ECONOMYNEXT – Sri Lanka’s central bank has been aggressively injecting liquidity on a longer term in the past weeks reducing liquidity shortages in the banking system, which if overdone could lead to forex shortages and instability again.

The central bank has injected 340 billion rupees through term injections – largely replacing lending window operations from January 09 and overnight injections began on January 17.

While liquidity shortages beyond a certain point has no value, care should be taken to ensure that excess liquidity conditions do not re-emerge.

A liquidity shortage emerges in Sri Lanka’s banking system because a pegged regime is operated, despite whatever claims to the contrary.

In past currency crises, almost all the liquidity shortages from dollar sales (losses of foreign reserves) made to defend a peg were filled permanently to maintain an artificially low policy rate.

Currency crises and balance of payments deficits do not come from defending pegs as claimed by post 1935 academics and economic bureaucrats, but from money printed through open market operations to mis-target rates and maintain an artificially low policy rate after intervening.

Fictitious Capital

In this currency crisis, the worst created in the history of the central bank of Sri Lanka, large volumes of liquidity were only filled overnight. This is better than filling permanently, as it may prevent banks from giving credit due to asset liability mis-matches.

The liquidity injections allow banks to lend without deposits and trigger forex shortages, expand the external current account deficit – unless they were used to buy assets from fleeing foreign investors and more forex losses.

Classical economists have called such injections ‘fictitious capital’ in a pegged regime.

However US academics (led by Mercantilists like John H Williams) and economic bureaucrats who built the Bretton Woods and the International Monetary Fund, thought it was possible to do so as their knowledge of classical theory seemed to have been weak, and instead used statistics to claim that it was possible.

That it was not possible was proved with the collapse of the Bretton Woods. But third world countries – outside of East Asia and GCC – continue to believe that it is possible, with disastrous consequences and never-ending trips to the IMF.

A third world country is necessarily pegged. No single anchor regime country will remain poor for long.

In past currency crises, foreign reserves losses (losses of NFA) were filled permanent purchases of Treasury securities, so large liquidity shortages running into hundreds of billions of rupees were not seen.

New Sources of Liquidity Shortages

Outside of the net foreign assets losses, in this currency crisis, due to downgrades of credit, foreign banks parked large volumes of cash in the central bank instead of lending in the overnight market in a private sterilization style activity. (Sri Lanka injects Rs130bn outright amid high private sector sterilization)

As a result, a few foreign banks ended up with over 300 billion rupees of excess cash.

This is similar to people withdrawing cash from the banking system and burying them in proverbial coffee tins in their backyard as reportedly happened in the US during the Great Depression.

A third reason for expanding liquidity shortages was the roll-over of central bank held Treasury bills (zero coupon bonds) with interest.

As a result, Sri Lanka’s net credit to government went up, without any changes in net foreign assets – since the central bank has run out of reserves – while reserve money or at least notes in circulation fell.

Loosening Monetary Policy

Over the past few weeks, the central bank started injecting liquidity (printing money) on a longer term basis reducing the overnight shortages.

In addition, the central bank also stopped banks with excess cash from depositing money in the repo window at 14.50 percent, encouraging them to lend in the overnight market or buy Treasury bills. (Sri Lanka central bank to limit access to policy rate windows)

This has started to happen and Treasury bill yield are coming down.

Any of foreign bank money, or newly injected money that is used to buy Treasury bills will end up in state banks.

The central bank should maintain a liquidity short to absorb any liquidity that foreign banks use up to buy Treasury bills.

The central bank was blamed by many for the current high rates.

Though it is true that country’s chronically high rates – and the high rates of all third world soft-pegged countries – are due to monetary instability coming from the central bank’s mis-management of a soft-pegged exchange rate regime, in this currency crises the threat of a domestic debt re-structuring has also contributed.

This column has warned for many years that the central bank cannot inject liquidity to suppress rates when private credit picks up and maintain the peg. Each time it is done, forex shortages emerge and the corrective rates are higher than if the rates were allowed to go up a little naturally to balance domestic credit and savings.

After months of injections, the rupee then collapses and rates go up steeply. This has happened repeatedly and has worsened under flexible inflation targeting. A floating exchange rate regime is needed for any type of inflation targeting (to operate a domestic anchor based monetary regime the external anchor has to be abandoned).

In this context caution should be exercised in the current liquidity injections.

A Fragile but so far Consistent Peg

Sri Lanka is maintaining a peg at 360 to the US dollar without any reserves at the moment. It is done by a surrender rule where forced sales are made at around that price to the central bank, injecting liquidity and selling the same dollars back to banks.

Depending to the spread, this activity can also lead to liquidity shortages. In fact, the Bank of Thailand many decades ago re-built foreign reserves devastated by Japanese driven money printing during World War II, through such a strategy.

This column has in the past advocated floating the exchange rate and re-pegging, to re-establish the credibility of the peg. Before any float the surrender rule should be removed.

Exporters are still not selling forward, indicating that there is no market credibility for the 360 peg, though the central bank has operated monetary policy consistent with such a regime through liquidity shortages and negative private credit through higher rates.

Risks Remain

Until the credibility of the peg is fully restored, some overnight liquidity shortages should to be maintained, especially at state banks, for the following reasons, despite private credit being negative.

a) The Treasury has warned that it may still require printed money. Overnight liquidity short should be large enough to absorb any such injections.

b) The first quarter of any year is where a drought comes and electricity sector losses are financed with credit. This column in early 2021 that rates be hiked and the currency floated before the drought. (Sri Lanka has to hike rates, tourism recovery will not help end forex crisis: Bellwether)

c) The shift of private sterilized money from foreign banks to state bank DST accounts should be absorbed as mentioned before.

This is because any of the new liquidity injections, and the privately sterilized money shifting from foreign banks to state or other banks can create forex shortages if loaned to the Ceylon Petroleum Corporation or Ceylon Electricity Board, to import fuel.

Though private credit is negative and the risks of foreign shortages, re-emerging are reduced, credit given to state energy utilities hit the forex market direct.

It is also not clear whether there will be any central bank profit transfers this year. In 2022 NFA was negative, but there are profits from domestic assets which if transferred as printed money can create forex shortages as they are used by the recipients.

That is why this column has advocated in the past that profit transfers be made in US dollars in the first instance and be done with it.

Sri Lanka has not yet got the IMF program, therefore confidence is low and any excess liquidity can undermine the very fragile peg.

Though there has been net excess liquidity in the market for a few days, some banks were still short by 132 billion rupees.

Peg and a Hard Place

The central bank is caught between a peg and hard a place, with a clamour by businesses to bring down rates.

In past crises, rates have started to come down from about two to three months after the currency is successfully floated, private credit turns negative and budget deficits begin to narrow .

But there has been no successful float to create credibility of the exchange rate in the market, the IMF deal and the attendant inflows that accompany it are yet to come.

Therefore, despite private credit being negative, due to problems in the CEB in particular and generally the budget, caution has to be exercise in liquidity injections and it will be a prudent strategy to maintain a short overall of at least 50 billion rupees.

After the IMF program comes, or even before that if there is a successful float and re-pegging, the central bank should consider abandoning the floor repo rate.

Many East Asian central banks do that and it helps economies recover faster.

The recent blocking of access to the repo window is a similar strategy, but is fraught some risks at the moment because the new liquidity is not coming from an acquisition of foreign assets but from domestic assets.

The central bank could also consider rolling over Treasuries at par through a legal change until they are sold down to re-build reserves after the IMF program comes. This will reduce the government interest bill and eliminate any risks from a single day profit transfer.

Having said that IMF programs are no solution to a trigger-happy pegged bank that injects liquidity through open market operations.

The State Bank of Pakistan is melting now within an IMF program. Sri Lanka had currency problems in both 2011 and 2018 within IMF programs which were temporarily suspended as liquidity injections were made amid high domestic credit which led to missed foreign reserve targets.

Liquidity shortages lose their value beyond a certain point, so the recent injections may not be harmful.

However care should be taken never to go to back to excess liquidity conditions except through net foreign asset acquisitions.