ECONOMYNEXT – Sri Lanka printed enough money after a failed bond auction last week to potentially wipe out foreign exchange reserves equivalent to a central bank swap being negotiated with Bangladesh, according to official data.
Shares of central bank treasury bills reached Rs.1194 billion on August 2, the bond settlement day, which was up Rs 53.9 billion from Rs.1141 billion a day earlier.
Last week, the central bank offered 125 billion rupees of bonds in a price-controlled bond auction and only 86 billion rupees of offers were accepted in the market, leaving around 40 billion rupees. unsold rupees without counting the expired coupons.
After the obligations were settled, excess liquidity in the banking system rose to 53.6 billion rupees from 8.7 billion rupees the previous day.
When the central bank eventually redeems the rupees, through a sale of unsterilized dollars, about $ 250 million in reserves, or the amount expected from an exchange with the Bangladesh Bank, will be lost.
From early 2020 to July 2021, around US $ 4 billion in reserves had been lost due to cash injections through various means.
In the 18 months to July 2020, the central bank’s credit to the government had increased by 692 billion rupees, with additional liquidity injected through two reductions in the reserve ratio one of which was 115 billion rupees, a transfer benefits and a credit program refinanced by the central bank.
Sri Lanka cuts reserve ratio by 2.0%, injects 115 billion rupees into banks
However, banknotes in circulation had increased by Rs.261 billion as the public held more cash during a coronavirus pandemic.
Classical economists refer to a sudden demand for liquidity as “internal leakage,” which does not lead to losses in foreign exchange reserves, although the demand for foreign currency may also increase due to rising prices for goods and services.
However, the rest of the injected liquidity had flowed in an “external leak” triggering a balance of payments deficit of US $ 2.3 billion in 2020 and a deficit of $ 1 billion until May, before that a billion dollar sovereign bond and certain other accounts are not paid. in July.
Unless it is mopped up by the sale of securities held by the central bank (sterilized), liquidity flows in the form of sales of unsterilized foreign exchange reserves, as the exchange rate is under the pressure of new liquidity .
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Most of the cash injected in 2020 and 2021 had been used to defend the yields of gilts that function as de facto key rates beyond overnight.
Analysts had warned that the country’s obsession with low interest rates would lead to external problems and higher interest rates in the long run due to monetary instability and a depreciated currency that destroys capital.
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Sri Lanka has placed import controls in a mercantilist gut reaction, but credit has poured into sectors that are not prohibited and the trade deficit until May 2021 was higher than the level before the pandemic in 2019 .
Sri Lanka placed the most draconian import and foreign exchange controls by purchasing large volumes of treasury bills on the central bank’s balance sheet during the 1970s, despite the failure of treasury bill auctions.
“The Treasury has had to finance its spending more and more by resorting to Treasury bills despite the fact that no major tender has been issued to absorb successive issues of Treasury bills,” wrote a classic economist unknown in 1975 when the economy at large was mired in price controls and forex. shortages and exchange controls.
âThe responsibility for absorbing the unsubscribed portion of the Treasury bill issuance rested with the central bank.
âA major disadvantage of financing budget deficits with central bank credit is that while the process involves an expansion of the money supply, it is not necessarily accompanied by an expansion by a corresponding increase in the national product.
âTherefore, the increased demand for central bank financing of budget deficits had to be met by increased reliance on foreign supplies, which put pressure on the country’s external payments.
“Thus, although the government’s budget problem and the balance of payments deficits were two separate problems, they were nonetheless intertwined, in that the balance of payments deficits and the loss of foreign assets resulted in part the method by which the government sought to finance its deficits.
“With the continued loss of reserves and the accumulation of external liabilities, the ability of the Central Bank to maintain the international value of the rupee has been gradually compromised.”
Bonds that were redeemed with printed money (an expansion of reserve currency exchangeable for dollars) were not tied to the current year’s budget, but are maturing debts related to past deficits that , as government securities, were not readily exchangeable for dollars.
By monetizing historic deficits, a central bank can trigger a currency crisis, even if the budget was in surplus. However, Sri Lanka’s budget is now in disarray after tax cuts in December 2019.
Monetization of historical deficits
Sri Lanka had a âbanknotes-onlyâ policy established by former Central Bank Governor AS Jayewardene, who studied at the London School of Economics, until the last so-called Yahapalanaya administration, where monetary policy took hold. is seriously deteriorated.
The banknote-only policy was bluntly abandoned by the “Yahapalana” administration and politicians who stood by as the money was printed to target a production gap and destroy the exchange rate, giving “l ‘central bank independence’ the electorate award.
A similar phenomenon was observed in the United States during what mercantilists mistakenly call the Korean War boom.
The commodities bubble was actually triggered by liquidity injected – at Sri Lanka – into the US banking system during the defense of the face value of a World War I debt instrument known as the Liberty Bond.
The Fed ultimately resisted pressure from US Treasury Secretary Walsh Snyder and prevented the collapse of the Bretton Woods soft-peg system.
âOur responsibility is not minor; this is a very big one under the conditions that exist, and if we fail history will record that we were responsible, at least to a very great extent, for the destruction or defeat of the very system as our defensive effort. is being done to protect and defend, âsaid Fed Governor Marriner Eccles, a classic economist in the style of 19th century greats such as David Ricardo who had powers of logical reasoning, in minutes from 1951 from the Fed.
âWe are not at war. We do not currently have deficit funding.
âYou only protect public credit by maintaining confidence in the government and its securities and to the extent that the public will buy and hold those securities. The thing we are doing is allowing the public to convert government securities into money and increase the money supply of this country by $ 7 billion in six months. “
This was not done with the aim of fulfilling our responsibilities, but with the aim of trying to maintain the structure of interest rates, âGovernor Eccles said.
“It was entirely due to our efforts to fulfill requests or requests from the Treasury.”
âWe are almost solely responsible for this inflationâ¦ the whole issue of rationing and price control is due to the fact that we have this monetary inflation, and this committee is the only agency in existence that can curb and stop the growth of the currency. “
âWe cannot pass this responsibility; we should inform the Treasury, the President and Congress of these facts and do something about it. ”
Policymakers and central bankers in countries entering currency crises do not understand the link between cash injections, credit and the external sector.
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Analysts traced the problem to Keynes, who argued after World War I that Germany had a “transfer problem” in paying for repairs and that a current account surplus was needed to do so.
(Colombo / August05 / 2021)