Gross official forex reserves dropped by $452.6 million in May 2021 to $4.02 billion, Central Bank data showed amid financial account pressure and the use of modern monetary theory, Echelon’s sister news platform EconomyNext.com reported.
In April, forex reserves recovered to nearly $4.5 billion from a ten-year low of $4.05 billion in March 2021 after the China Development Bank granted Sri Lanka a $500 million loan. Following the injection, new money printing stopped, and the Central Bank sold some of its reserves. In April, the Central Bank also bought $62.8 million from the market. However, excess liquidity from previous injections remains in the system. Forex reserves have been on a steady downward path from around August 2019, when liquidity injections for output gap targeting began. In the Nixon-era US, output gap targeting with a (gold) peg by the Fed led to the collapse of the Bretton Woods system and with it the centuries-old gold standard, especially after Nixon removed then Fed-chief William McChesney Martin.
Sri Lanka’s soft peg with the US dollar had collapsed from Rs110 to 131 against the US dollar due to pro-cyclical liquidity injections in 2011/2012, and fell further from Rs131 to 151 due to pro-cyclical liquidity injections in 2015/2016, and eroded further Rs182 due to pro-cyclical liquidity injection in 2018. Since the beginning of 2020, the rupee has collapsed to Rs200 against a US dollar due. The collapse is due to liquidity injections, which were not always pro-cyclical (credit collapsed from April to September), but did not match developments in the financial account either, especially after a severe credibility loss that occurred particularly after the ‘flexible exchange rate’ episode in March 2020. Liquidity injections continue. Sri Lanka got into a currency crisis in 2018 while having a significant loan from the International Monetary Fund. In 2019, taxes were slashed in another ‘policy-making by manifesto’ operation, outdoing the ‘100 day programme’. “Manifesto making is political,” explained Rohan Samarajiva, a regional policy specialist in Arthashastra his column in Echelon and sister concern EconomyNext titled ‘Sri Lanka’s misguided state priorities and how to reset them’ “Experts, or those perceived as experts, may be called in to contribute, but the principal criterion is not expertise, but trust. Those who have been involved in manifesto making will testify to the opacity of the process, wherein what is accepted one day can disappear the next, and new clauses and conditions can mysteriously appear even after ‘finalization’,” he wrote. Forex reserves then deteriorated sharply as the Central Bank cut rates, reducing reserve ratios as the government budget deteriorated. Analysts have pointed out that Sri Lanka’s monetary policy eroded sharply after Deputy Central Bank Governor W A Wijewardena retired from the Central Bank. When foreign reserves fall to uncomfortable levels, monetary authorities usually hike interest rates and float the exchange rate. However, interest rate hikes can be capped to some extent by raising taxes and cutting state spending. Central banks that do nothing may end up in dollarization.
Forex reserves have been on a steady downward path from around August 2019, when liquidity injections for output gap targeting began
The fall in net reserves comes as the policy at the anchor central bank is also deteriorating. Inflation in the US hit 5% in May 2021, in line with forecasts made by classical economists. Analysts had warned that the central bank had to guard against a runaway Federal Reserves. Sri Lanka’s first balance of payments crisis in the early 1950s also took place as the Fed printed money to target the yield of ‘Liberty Bonds’. When oil prices rise Sri Lanka usually tries to fix oil prices, losing tax revenues and driving up domestic credit, under a policy popularized by current industries Minister Wimal Weerawansa called ‘removing the World Bank plug’. The rising domestic credit triggers more money printing under a policy rate targeting exercise. A Bellwether column has warned that 2021 would pose the biggest economic challenge in Sri Lanka’s history with the Central Bank printing money like there is no tomorrow under Modern Monetary Theory, while ordinary people are strangled by import substitution. In most countries, money printed to pay salaries of state workers and the military trigger currency collapses along with hyperinflation. If taxes are slashed, then interest rates must go up as people’s savings are borrowed to pay state worker salaries. But it has not happened. Instead, forex reserves are falling steadily. Meanwhile, the Central Bank has revised Sri Lanka’s 2021 GDP growth downwards to 5%, from an earlier 6% estimate, after the country plunged into a three-week lockdown to contain a deadly third-wave of the Covid-19 pandemic. The economy had contracted by around 3% in 2020. “The government had to balance between keeping growth going and saving lives, and it was necessary to strike a balance,” Central Bank Governor W D Lakshman said. But businesses had gotten used to operating under a lockdown, and the May-June lockdown was not as tight as the first one in 2020, he said. Inflation will also be within target in 2021, Director of Economic Research Chandranath Amarasekara has said. Though there were supply constraints, the Central Bank did not expect aggregate demand to increase by much. The 5% growth was also coming from a low base as the economy contracted in 2020, he said.