Under fire Sri Lanka central bank defends money printing

ECONOMYNEXT – Sri Lanka’s central bank defended its money printing, which led to forex shortages and fears of repaying foreign debt leading to a credit downgrade as monetary authority came under more scrutiny than in the past for triggering monetary instability and trade controls.

“Especially in unusual or exceptional circumstances we are facing like now, it is the prime responsibility of any central bank, not just the central bank of Sri Lanka any central bank around the world – to provide sufficient liquidity to the banking system,” Deputy Governor Nandalal Weerasinghe said in an online forum.

“And also for the public to have sufficient currency in their hands, especially in the lockdown period.”

Central Banking

However data show that injections not only covered a cash-drawdown and liquidity needs of the period but banks deposited up to 165 billion rupees in excess liquidity in the central bank’s excess cash window by May 05, which was about 15 percent of the pre-crisis monetary base.

Weerasinghe said in some advanced countries money supply has expanded by 10 to 15 percent of gross domestic product in advanced nations.

“This is all over the world, this is how central bank business are conducted,” he said.

Sri Lanka’s central bank however does not operate fully floating exchange rate nor is the rupee an ‘internationalized’ currency which is freely exportable with an international monetary base unlike the US dollar.

The money is believed to be printed to enforce rates cuts by targeting a call money rate in the middle of a policy corridor

The injections coupled with a ‘flexible exchange rate’ with a so-called DMC (disorderly market conditions) rule where interventions after printing money are delayed until forex market participants are in full panic mode.

Analysts say this tends to trigger monetary instability as soon as a small credit recovery takes place.

A similar strategy of cutting rates and injecting excess liquidity in a ‘monetary stimulus’ brought down the rupee from 153 to 162 from around April 2018 and triggered another slide in August 2018 which was worsened by a political crisis, analysts have showed.

The US Fed (collapse of the Bretton Woods gold peg) and the sterling pound (Sterling crises – collapse against the US dollar and gold) faced the similar problems when they operated soft-pegs and printed money.

Critics have blamed many of Sri Lanka’s economic problems, involving inflation, cost of living, strikes, currency collapses, forex shortages, (balance of payments problems) and resulting import controls and imports substation rent seeking, on creating the liquidity injecting unstable peg in 1951.

Sri Lanka replaced a system that Singapore and Hong Kong and almost similar to Dubai (moving short term rates) with a collapsing currency in 1951.

Out of all monetary authorities that were originally based on the Indian rupee at around 4.70 to the US dollar, the Sri Lanka’s central bank has been the worst performer falling to 186 so far while Maldives has been the best.

Pakistan has been second worst. Pakistan also has a ‘B-‘ rating like Sri Lanka and is a top customer of the International Monetary Fund, which was created to help Bretton woods soft-pegs which collapsed from money printing.

Liquidity Injections

The 2018 currency collapse led to a consumption and credit slowdown, which in turn led to weak revenues of companies and bad loans in banks.

Sri Lanka’s central bank has injected rupees in to the banking system in multiple ways since late February 2020.

A 24 billion rupee injection was made by a central bank profit transfer in the last week of February after an earlier rate cut.

A statutory reserve ratio cut released another tranche of over 50 billion rupees in to the banking system.

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On top of it the central bank bought large volumes of domestic assets taking its Treasury bill stock to 307 billion rupee from about 69 billion at the time when prudent monetary policy ended.

Reports had earlier indicated that the cash drawdown was about 140 billion rupees only. Such a cash drawdown which is called private sector sterilization by classical economists does not generally lead to a currency collapse.

Weerasinghe usually money is injected by Treasuries bought from the primary market (in auctions) as well as from the existing holders in the secondary market.

“This is what people in simple terms call money printing, but at the central bank we call providing liquidity,” Weerasinghe said.

“Imagine the situation we would have had to face. People would not have had enough cash and banks would not have sufficient liquidity.”

In the case of bonds bought from the secondary market the second market, the newly minted money will go to banks – who hold most of the traded bonds – or primary dealers and bond investors.

The new money will create demand and imports when loans are used by customers or bond holders who were repaid with newly created money purchase goods and services.

Open Trading

When bonds are bought in the primary market, the newly created central bank credit will go to the Treasury account at a state bank to directly finance the deficit and will be used to who will pay salaries of workers or suppliers or repay maturing bond holders boosting demand and imports.

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“Our economy was and is both small and open. Financing budget deficits through Central Bank credit creation appeared to us as an invitation to disaster,” Singapore’s first finance minister Goh Keng Swee said when explaining why the country did not create a Sri Lanka – style central bank.

“There was no effective way of exchange control in an open trading economy like ours to deal with the inevitable balance of payments troubles.”
When excess liquidity triggers excess demand through imports the currency would fall unless it is defended.

However Weerasinghe said minimum interventions had been made in the forex market.

“If we are printing excess liquidity in the market we are going to see it in pressure on the currency,” Weerasinghe said.

“Our interventions have been minimal.”

The central bank sold 174 million US dollars in March a month with strong credit, but the currency still fell as interventions were not consistent. In April 98 million US dollars were spent.

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The numbers do include any dollars given from reserves to the Treasury to repay foreign loans, which is also an intervention due to forex shortages.

Sri Lanka’s gross official reserves which also include forex holdings of the Treasury fell to 7,179 million dollars in March 2020 from 7,533 million US dollars in February 2020.

Low Inflationary Pressure

With curfews consumption had been brought to a halt, import controls have also been brought. This had also helped slowed credit and economic activity. The rupee has appreciated to about 186/187 by May 22.

“There is pressure on the currency to appreciate,” Weerasinghe said. “It is held by certain controls on imports as well.

“There is no pressure on inflation.”

A credit slowdown generally leads to a fall in demand which will help keep a lid on inflation. Most analysts are expecting private credit to be in the low single digits in 2020.

If the rupee is allowed to appreciate – Sri Lanka’s central bank generally does not allow the rupee to appreciate after depreciating – inflationary pressure is likely to be less, analysts say.

In 2019 inflation was also kept in check with an economic and demand slowdown after the 2018 bout of money printing.

However bad loans would continue to rise after the latest round of monetary instability, tax revenues would be weak and it would be also more difficult to access international markets after the latest bout of money printing and rating downgrade.

How import controls would hit big and small businesses which are already hurt by Coronavirus and would hit banks in turn is not yet known.

Standard and Poor’s which downgraded Sri Lanka to ‘B-‘ after Fitch said import controls would hit government revenues.

“With COVID-19 dampening domestic economic activity and lower excise duty earnings due to broad import restrictions, we now expect that government revenues will decline to below 10 percent of GDP in 2020,” the rating agency said. (Colombo/May24/2020)