Anatomy of the balance of payments crisis in Sri Lanka

The Central Bank has destroyed the country and the wealth of its people since 1951, bringing misery and mayhem; and it’s unlikely to stop now unless its underlying law is radically changed and new rules limit its discretionary power

Sri Lanka is now emerging from its latest balance of payments crisis, with all private sector workers in particular poorer as the rupee collapsed to Rs146 from Rs131 to the US dollar and with events progressing pretty much as expected.

State workers, who got a salary hike with printed money, perhaps preserved some of their purchasing power. People who bought cars and other assets at low interest rates will also escape. Everyone else will be poorer than when the Yahalapalana administration came to power. The updated version of the graphic depicting the Central Bank’s domestic assets stock – a proxy for the volume of money printed – shows that the tide has turned with the stock falling. Provided that the monetary authority keeps policy prudent, things can continue to improve. This column first warned that monetary policy has to tighten when fiscal policy loosens during the presidential election in October 2014. (“Sri Lanka in danger of travelling the PIGS path, with low nominal interest rates: Bellwether”).

Early Warning

When August credit data was available in November, this column warned in December that the Central Bank will no longer be able to build reserves except through earnings on its reserves (“Sri Lanka may lose the forex reserve beauty contest amid ultra-low interest rates: Bellwether”) and that the currency will soon come under depreciating pressure, forcing the Central Bank to defend the currency. In September, foreign reserves were at $8.8 billion.

“Dollar sales will mop up excess liquidity and foreign reserves will be depleted somewhat,” this column said.

“This will put upward pressure on interest rates. This pressure should not be resisted with liquidity injections, precipitating a balance of payments crisis. The most dangerous action a central bank can engage in is sterilised foreign exchange sales. This is what Latin American and other third world, weak exchange, soft-pegged central banks do.

International commodity prices are low, and the trigger for the 2011 BOP crisis of bank-funded, central bank-accommodated energy subsidies is unlikely to occur in 2015, but stronger private credit and historically low interest rates will weigh in as negative factors.

But, at 6% interest rates, even a deficit of 4-5% of GDP may have the same effect on the broader credit system as a 7-8% GDP deficit. Rating agencies and others may not realise this.

Because there are foreign investors in rupee and dollar bonds, Sri Lanka can no longer take the chances it did in earlier years, say 10 years ago.

That means the Central Bank will have to stand ready to raise interest rates. It should watch credit, foreign reserves and the exchange rate, and refrain from keeping rates down when excess liquidity runs out.”

The Central Bank, of course, did not raise rates when liquidity ran out. This is not Singapore, Hong Kong or some other well-managed economy. This is Sri Lanka, with its economic mis-management and a central bank with a crawling peg that goes crawling to the IMF after drunkenly printing money to help elected rulers give subsidies every few years to deceive and impoverish the citizenry. The budget deficit in 2015 was also much worse than this column forecasted after the new administration came to power. Far from raising rates when excess liquidity ran out with dollar sales, the Central Bank released term repos to sterilise interventions, and pushed demand and credit to a new high, losing forex reserves on the way.

From somewhere after February 2015 (see graphic), when term repos were over, the Central Bank began to sterilise interventions with outright Treasury bill purchases. By March 2016, the Central Bank had printed Rs84 billion, and excess liquidity was at an unbelievable Rs99 billion. When rates were cut in April, foreign investors started to sell.

La La Monetary Policy

By end-April 2015, excess liquidity was at Rs128 billion and absolutely no attempt was made to mop up the cash through bill sales. Instead, the Central Bank waited until credit growth picked up and the rupee came up for redemption in the forex market to mop them up with forex reserve sales.

This was a deterioration of policy straight to la la land, with the Central Bank printing money not just to sterilise the interventions 100%, but to generate and maintain excess liquidity over and above the interventions. It was an unbelievable money printing frenzy not seen in the memory of this columnist, except in Zimbabwe where money was printed at one end and taken through standing windows at the other end (at a much higher rate).

It is difficult to imagine why a central bank faced with balance of payments pressure chose not just to sterilise the intervention, but to generate excess liquidity. In May, some dollar inflows came, but the Central Bank began to drive credit again, keeping excess liquidity high, although some liquidity was mopped up.

Policy improved in June 2016, when the Central Bank, instead of printing money to keep excess liquidity, started to keep the markets short with only overnight injections to sterilise interventions. This was a decisive change in direction

An attempt was made to float the rupee in September, but with literally Rs100 billion in excess liquidity, it was doomed to failure. It was another money move close to the lunatic fringe. The rupee collapsed to Rs141 to the US dollar in that month. Interventions continued. About Rs180 billion had been printed by then, not counting term repo releases.

In November, foreign borrowings came in and some of it was mopped up in paper transactions, and the Treasury bill stock of the Central Bank was brought down to Rs82 billion. But unbelievably excess liquidity, which was Rs82 billion on October 30, was allowed to go up even higher to Rs120 billion (see table page 32).

To understand the magnitude of this number, it is about one-fifth of the country’s base money, which had also shot up to Rs640 billion by that time.

Meanwhile, car imports were blamed in the usual fit of Mercantilist scapegoatism. In past balance of payments crises, oil imports were blamed. This time, oil prices had collapsed. So only cars could be blamed. This columnist warned earlier that it would happen, since that is a Mercantilist ritual ingrained during periods of monetary mayhem.

By the end of January 2015, Rs150 billion had been printed. No amount of dollar bond sales could help ease the balance of payments crisis. Money was printed again and again, after sterilising some of the bond proceeds, driving credit to high levels. By end-March 2016, Rs198 billion was printed.

From around March 2016, policy improved a little, with crazy levels of Rs40 billion in excess liquidity going down to about Rs10-15 billion levels, which was bad enough. The Central Bank injected overnight cash during the usual April holiday season instead of buying Treasury bills outright. But policy continued to be loose, with excess liquidity. Although rates had been hiked, analysts warned that, as long as T-bills were purchased to inject liquidity, balance of payments pressure would continue.

Turning Point

Policy improved in June 2016, when the Central Bank, instead of printing money to keep excess liquidity, started to keep the markets short with only overnight injections to sterilise interventions. This was a decisive change in direction. A deal was also struck with the international

Monetary Fund. Whether the monetary policy department of the IMF had anything to do with this move is not known.

On July 20, the Treasury bill stock peaked at Rs290 billion. After that, any cash from dollar inflows simply reduced the overnight injection, as if the purchase was sterilised.

The BOP crisis probably ended on July 20. This columnist says “probably” because the Central Bank cannot be trusted to keep policy tight and the market short. For example, excess liquidity by end-August was again allowed to build up to Rs20 billion, renewing credit and import pressure. Because credit demand is still strong, the Central Bank cannot afford to take its foot off the brake.

It is one thing to let excess liquidity slosh about when credit is negative like in early 2014, but quite another thing to do so when credit demand is still strong.

The Central Bank has destroyed the country and the wealth of its people since 1951, bringing misery and mayhem; and it’s unlikely to stop now unless its underlying law is radically changed and some rules are brought in to reduce its discretionary power.

Having said that, judging from the public pronouncements, new Governor Indrajit Coomaraswamy seems to be aware that the Central Bank is a dangerous animal that can fire bubbles at will and not an agency to generate prosperity from monetary pyrotechnics.

By the last week of September, the Central Bank’s Treasury bill stock has come down to a little over Rs200 billion.

What Now?

The effects of the crisis will persist for some time. The collapse of the currency will feed through to non-trade sectors, pushing up inflation for some time, whether rates are raised or not, unless the rupee is allowed to appreciate back. Interest rates will ease if monetary policy is kept tight with aggressive domestic operations. It will not be easy to build up reserves, as in the next couple of years, large repayments to the IMF have to be made, despite some money coming in.

All Central Bank profit transfers have to be halted. In fact, this column advised the move in 2014.

The fully auction-based bond sales started by ex-Governor Arjuna Mahendran will stand the country in good stead. If not for the auctions, the country’s interest rates may have gone much higher. In fact, massive amounts of bonds had to be accepted above the announced volumes to push up rates, exposing the rigged nature of the auctions to all and sundry. If the auctions are not rigged and the volumes required are announced beforehand, rates will fall quickly.

Sri Lanka’s balance of payments crisis was made much worse through so-called private placements because it delayed price signals and failed to bring in funds when the budget deficit deteriorated. In the same way, rates will also fall much faster when announced volumes are taken. In the past, after a BOP crisis, rates did not fall quickly because higher-than-announced volumes were taken, preventing a rate rise.

But rates will not fall to 2014 levels. Bank credit demand is now much stronger, even if deficits improve. Money may also move out of bond markets to the banking sector.