ECONOMYNEXT – Sri Lanka’s forex reserves grew by 1.58 billion US dollars to 7,621.9 million US dollars by end March 2019 from 6,035.16 million US dollars, helped by sovereign bond sales and actual mopping up of inflows amid weak credit and better monetary policy.
Gross official reserves are made up of central bank’s monetary reserves and fiscal reserves of the Treasury which are borrowed outright.
The central bank also borrows reserves outright from the International Monetary Fund.
It also technically borrows reserves from private or state entities giving explicit forward convertibility undertakings (dollar rupee swaps), which is the most dangerous form of reserve building.
Unwinding of those swaps later will shrink reserve money and when money is printed to stop rates rising, balance of payments trouble develops.
The central bank can also built reserves by permanently mopping up rupees generated from dollar purchases from the interbank market of when credit is weak.
If reserves are mopped up by outright sales of sterilization securities (Treasury bills taken into its balance sheet to generate monetary instability in the country in the past) it will permanently ‘purchase’ the reserves or its own securities) and the dollars remain locked in its balance sheet.
In the past the central bank sold its own securities when it ran out of Treasury bills to lock up reserves.
A few years ago the central bank stopped selling its own securities, which analysts have identified as one reason for frequent balance of payments crises and monetary instability.
The central bank instead temporarily mopped up reserves by entering into term repo deals, which mature in a few days or weeks releasing the liquidity back to banks who then loans them to generate imports.
Liquidity shocks from term repo terminations were the key driver of the 2012 and 2015 balance of payments crises and also the run on the rupee from April 2018, when term repos which were started in that year itself were released as credit picked up in March.
In December 2019, when the economy was starting to recover analysts warned that it should resume selling to stop another balance of payments crisis from developing because the economy and the credit system was starting to recover from the previous crisis. (Sri Lanka’s Central Bank should sell own securities in new credit cycle: Bellwether)
Instead from February it stopped mopping up all reserves and in March terminated term repos and in April cut rates and recklessly injected money in a way that left observers non-plussed. In January 2019 private credit turned negative for the first time in four years ending a run on the rupee and placing Sri Lanka’s dollar peg on the strong side of its convertibility undertaking.
In 2019, the central bank has bought dollars on a net basis in February and March deploying a strong side convertibility undertaking of its unstable soft-peg. It kept overnight money markets short.
Its permanent Treasury bill stock, excluding those involved in reserve repo injections which rose to 179 billion rupees in January – partly due to reserves sold to the Treasury to settle foreign loans – has been brought down to 163 billion rupees by April 12.
A central bank that deploys convertibility undertakings (buys or sells dollars for whatever reason in forex markets) make the balance of payments drive the monetary base (reserve money).
If that central bank then resists the natural growth of reserve money by mopping up dollar purchases, it will slow economic activity a little but will build up reserves and keep the currency peg strong. In the process it will keep short term rates slightly above the free market or currency board rate.
If it expands reserve money over what is determined by the balance of payments through open market operations (terminating term repos, engaging in reverse repo deals or buying Treasury bills outright) the central bank will generate a balance of payments crisis and weaken the peg.
Though rates will initially fall, the monetary instability it triggers will generate capital flight and higher interest rates later.
Currency depreciation will also keep nominal interest rates permanently higher than countries with consistent and stable monetary regimes (free floating or currency boards or even tighter-than-currency board like China from 1993 to 2005).
In 2019 monetary policy has been prudent, other than an anomaly where term money is injected at lower rates than the ceiling policy rate.(Colombo/Apri14/2019)