Sri Lanka’s central bank net buyer of forex in July

ECONOMYNEXT – Sri Lanka’s central bank has bought 204.56 million from commercial banks in July amid renewed foreign investor inflows into bond markets and the bank had sold only $53.90 million, official data show, with its Treasury bill stock being steady.

In June, the central bank also bought $178.7 million, but also sold $194.02 million.

When there are foreign inflows, at a given interest rate, the banking system can either give more credit with the money, which will generate imports, or the central bank can sterilize the rupees generated (mop them up) to curb credit and build up forex reserves.

The central bank’s Treasury bill stock, which indicates net mopping up or printing new money, was almost unchanged throughout the month, indicating that no new money was created to put pressure on the rupee.

However, it also means that monetary reserves had not gone up much either.

Analysts say the data goes to show that the central bank was right in raising policy rates.

Although the central bank is getting small payments from the International Monetary Fund, and is earning interest on existing reserves, it is also facing payments to the Fund on earlier loans.

Since the amount of foreign reserves the central bank is able to build permanently depends exactly on the amount of Treasury bills in its holding, it is able to sell-down the interest rate, and domestic credit determines both foreign reserves and the direction of the balance of payments.

If the country or the central bank is facing outflows on account of debt repayments, the domestic interest rate has to be high enough to cover both domestic credit and foreign repayments. The same applies if it has to build up forex reserves under an IMF program.

A build-up of foreign reserves is actually a so-called ‘below the line’ outflow in the balance of payments.





In addition to raising policy rates, the central bank has also not filled liquidity shortages coming from forex interventions (a result of excess domestic credit driving imports) permanently by purchasing Treasury bills outright over the last two months, in another tightening measure.

Banks are, therefore, under pressure to find real deposits to extend credit. If the central bank bought Treasury bills to permanently inject rupees, the BOP crisis would continue at almost any interest rate.

The central bank cannot create a sustained balance of payments crisis without purchasing Treasury bills outright steadily (to maintain a money supply target, interest rate or simply to fill liquidity shortages).

The central bank’s Treasury bill stock has been around Rs270 billion for almost two months, indicative of about $2 billion of excess demand injected to the economy, not counting earlier liquidity releases through terminated term repo deals.

Balance of payments crisis is a kind of monetary disease that hits central banks that have soft-pegged exchange rate regimes (managed floats), which also try to control interest rates by purchasing Treasury bills or giving large volume lenders of last resort money without raising rates.

By purchasing Treasury bills and rejecting bids at Treasuries auctions, the central bank "makes it possible for the public to convert Government securities into money to expand the money supply.." in the words of former Fed Governor Mariner Eccles, who saved Bretton Woods and the United States by refusing to buy Treasuries. (Colombo/Aug13/2016)

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