ECONOMYNEXT – Sri Lanka’s has sold 76.4 million dollars to defend a soft-dollar peg, which shortly ater tens of billions of printed money on top of a period of prolonged excess liquidity from unsterilized dollar purchases.

The central bank 128 million US dollars from the interbank market in July to inject base money into the banking system, official data show.

The central bank effectively stopped mopping up injections on July 11 after selling down its Treasury bill stock from 118 to 107 billion rupees and allowed excess liquidity to build up in the next few weeks.

Banks deposited 19 billion rupees in excess liquidity at the central bank on July 12.

By August 06, banks were depositing 40 billion rupees of unsterilized cash in the central bank’s excess window.

But from August 08, the central bank started printing around 20 to 25 billion rupees a day through domestic operations, to drive up excess liquidity further.

On the following week a large 25 billion rupee liquidity withdrawal was made, by a disruptive sell-down of central bank held Treasury bills and lower amounts of money was printed.

The large volumes of money were apparently printed to suppress a call money rate.

Around the same time, money was also printed up to 10 months or more at rates below the overnight liquidity injection window rate.

Though the central bank buys dollars stop the rupee going up (a strong side convertibility undertaking), even if the rupee strengthens intra-day or mop up excess liquidity before breaking the peg and floating.

Dollar sales (weak side convertibility undertaking) are delayed until the rupee falls in a ‘disorderly adjustment’, in a float.

“There is no ‘disorderly adjustment’ when the rupee strengthens dollars are bought,’ explains, EN’s economic columnist Bellwether.

“Dollar are bought even when the rupee is floated and there is an intra-day strengthening.

“While excess liquidity is left unsterilized for long periods when the rupee is strong and dollars are bought, liquidity shorts are filled overnight when the rupee is weak under a ‘flexible exchange rate’.

“As a result money and exchange policies are weighted against the rupee in this ‘flexible exchange rate’. In this way it is possible to generate pressure on the rupee even when private credit is weak.”

The falling rupee then spooks, importers, foreign investors and also exporters generating monetary instability.

The rupee fell around 176 to 180 to the US dollar in the current period of instability.

Sri Lanka’s private credit has been weak or negative for most of 2019, which analysts have said will help recover from monetary instability quicker.

Foreign investors have also reduced sales of rupee bonds in the past two weeks. In the week to September 11, the stock of rupee bonds held by foreigner fell to 110.2 billion rupees from 110.8 billion rupees a week earlier.

On August 23, the central bank cut rates and printed money to enforce a call money rate, despite weakness is government revenues.

Further complicating monetary management are legacy swaps, which are forward exchange guarantees given by the central bank. Analysts have called for the practice to be banned as China did to strengthen its currency in the 1990s. (Colombo/Sept16/2019)