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Monetary policy review on April 22: Central Bank                                          
Fri, 18 April 2014 14:30:36
Sri Lanka central bank calms forex markets as treasuries stock rockets to Rs59bn
24 Oct, 2008 07:33:07
Oct 24, 2008 (LBO) – Sri Lanka's central bank says it is ready to accommodate additional foreign currency outflows from foreign bond holders even as snowballing T-bill purchases showed pressure building up in the monetary system.

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By Thursday the treasury bill stock held by the central bank, which is an indication of new money 'printed' to accommodate dollar outflows arising from central bank foreign exchange market interventions, had shot up to 59 billion rupees.

Sterilized Intervention

The central bank had also cut reserve ratios and added 7.5 billion rupees to the system in October, indicating that total central bank accommodations of outflows from September were 66.5 billion rupees (615 million dollars).

In September the Central Bank lost only 202 million dollars from interventions to defend a dollar peg at 108.00 rupees.

But analysts have warned that liquidity injected to offset (or sterilize) such losses would increase pressure in the banking system which will result in large losses of foreign reserves in a short time.

Analysts believe that the 'sterilized intervention' cycle was triggered by relatively small withdrawals of money by foreign bond holders, but central bank defence of a dollar peg had now resulted in the monetary authority backing ordinary trade transactions with its own reserves, creating severe inflationary and foreign exchange pressures.

To break the cycle the central bank has to float the rupee. With the world faced with a deflationary collapse, Sri Lanka could easily depreciate the rupee with no 'imported inflation' and also help the export sector.

The central bank said in a statement Thursday that it had 'absorbed' dollar inflows of 622 million in the first eight months of the year "to deal with any adverse shock that could arise from a sudden withdrawal of foreign currency from the system."

The bank says it "retained" a part of the capital inflows that came from Treasury Bond and Bill sales to foreign bondholders. Government securities were opened to foreign players after budget deficits increased and fiscal policy deteriorated.

"The accumulation of foreign currency on that basis also substantially increased the international reserves of the Central Bank," the central bank said.

Soft-peg problem

Analysts had warned at the time that sterilizing the rupee liquidity arising from dollar inflows (resisting an increase in the monetary base) and taking dollars out of the country as central bank foreign reserves cancelled out any potential benefit to the economy from capital inflows generated from bond sales.

At that interest rate the government could have raised the same amount of money from the domestic market, with the same 'crowding out' effect on the private sector with no foreign exchange debt liability and consequently no increase in foreign reserves.

This is a common problem associated with sterilizing soft-pegged central banks that try to control money supply while maintaining a managed (dirty) float or peg, and has been documented by economists in a wide range of pegged-exchange rate central banks ranging from Mexico to China.

The central bank says foreign investors who bought bonds were liquidating "a certain part" of the foreign investments in government securities due to the financial crisis in their own economies.

"While these demands have been comfortably accommodated so far, the Central Bank also stands ready to accommodate any further outflows, if such outflows arise at any time in the future," the Central Bank said.

While the Central Bank could 'accommodate' any dollar outflows arising from maturing bills directly from its reserves without affecting the domestic monetary system, analysts warn that 'accommodating' any sales of unexpired securities to the local market would result in further inflationary and foreign exchange pressures on the monetary system.

Currency crises usually arise from such central bank actions.

Commodity Easing

The central bank says the current falling oil and commodity prices is expected to ease pressure on outflows in the next two months and an increase in remittances in November and December is expected to reverse an "overall dip in foreign currency reserves" that has taken place in October.

Meanwhile petroleum bill payments had also been postponed through an Iranian government credit from four to seven months, which the central bank says is expected "ease the pressure on the foreign exchange market during the next couple of months."

"These favourable trends are expected to result in continued stability in the foreign exchange markets," the Central Bank said.

However economic analysts have warned that trade transactions have little to do with foreign exchange pressure, which is a monetary phenomenon arising from central bank liquidity injections or 'printed money' which exceed dollar inflows in a given period.

Recent forex market interventions, to defend a peg at 108.00 rupees to the dollar have caused a severe cash crunch in the monetary system.

The shortage of rupees caused by its forex market interventions have been filled by printing money to purchase treasury bills, relaxing access to the reverse repo window so that market participants can access more printed money more easily than before and cutting the reserve ratio and releasing money tied up inside the central bank.

Impossible Trinity

The central bank says its purchases of Treasury bills in the primary market was within "the leeway available in the reserve money programme."

"The above indicates that the continuous monitoring, precautionary actions and timely interventions by the Central Bank of Sri Lanka to ensure stability in the Sri Lankan financial markets has ensured that the Sri Lankan economy maintains stability and is able to withstand the current turbulent global financial markets, with confidence," the Central Bank said.

"Even in the future, the Central Bank would continue to monitor the conditions carefully and respond to the needs of the economy with suitable interventions, if and when any further interventions are required."

But analysts have warned the central bank several times that there is no 'leeway' in a reserve money targeting program if a peg is maintained.

Any sterilization (sales or purchases of T-bills) would either 'crowd out' the private sector (sales of t-bills) or create inflationary and exchange rate pressure (purchases of bills).

In 2007 the central bank's reserve money program was undermined by similar actions resulting in 20 percent plus inflation and a foreign exchange crisis in the middle of the year.

To effectively run any type of independent monetary policy, a floating exchange rate is needed and a peg has to be abandoned.

This is a well understood monetary phenomenon associated with pegged exchange rates, known as the impossible or 'unholy' trinity which says that independent monetary policy (in the current instance liquidity injections to prevent interest rates from skyrocketing) is impossible while maintaining a peg and permitting the free flow of foreign exchange.

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READER COMMENT(S)
1. Anura Nov 03
Attention: Sri Lanka Government
Please let Central Bank to do its duties independently. Let higher grade officers of CB to take right decisions. They have the capacity. But political intervention has created this bad situation.