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Sri Lanka’s problem linked to insolvency, not liquidity: Harsha

THE SLIDE: Sri Lanka current BOP slide began with a policy reversal around August 2019.

ECONOMYNEXT – Sri Lanka’s external problem is linked to medium and long term solvency requiring debt restructuring and is not a short term liquidity problem that can be solved by swaps, Harsha de Silva, an opposition legislator said.

Sri Lanka’s 2022 sovereign bond, which was issued at 5.75 percent was now trading at 46 percent, and Sri Lanka could no longer to go international markets to borrow, he said.

“That is the confidence the international markets have in us,” he said. “Then how can we go and take a loan from the international market to fulfill our requirements?”

Despite import controls, Sri Lanka’s imports were continuing, with some imports higher than last year, he said.

Long Term

Foreign reserves were falling. The solution put forward was to get central bank swaps.

“So there is a problem, but the government has analysed this problem as a problem in liquidity,” de Silva said.

“They said that they will solve this problem through a swap of 1.5 b dollars from and another one billion dollar swap from India and another loan of 700 million from China,” he said.

But the problem was not a short term liquidity problem that that could be solved by swaps, he said.

“I see this not as a liquidity problem but as an insolvency problem, whether we can fulfill the medium and long term financial responsibilities of the country,” he said.

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There was a gap between reality and the picture painted by government spokesmen, he said.

If solutions are delayed, the blow on the people would be harder, he warned.

“We should restructure our debts, if the government do that then they will be able to find a medium-term solution to this problem,” he said.

Sri Lanka’s gross official reserves were down to 4,557 million US dollars by 2021 was barely enough for about three months of imports at around 1,500 US dollar a month, he said.

“This is a very dangerous situation, generally in economics, we measure the reserves to how many import months is it enough,” de Silva told reporters in Colombo.

Describing reserves in terms of foreign reserves is a yardstick used by some analysts to measure ‘reserve adequacy’.

Before Keynesian interventionism involving ‘flexible’ policy led to frequent currency collapses, the reserve backing of a currency issue – like the gold standard – was a tool to maintain monetary stability and served as a check against central bank excesses.

Pegged central banks do not use foreign reserves to pay for imports for months on end in practice, unless money is steadily printed (liquidity injections made) and there is an ongoing currency crisis where forex sales are sterilized with new liquidity injections.

Peg

In a consistent pegged regime, the monetary authority supplies an unlimited amount of foreign exchange to maintain a fixed exchange rate, triggering contraction in reserve money (reduction in bank rupee reserves) and a spike in short term rates, forcing bank credit to be sequenced and rationed at the margin.

Rupee reserves in banks may be used for import generating credit, credit to buy dollars to repay foreign debt, or to buy assets from fleeing foreign investors, any of which will crowd out other credit, as long as no new liquidity injections are made.

Imports and other forex outflows are therefore matched and sequenced to inflows in a consistent peg with no additional injections.

In practice, in a working pegged system with high credibility, forex losses to trigger a reserve money contraction and tighten liquidity may be measured in weeks (or days) rather than months, analysts say.

A forex sale by the monetary authority to maintain a peg will ration credit below the available new deposits and loan repayment inflows in banks. A forex purchase which injects new liquidity will enable credit over and above deposits and loans repayments in to the banking system, matching outflows of forex to inflows through the credit system.

Therefore there is no depreciation and the peg (external anchor) is kept.

Floating

In a true floating regime the central bank does not supply a single dollar to the forex market.

Therefore the monetary base and interest rates are unchanged by foreign exchange flows and credit is automatically rationed to the available deposits and loan repayments in the banking system.

A floating regime matches outflows to the inflows by not altering the monetary base for all intents and purposes, because liquidity is trapped within the domestic credit system even if there is an increase in cash use, unless currency is physically exported.

As part of measures during the East Asian crisis – mis-reported in international financial media as ‘exchange controls’ – Bank Negara Malaysia slapped limits on the export of ringgit notes.

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However the exchange rate may change in the short term (float) due to timing differences in inflows, credit and outflows. The day to day differences are smoothed out by bank net open positions and buyers and sellers who may delay transactions for few days for a better rate. Such currencies do not depreciate and tend to be strong.

The strength of the exchange rate (and real changes in reserve money) is based on the inflation target (domestic anchor) and how successfully the target is reached.

Most floating exchange rates with a low inflation target (below 2 percent) are strong and are usually referred to by Mercantilists as ‘hard currencies’ analysts say.

Since a floating regime matches outflows of dollars to inflows by not changing reserve money and a pegged exchange regime matches inflows to outflows by changing the reserve money in-step on a daily basis, the systems operate in diametrically opposite ways.

Countries get into trouble when intermediate regimes which are neither true (hard) pegs nor true floats are operated.

They may also flip regimes back and forth suddenly and rapidly (flexible exchange rate) dooming them to regime conflict, triggering monetary instability involving currency crises, low growth and eventually default, analysts say.

Many East Asian pegs have kept rates slightly above the required rate to match forex reserves to domestic money supply, rationed credit in excess and built up large forex reserves exceeding the domestic money supply by selling central bank securities to the banking system and exporting savings below-the-line to an extent more than a neutral hard peg (currency board) would have done.

Latin American nations and Sri Lanka sometimes over-rations credit selling central bank (or CB held) securities to banks, keeping rates above what is required to keep the peg, building forex reserves, and then buys back securities keeping rates lower than required, injects liquidity and loses reserves triggering collapses.

Beginning of the end

Sri Lanka’s current monetary instability began on or around August 2019, when prudent policy ended and output-targeting-with-a-peg began, analysts who closely follow the country’s monetary policy errors and currency crises say.

Sri Lanka was withdrawing excess liquidity from the banking system until July 17, and selling down the central bank’s securities holdings to the banking system, keeping rates slightly higher than required for a neutral peg.

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However by August 07 policy reversed.

At the time the central bank was given full independence by political authority to target an output gap, despite its monetary law having a mandate only for ‘economic and price stability’.

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Monetary instability and capital flight then followed.

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In August 2019 when monetary policy reversed and money printing to target an output gap started, Sri Lanka’s gross official reserves made up of the central bank’s monetary reserves linked to reserve money and finance ministry dollar balances were 8.5 billion US dollars.

Up to July 2019, the central bank had collected 354 million US dollars from forex markets and steadily mopped up liquidity. Te central bank was buying dollars on a net basis every month.

After policy reversed only 32 million US dollars were collected on a net basis for the rest of the 2019.

In 2020 unprecedented money printing started under so-called Modern Monetary Theory after tax cuts in December 2019 further eroded state revenues putting more pressure on the domestic credit system and triggering downgrades.

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Sri Lanka posts record US$2.32bn BOP deficit in 2020 with MMT

In 2020 Sri Lanka ran a balance of payments deficit of 2.3 billion US dollars. (Colombo/Mar09/2021)

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