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Saturday November 27th, 2021

Sri Lanka’s central bank takes in Rs90bn in Treasury bills for forex financing

ECONOMYNEXT – Sri Lanka’s central bank said it had received 90 billion rupees of Treasury bills (about 500 million US dollars) after filling a foreign currency financing gap of the government.

The central bank’s Treasury bill stock went up from 68 billion rupees on December 10 to 100 billion rupees on January 11 and 160 billion on January 14, the day a billion dollar sovereign bond was repaid.

The central bank said it bought the bills due to a delay in getting foreign currency to meet Treasury’s cashflow for January 2019.

"The Monetary Board has acceded to the Treasury’s request in the national interest and under exceptional circumstances," the central bank said.

"Having reviewed the macroeconomic consequences of subscribing to T-bills by the CBSL, the Government has agreed to reverse part of the transaction in February and the balance during the first quarter of 2019 once the Government’s borrowing programme is brought back on track with realisation of expected financial arrangements."

Reserve Pass through

Analysts have pointed out that as long as forex reserves are appropriated by the Treasury through back-to-back paper transactions without disturbing reserve money (and any money is injected and taken back from the same bank) it will be equal to a transaction that has no ‘reserve pass through’, though foreign reserves will go down.

Transactions with the International Monetary Fund also have no reserve pass through, though forex reserves change and are monetary policy neutral.

However any Treasury bills bought by the central bank to finance domestic expenses of the Treasury will pressure the currency and may also push inflation up.

Sri Lanka’s credit system now has large liquidity shortages due to peg defence. Any money printed for the Treasury’s domestic expenses will reduce the liquidity shortfall.

If the central bank has been steadily selling down its Treasury bill stock to mop up inflows, keeping the peg on the strong side of a convertibility undertaking and its credibility intact, any T-bills taken in to its portfolio in return for forex reserve sales could also be easily sold down subsequently.

Unwinding central bank held T-bills will further contract domestic credit and generate excess dollars helping replenish the lost forex reserves.

However if the credibility of the peg had been lost, and the central bank is printing money after defending a peg through open market operations it is not possible to immediately sell down the Treasuries to banks, to contract credit and replenish reserves.

Credibility of a peg is usually lost due to a build-up of excess liquidity whether due to fiscal dominance of monetary policy or due to a monetary policy error due to chasing an interest rate target.

Once credibility has been lost, a soft-pegged central bank will defend the peg and print money through open market operations (sterilizing forex sales), to defend an interest rate target, creating a vicious cycle of reserve losses and more injections.

Ricardo’s Evil

Defending the weak-side convertibility undertaking of a peg with dollar sales and injecting rupees to prevent rates going down, (sterilizing forex sales) though open market operations, usually involves injecting additional reserves to multiple banks to make up for a liquidity shortfall, pressures a currency peg, according to classical economists (David Ricardo’s evil and Adam Smith’s Penelope’s web).

Sri Lanka’s central bank is now trying to boost reserves by borrowing through central bank swap lines (which are also structured to be monetary policy neutral).

The government is also borrowing separately.

The central bank turned the peg to its weak side after around March 2018, after it halted mopping up inflows, as credit demand recovered.

In April excess liquidity was built up by printing money (acquiring Treasuries) and in August the excess liquidity came from unsterilized dollar purchases and rupee/dollar swap with the Treasury.

To break the cycle, the currency has to be floated or rates hiked or both. (Colombo/Jan16/2018)

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