ECONOMYNEXT – Sri Lanka’s gross official reserves rose by 478 million US dollars in April 2024 to 5,438 million US dollars, official data shows, as the central bank continued broadly deflationary policy.
Deflationary policy (net sell downs of central bank-held domestic securities) at a market-appropriate interest rate allows a balance of payments surplus to develop.
The rupee sharply appreciated in March and early April, leading to importer bill delays and heavy reserve collections.
Some pressure came in the latter half of the month largely due to oversold position and the central bank used moral suasion and some dollar sales to keep the exchange rate stable.
Sri Lanka’s private credit is still weak, allowing reserves to be collected and the external sector to be kept stable easily.
The gross reserves also includes fiscal balances from loans. The central bank also has 3.2 billion US dollars in swaps outstanding, which exposes the monetary authority to exchange rate risk and large losses when rates are cut with inflationary open market operations (flexible inflation targeting).
However the central bank is steadily settling other loans, including to the IMF and India, which is improving the net foreign assets position of the monetary authority and net international reserve position overall.
Though China has given a swap, the People’s Bank of China put a rule saying it cannot be used if reserves fell below three months of imports, protecting Sri Lanka from further losses and the effective refinancing of private sector imports at the expense of negative reserves of the monetary authority and exposing the agency to forex losses.
Sri Lanka’s net international reserves improved radically to only a negative 404 million US dollars by end December 2023 from minus 3,229 million dollars in 2022, sharply over-performing the IMF target of a negative 1,592 million dollars, by not cutting rates hastily and boosting confidence.
Despite reserves collections, despite higher real rates, the economy has started to recover strongly amid currency and monetary stability. Steep short term appreciations are also not a sign of stability, analysts say.
Since the end of the war Sri Lanka’s monetary system had tended to unravel as soon as private credit recovered, as rates were cut with inflationary policy (reverse repo injections/standing facilities), leading to missed IMF reserve targets and currency depreciation.
Amid flexible inflation targeting (targeting high levels of inflation without a clean floating rate amid reserve targets), potential output targeting (printing money for growth), Sri Lanka ran into currency crises and output collapses.
Budgets and debt deteriorated after each stabilization episode after flexible inflation targeting/potential output targeting.
Eventually growth fell to levels seen in war time, amid back-to-back IMF programs (based on the same monetary doctrine), and the country defaulted.
At the moment the central bank is providing monetary stability, and interest rates are slightly higher than required to keep the external sector in balance (leading to reserve accumulation) and growth is recovering due to monetary stability provided.
However, allowing steep short term currency appreciation made possible by policy also leads to speculative behaviour (importer cover delays, negative NOPs) as the future value of money is in doubt, analysts say.
Sri Lanka’s external sector has tended to unravel post-war as soon as rates are cut with inflationary policy (reverse repo injections/non-penalty rate standing facilities) as credit demand recovers from the previous currency crisis.
In the past, May has been a month that led to currency pressure after April excess liquidity. (Colombo/May07/2024)