Sri Lanka spends $736m to defend $200 to dollar peg as ‘import reservations’ escalate


ECONOMYNEXT – Sales of Sri Lanka’s foreign exchange reserves to commercial banks defend a 200 peg to the US dollar that soared to $736 million from September to November 2021, official data shows, forcing money to be printed to maintain a fixed interest rate.

In November and December alone, $664 million of reserves were sold to commercial banks.

The injection of money after such “import reserves” to defend a peg (sterilization of interventions) prevents the contraction of the reserve currency, prevents a rise in short-term interest, and prevents a necessary slowdown in private credit. and boosts import demand.

In a remarkable descent into mercantilist ideology, calls were made for Sri Lanka to spend more reserves on imports, while simultaneously claiming that a 200 peg to the US dollar was unsustainable.

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Any reserve selling for imports is a defense of the peg, which commits a central bank with a fixed policy rate to printing more money through “open market operations,” triggering even more imports. .

If reserves are used for imports without allowing the monetary base to fall, default on sovereign and private external debt could become inevitable even if debt is restructured, analysts warned.

The injection of money after giving up reserves for imports is the hallmark of a soft or unstable peg (now called a “flexible” exchange rate), which triggers currency crises and balance of payments deficits.

A clean float (convertibility suspension) is necessary to stop the cycle of sterilized interventions.

Sri Lanka demanded structurally higher interest rates as soon as the country was shut out of the bond markets in 2020 to generate resources to pay down debt. However, rates were reduced in 2020 amid downgrades.

Sri Lankan market rates rose after yield controls were lifted, although most three-month bills were bought and monetization of the deficit was minimal.

By sterilizing reserves for imports, liquidity is injected into commercial banks (private sector) but to later observers it appears as deficit financing, since the money is printed not against private securities but government debt.

For centuries, during the days of the gold standard, the Bank of England used its discount rate (which was not fixed) against private debts (bankers’ acceptances) which were negotiable in the secondary market.

Open market operations as they are known today were invented by the Federal Reserve during the outbreak of the “Roaring Twenties” bubble that led to the Great Depression, analysts say. Part of the bubble involved increasing inventory with margin credit.

The way the central bank engages in the sale of reserves for debt repayment against newly created treasury bills, it is possible to appropriate the reserve for debt repayment without changing the reserves in rupees individual banks through a series of consecutive transactions (not transfer of reserves).

Sri Lanka created a loose peg in 1950, ending short-term floating rates and a fixed exchange rate that had shielded people from a Great Depression and two world wars. Sri Lanka has reserves worth 11 months worth of imports when the soft tie-down was introduced.

At that time, the United States was facing serious currency problems due to Keynesianism.

In November, the central bank sold US$310 million to commercial banks on a net basis that rose to US$353 million.

Interventions are the highest since the 2018 currency crisis.

Sri Lanka’s past currency crises until around 2005, which caused the rupee to fall from 4.70 to the US dollar to around 110, intensified with sales of sterilized reserves to defend a peg, although the crisis may be initially triggered by budget financing or rural credit.

Amid more discretionary and contradictory monetary policy after the end of a 30-year war involving a ‘flexible’ exchange rate and ‘flexible’ inflation targeting Sri Lanka faced currency crises and depreciation in quick succession and the rupee is now at 200 against the United States dollar.

Parallel exchange rates are around 248 per US dollar.

The central bank has also imposed a buyback requirement for exporter dollars and remittances, although the peg is weak, necessitating tighter monetary policy.

In the nine months to September, the central bank bought $228 million on a net basis from commercial banks under a repurchase obligation despite a peg that had already weakened.

A purchase of dollars by the central bank also creates money, which should only happen when domestic credit is low and interest rates need to fall. (Colombo/08/02/2021)

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