have cutoffs of around 11.90 percent.

An 86 billion rupee Treasury bill auction is due on Wednesday. Market rates are catching up to the budget deficit but deposit rates also have to rise.

To make investors comfortable with holding bonds, rates have to rise to levels that allow any policy rate hikes to catch up.

But partially failed bond auctions that inject liquidity may lead to excessive rises in rates even as monetary instability continues, analysts say.

A monetary policy decision is due to be made public on October 14.


Sri Lanka bond auction yields rise around 100bp across maturities

Sri Lanka’s bond auctions have failed ever since domestic economic activity improved and the country’s note issue bank started over-issuing notes to keep rates down.

Failed domestic bond auctions whose price is artificially propped up by central bank purchases (effectively an inability of the government itself to service domestic debt) leads to an inability of the government to service external debt.

In Latin American countries like Argentina where government budgets are much better, external default comes from the loss of credibility coming from the failure to roll-over sterilization securities at auctions.

Aggregate Demand Bubble

The US Fed is printing money despite a post-Covid recovery creating all kinds of distortions across the globe including a commodity bubble.

Sri Lanka’s policymakers last year pointed to Jerome Powell’s money printing to justify domestic policy errors.

The International Monetary Fund says the post-Covid recovery was unusual and has features not seen in the past.

“There are labour shortages and unemployment at the same time,” IMF’s Chief economist Gita Gopinath said in October 2021 releasing the agency’s World Economic Outlook report.

Related Sri Lanka 2021 GDP growth downgraded to 3.6-pct by IMF, global growth lowered

Critics say economic disruptions are one outcome of firing indiscriminate aggregate demand bubbles also known as the Keynesian stimulus or John Law policies.

Nobelist Friederick Hayek had explained how it happens.

“Just as there cannot be a uniform price for all kinds of labour, an equality of demand and supply for labour, in general, cannot be secured by managing aggregate demand,” he wrote.

“The volume of employment depends on the correspondence of demand and supply in each sector of the economy, therefore on the wage structure and demand between the sector.”

Eventually, as inflation stops accelerating higher unemployment than earlier is the result. (Colombo/Oct14/2021)

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