Sri Lanka’s central bank on track to insolvency, quasi-fiscal losses looming

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ECONOMYNEXT – The reserve liabilities of Sri Lanka’s central bank exceeded its net reserves by around $ 400 million (Rs 83.6 billion) in July 2021, data shows, putting the monetary authority on track insolvency, which can lead to significant losses and possible default. .

The negative $ 400 million difference in the central bank’s dollar balance sheet was reported when gross reserves stood at US $ 3,543 million.

By August, gross reserves had fallen further from US $ 962 million to US $ 2,583 million, indicating a further deterioration in net foreign assets.

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It is unclear how much of the decline in reserves stems from the unwinding of swaps, which will also reduce liabilities. All Asian Clearing Union regulations are already accounted for.

In October, the central bank had given more dollars for business transactions.

Insolvency in dollars

The central bank’s net foreign assets as part of the monetary base or reserve currency, or the dollar-backed reserve of national rupees, have steadily declined over the past six years and are now become negative.

Analysts had warned early in 2021 that the cash injections and failed bond auctions would lead to such an outcome, particularly because Fed chief Jerome Powell was printing money and throwing money out. bubbles on raw materials.

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Sri Lanka embarked on a militant inflationary monetary policy from September 2014, gradually bringing the central bank closer to the insolvency of the dollar.

When an indexed central bank injects liquidity into banking systems (inflationary policy), currency shortages occur, making it difficult for companies or governments that operate in the money, to capture current inflows to repay debt. maturing or even making current payments.

The injections of liquidity cause the outflows of foreign currency to exceed the inflows.

As a result, foreign exchange reserves are exhausted. In Sri Lanka, new debts are incurred to repay debt and also to make current payments through lines of credit or supplier credits.

Sri Lanka recorded a balance of payments deficit of US $ 2.3 billion in 2020 and US $ 2.7 billion through July 2021, as net credit to the central bank government increased due to failed bond auctions.

From September 2014 to August 2021, a non-inflationary policy was observed only in 2017 and part of 2019. The inflation policy came from targeting a call rate with excess liquidity, a spread production (light Keynesian stimulation) and a fully-fledged modern monetary theory from 2020 with outright monetization of the deficit.

Sri Lanka is one of many Latin American-style central banks created by money specialists from the Federal Reserve, modeled on Argentina’s central bank. Many of them collapsed and led to new currencies or dollarization.

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These include those from El Salvador, Ecuador, Argentina itself and the Philippines, which have been recapitalized. The sharp depreciation of a bank issuing banknotes or its collapse has serious consequences on an economy; it is the monopoly of money.

Sri Lanka last faced the collapse of a banknote issuing bank when the Oriental Bank Corporation fell on May 3, 1884. Colonial administrators then set up a currency board with a rate of 1 to 1 with the Indian rupee in silver which held up to the Latin American style. The central bank was established in 1950.

The error of equating the value of a banknote-issuing bank’s currency with the economy by neo-mercantilists that began in the last century was not made at the time, as the Chartered Mercantile Bank was issuing also tickets, analysts said.

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The Oriental Bank Corporation, however, had the largest monetary base of 3.2 million Ceylon rupees against 921,000 rupees for the Chartered Mercantile Bank.

Quasi-fiscal losses

In recent months, debt had effectively been transferred from the government to the central bank’s balance sheet through reserve reductions and dollar borrowing through swaps.

During times of printing money, Ceylon Petroleum Corporation was also forced to borrow dollars instead of buying them in the market, acquiring about $ 3.0 billion in loans, making big losses each time. let the rupee fall.

Similar losses would also be suffered by the central bank when the rupee falls.

Such losses are called quasi-fiscal losses, and the deterioration of the balance sheet will ultimately make it difficult for the central bank to apply monetary policy on the exchange rate and national currency as well.

In the past, with positive net foreign assets, the central bank made book profits when the rupee fell.

Even at the current exchange rate, the spread would widen whenever interventions are made to keep a fixed exchange rate and any swap would worsen the negative spread and could eventually lead to default of any dollar debt and swaps. themselves.

If a US $ 1.5 billion swap from China is used to repay debt, the hole in its balance sheet will increase the negative spread to Rs300 billion at the current exchange rate.

Sri Lanka’s central bank now has swaps owed to domestic players, the Bank of Bangladesh, and about US $ 1.3 billion to the International Monetary Fund due to loans taken out after previous cash injections.

Several central banks that have injected liquidity have already defaulted on IMF loans.

Flexible and unembedded policy

Analysts had criticized the IMF for providing technical assistance to calculate an output gap giving it the basis for printing money to close it without making economic reforms or real activity.

The US Fed collapsed against gold and the pound suffered multiple “pound crises” with a Keynesian output gap target.

The IMF had also institutionalized anchoring conflicts in its last program with a high inflation target of 8% (domestic anchoring which required a floating exchange rate) and a foreign exchange reserve objective which required external anchoring (interventions on foreign exchange markets).

Unanchored monetary policy without a credible domestic or external anchor was known as “flexible” inflation targeting with a “flexible” exchange rate.

Currencies collapse due to a central bank targeting two anchor points – printing money to target inflation through low interest rates – while collecting foreign exchange reserves by buying currencies by intervening in the foreign exchange markets.

When the US Fed – which is the anchor currency issuer of an index-linked system – tightens its policy amid injections of liquidity, the country faces capital flight and can lead to a faster collapse of the currency. and a sovereign default.

This happens several times in Latin America.

A central bank that collects reserves and intervenes in foreign exchange markets has a convertible monetary base.

When they lack foreign reserves to exchange for national currency, the rapid deterioration of the currency can be stopped by a clean float of the currency which makes the reserve currency inconvertible.

A float is a convertibility suspension. However, the failure of bond auctions that inject liquidity can prevent the establishment of a float and lead to further declines in the currency.

Sterilization trap

It is generally said that a central bank cannot fail on its domestic monetary base.

The national money supply in rupees is a liability of the central bank, but thanks to a float, it can exist in perpetuity.

However, it may still incur losses on its sterilization activity and deplete its capital as well as lose its ability to conduct monetary policy as the losses accumulate.

Quasi-fiscal losses can also arise from the costs of sterilization, although sterilization is a “monetary policy”.

Sri Lanka’s central bank also refinanced a Covid loan by injecting cash in 2020 at around 2%, which will need to be sterilized at market rates when repaid.

The central bank using its balance sheet has also given guarantees to Covid-19 loans in a more responsible manner, but this can also lead to bad debts. By the end of 2020, the central bank had provided 154 million rupees for credit losses.

Sri Lanka, meanwhile, suffered the initial losses from the sterilization trap last week as it began to mop up money from failed bond auctions, EN business columnist Bellwether said.

As the rates are increased, the losses will tend to increase.

The central bank which injected 87-day money at 6.13% last month has now started to mop up liquidity from failed bond auctions at 6.00%. The 87-day money was to partially reverse a hike in the statutory reserve rate.

In Sri Lanka, SRR is unpaid and has no costs or losses.

It also injects money overnight at 6.0%.

Central Bank Governor Nivard Cabraal has lifted price controls on bond auctions that had crippled bond markets, but they are still not functioning effectively. There is also no functioning cash market.

It’s best to act early, analysts say.

Analysts have also warned that while banknote issues and changes in central bank balance sheets are a mystery to most people, including rating agencies, they understand foreign exchange reserves.

When liquidity injections affect foreign exchange reserves or exchange after going through the credit system, degradations ensue.

Economists urged authorities to opt for an IMF program to restore confidence and avoid outright sovereign debt default and consider preemptive restructuring. However, the Sri Lankan authorities do not like to restructure and try to repay the debt.

An IMF program will usually be to raise taxes, cut spending, and raise interest rates. However, an IMF program will also release budget support loans.

If a country’s debt is deemed “unsustainable,” the IMF cannot lend, and other development partners, including the World Bank and the Asian Development Bank, cannot provide budget support loans either. .

Sri Lanka’s current fiscal problems stem in part from “revenue-based fiscal consolidation”, a reckless strategy followed in the pursuit of a magic number between revenue and GDP.

In the absence of expenditure-based consolidation, the pursuit of the magic number has shifted a large volume of taxes from productive sectors to state workers, increasing expenditure to GDP from 17 percent to 20 percent. . (Colombo / Oct09 / 2021)


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