ECONOMYNEXT – Sri Lanka wants to limit foreign borrowings to levels sufficient to meet repayments and raise more money domestically, Central Bank Governor Arjuna Mahendran said.
"So that I think is the broad strategy. We want to see that our foreign borrowings are kept down to the absolute minimum," Mahendran told reporters in Colombo.
"And that too to refinance any repayments of any foreign debt that are coming due, rather than contracting new debt and adding to that debt burden which escalates if the rupee weakens against the dollar."
Sri Lanka has an inherently unstable Bretton Woods style ‘soft-peg’ to the dollar which falls when the Central Bank prints money to manipulate keep rates down every time domestic credit picks up.
In addition to generally injecting short term money through its reverse repo window, the Central Bank also engages also monetizes debt as budget deficits go up, injecting term cash and cutting policy rates to hit the exchange rate.
In addition, when exchange rate pressure builds up, it engages in sterilized foreign exchange sales, setting of a deadly cycle of simultaneous dollars sales and liquidity injections that sends the rupee careening downwards 10 or 20 percent in a matter of weeks until a full-float is made.
Analysts have called for fundamental reforms of the central bank or its abolition in favour of a currency board to stop a one-way weakening of the currency.
"If borrow in yen or dollar or any other major currency, the issue is what is the impact of the rupee exchange rate going to be against these currencies in the future.
"So for instance if you borrow in dollars about 6 and 1/8 percent – which is what we did a few weeks ago – you have to add in the possibility that the rupee may depreciate. If you look at historically the rupee has depreciated about 5 to 7 percent annually.
"So effectively you are adding that to the interest payments you are paying on the foreign currency debt. So to that extend we want to minimize it – that sort of effective escalation in the interest rates you are paying inclusive of any exchange rate movement on foreign currency borrowings.
Mahendran said a decision was taken to ‘deepen and broaden’ rupee borrowings markets to move towards a fully auction-based system.
Treasuries are now being auctioned in large volumes and it had brought results.
"The volumes of money that has been raised on shore in the rupee markets have been significant. So much so that we go for 10 billion ticket sizes rather than one billion as was usually in the past.
"So that has been the broad strategy."
Classical style economic analysts have pointed out that when the currency falls, the real value of foreign debt remains the same, but what actually happens is the real value of rupee debt falls hurting pension fund beneficiaries and even bank deposit holders.
Nominal state tax revenues go up when prices rise after depreciation and real cost of state salaries also fall. There is a similar impact on private salaries, which can then lead to labour unrest.
In first four months of the year domestic borrowings had rocketed 74 percent to 339 billion rupees unusually exceeding the overall budget deficit of 271 billion rupees during the period, partly because a maturing bond was not rolled over in January.
But interest rates had not picked up in tandem as there was excess liquidity. The excess liquidity has now mostly run out, along with the accumulated foreign reserves that generated it and analysts say tell-tale signs of debt monetizing is beginning to be seen from June 2014.
Mahendran said the state will have to collect more taxes from the people to be able to manage its affairs.