Sri Lanka to police exporters, tighten capital account to maintain soft-peg
ECONOMYNEXT – Sri Lanka said will police exporters through a hi tech surveillance system and will also tighten a capital account relaxation after triggering balance of payments trouble by operating a soft-pegged exchange rate regime with multiple convertibility undertakings.
The central bank said it intends set up a ‘International Transactions Reporting System’ (ITRS) to monitor cross border and internal transfers of foreign currency.
"The monitoring function will be strengthened further by developing a new real time foreign exchange reporting and monitoring system to capture data on foreign exchange sales and purchases," a policy roadmap for 2019.
Sri Lanka’s central bank has generates frequent balance of payments troubles mainly by applying the main tool of inflation targeting central banks with free floating rates (cutting interest rates when inflation falls) to a archetypical peg with multiple convertibility undertakings.
In October, Central Bank Governor Indrajit Coomaraswamy said he wants to partner with the Customs Department to monitor exporters to ensure that they are bringing back the dollars earned from exports.
Around August and September, the central bank de-stabilized a soft-peg with unsterilized excess liquidity partly generated from money printed through dollar/rupee swaps with the Treasury to manipulate interest rates.
In March and April pressure on the currency was triggered with excess liquidity generated from money printed to acquire domestic assets.
The central bank cut rates in April, despite US interest rates rising, and printed tens of billions of rupees to enforce the rate cut, de-stabilizing the credit system and putting foreign rupee bond holders to flight.
Data shows that in February and March the central bank stopped mopping up inflows, and then released previously mopped up liquidity in pro-cyclical move and went to print money in April until 44 billion rupees of excess liquidity was built up in money markets.
When the credibility of the peg is lost, exporters also hold back dollars, borrowing rupees to fund their operations.
A quarterly central bank survey showed credit to industries growing 17.8 percent from a year earlier in September, which was the highest compared to other sectors, despite a slowing down of credit to the construction industry.
Petroleum and rubber/plastic production, which are key industrial exports, drew in higher credit than the previous year.
Petroleum importing firms may also be forced to delay settlement adding a further complication.
Non-Credible Peg with Multiple Convertibility Undertakings
Sri Lanka’s soft-peg, which is called a ‘flexible exchange rate’ is fraught with multiple de facto and legally enforceable convertibility undertakings.
Legacy convertibility undertakings in the forward markets may also have helped further de-stabilize the credit system, generating a requirement to sterilize it.
In the September a large legacy forward convertibility undertaking matured, while the peg was already under pressure.
It is not clear whether a similar deal in April also played a part in de-stabilizing the peg in the first run on the rupee in 2018.
A forward convertibility undertaking given to a bank involving a foreign loan repayment has the same effect on the credit system as a bond sale.
However it has an added de-stabilizing effect that there is no upward pressure on even long term rates as the deal is fully accommodated by the monetary authority with printed money to maintain the policy rate.
Governor Coomaraswamy has now announced that the central bank will reverse a relaxation of the capital account where foreign investors were allowed to buy up to 10 percent of bonds outstanding and slash it to 5 percent.
Foreign investors in rupee bonds have also been blamed for generating pressure on the soft-peg this year along with ‘twin-deficits’, while the rupee fell against the currency of one of the biggest twin deficit countries of the world – the US.
Sri Lanka also operates additional convertibility undertaking in terms of targeting a real effective exchange rate index and a preventing a ‘disorderly adjustment’ of the exchange rate.
Preventing a ‘disorderly adjustment’ of exchange rate may involve accommodating bond holders who have been put to flight by the loss of credibility of the peg.
The central bank also undermined a key plank of the current administration’s economic strategy to maintain the soft-peg by slapping trade restrictions, on gold, cars and three wheelers.
The central bank and analysts have previously blamed fiscal dominance of monetary policy for balance of payments troubles and high inflation, but publicly admitted that money was printed this year for ‘monetary policy’ purposes.
Analysts say the central bank is generating pressure on the rupee primarily by applying the main tool of inflation-targeting free floating central bank (cutting rates when inflation falls) to a soft-peg with multiple convertibility undertakings called a ‘flexible exchange rate’.
Analysts had warned that the central bank will generated balance of payment trouble in 2018 as the economy and credit recovered, by printing money to cut rates as it did in 2011 and 2015. (Sri Lanka is recovering, Central Bank threat looms)
In August the first run triggered by March/April policy errors ended with the rupee falling from 153 to the US dollar to around 161 to the US dollar.
Analysts have warned that printing money is likely to push the country to dollar default, printing money with a peg leads to forex shortages. (Sri Lanka’s Weimar Republic factor is inviting dollar sovereign default: Bellwether)
There have been calls to reform the central bank’s domestic operations so that it could no longer de-stabilize the credit system, or abolish it altogether in favour of a East Asian style currency board. In a soft-peg, which was the lynchpin of the failed Mercantilist Bretton Woods system, a central bank targets fixed interest rates, printing after intervening and pushing the peg further in to its ‘weak side’, going against the principles of classical economics.
The central bank is now planning to move on to a modified inflation targeting framework called flexible inflation targeting. (Colombo/Jan08/2018 – Update II)