The Central Bank should avoid making past mistakes in this BOP cycle

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Sri Lanka’s credit is now slowing (compared to total bank deposits raised), allowing the Central Bank to easily purchase dollars and mop up the rupees created in the process (sterilized forex purchase) by selling down its Treasury bill stock to build forex reserves.

The more Treasury bills are sold down, the more credit will be restricted (compared to total deposits and inflows), creating a virtuous cycle. The Central Bank, if it wishes, can allow the exchange rate to appreciate and cut inflation; but under its current policy of creating a ‘competitive exchange rate’, it has not done so.

THIS IS AS GOOD AS IT GETS
It is now that the first policy errors that will create the next balance of payments crisis-cum-currency collapse will be made. The Central Bank should guard against this.

POLICY ERROR CYCLE
Sri Lanka’s balance of payments crises are not due to insufficient exports, excessive imports, oil or any other problem, but simply due to policy errors by a soft-pegged central bank, which has been making them now for 57 years.

Simply put, when domestic credit demand goes up (due to budget deficits, subsidizing imported energy, or simply private credit), instead of allowing rates to rise, the Central Bank prints money to keep rates down, driving credit and imports to unsustainable levels. The resulting pressure on the exchange rate, when seen by dealers, eventually drives foreign investors to sell bonds and generate capital flight, and exporters to hold back dollars and take further rupee credit.

As the Central Bank intervenes in selling dollars, and printing more money by purchasing Treasuries keeps rates going up (selling dollars shrinks reserve money, driving rates up and rebalancing the system as it did before 1951), a vicious cycle is generated. The Treasury bill stock of the Central Bank goes up and foreign reserves go down in a vicious cycle in sterilized forex sales, which does not end until rates are raised and the currency floated. The 2015 crisis was interesting in that the Central Bank tried to float the currency from mid-2015 without raising rates and made another policy blunder it had not made in recent earlier cycles. However, eventually, rates were raised. Banks also responded on their own, raising deposit rates, getting more savings to finance loans, instead of getting printed money by selling their Treasury bill holdings to the Central Bank.

THE VIRTUOUS CYCLE BEGINS
Looking at the Treasury bill stock of the Central Bank, it can be seen that money printing started to tail off in the first quarter of 2017. By the second quarter, the Central Bank was actively selling down its domestic asset stocks and building up foreign reserves.

Although dollars purchases tend weaken the exchange rate, the mopping up of liquidity reduces total credit and allows the exchange rate to appreciate. However, compared the 2011/2012 crisis, this time, the rupee is continuing to fall. This is because the Central Bank is targeting a real effective exchange rate (REER) in the mistaken belief of creating a ‘competitive exchange rate’.

Deliberately weakening the currency in this fashion will alter the price structure of traded goods (exports and imports), and eventually non-trade items as well, pushing up inflation. Even if policy rates are raised, it may not help, other than in slowing growth further and increasing foreign reserve collection. Whether or not there is real pressure on the exchange rate can also be seen by the money market rates.

When money market rates move towards the lower end of the policy band, banks are raising deposits and not giving out all in loans, credit slows, allowing foreign reserves to be collected. When money market rates move towards the upper band, pressure increases. The Central Bank creates a balance of payments crisis by enforcing upper rates (reverse repo rate) by printing money with Treasury bill purchases. All these indicators now show that Sri Lanka’s credit system is stable and, in fact, rates can be cut if needed. As long as the exchange rate does not depreciate, there will not be much more inflation than is generated by the US Federal Reserve at this point.

POLICY ERRORS TO BEGIN?
The Central Bank’s Treasury bill stock fell to about Rs20 billion by the last week of November, from around Rs40 billion at the end of September. Excess liquidity is around Rs20 billion.

By end-December, if the Central Bank keeps up mopping up liquidity, the bank will run out of Treasury bills to mop up liquidity and build up reserves. This is where the Central Bank will start making the first of its policy errors that will make the next BOP crisis and credit surge easy.

The Central Bank creates a balance of payments crisis by enforcing upper rates (reverse repo rate) by printing money with Treasury bill purchases

The US architects of soft-pegged central banks in South America, the Philippines and Sri Lanka created central bank securities to mop up liquidity and create foreign reserves over and above the domestic monetary base. Unlike British Colonial currency boards, this practice made the newly created dollar-pegged central banks keep policy tighter for longer than necessary and buy more US Treasuries with the foreign reserves collected. The political motivations of pegged central banks (for which J R Jayawardene fell hook, line and sinker) and central bank securities are complicated. But, whatever the motivations, the practice brought more stability than Sri Lanka’s recent actions.

BAD PRACTICES
Over the last decade, the Central Bank stopped issuing its own securities (which used to be issued for 6 months or more), and instead started mopping up liquidity through term repos using borrowed bills from the Employee Provident Fund.

Compared to Central Bank securities, this practice is riskier and contributes to instability. Domestic analysts warned against the practice of buying dollars through swaps and forwards, when baby steps were being made. Their warnings were ignored. The International Monetary Fund and others sat around until the swaps/forwards built up to billions of dollars before requiring them to be wound down. The practice of short-term mopping up, in a central bank that is prone to push up credit by sterilizing interventions at the drop of a hat, has not been talked about much. In order to reduce currency and BOP risks, the Central Bank should immediately start selling CB securities again. At first, it can sell 3-6 month securities, but go up to one year as soon as possible, if rates fall further.

The importance of ending the practice of temporary, short-term mopping up to build unstable reserves cannot be over-emphasized. All impediments regarding taxes or liquidity that made banks reluctant to buy them a few years ago have to be cleared. The Central Bank should take another important step. The monetary authority should make CB securities the only instrument that will be accepted for open market operations. By this single act, provided term auction and other operations are also conducted against CB securities (or US government securities even), the risks of balance of payments crises will be slashed or eliminated in Sri Lanka.