Sri Lanka has printed over 100 billion rupees in the past three months to meet deficit spending, resist a market interest rates rise and contractions in the monetary base amid capital flight, official data show.
Until June 2015, releases of cash tied up in term repo deals at the Central Bank which is also similar to money printing delayed interest rates from adjusting, despite the budget deteriorating sharply from January 2015 with state salary hikes and subsidies.
After terminating term repurchase deals, the Central Bank started buying Treasury bills outright from June 2015, printing money, injecting rupee reserves into the banking system, driving credit to unsustainable levels and generating balance of payments pressure, which has been documented step by step by analysts.
Though gilt interest rates started to edge up with a more auctions-based selling process after term repo deals ended, the acquisition of Treasury bills prevented short term rates in particular from moving up fully. Bank one year fixed-deposits are still at record lows of under 7.0 percent still.
During the latest episode there have been renewed calls to abolish the Central Bank and re-establish a currency board or hard peg so that Sri Lanka cannot print money, resist market interest rates and collapse the currency. (A solution for Lanka’s monetary, fiscal woes).
A currency board will also prevent deceptive politicians from expanding the budget deficit suddenly as they come to understand money cannot be printed and sovereign default is inevitable when such actions are taken, analysts say.
Sri Lanka had low national debt (of 16 percent of GDP) and a fixed currency until a central bank was built in 1952 with money printing powers that de-stabilizes the currency.
On Tuesday the Central Bank printed tens of billions of rupees to avoid sovereign default and repay maturing bonds, official data show, with its Treasuries holding – the main domestic assets stock of the monetary authority – ratcheting up to 129 billion rupees from 91 billion rupees overnight.
Out of a nearly 80 billion rupee maturing bond tranche only 60 billion was rolled over to the market.
Part of the rise also came from overnight injections of liquidity to meet ongoing reserve outflows, with 12 billion rupees borrowed by the banking system through a liquidity window.
Excess rupee reserves in the banking system, deposited at the Central Bank rose to 48 billion rupees from 25 billion rupees on September 01, helped by the 12 rupees borrowed window as well as the bond settlement, minus reserve outflows for the day.
Authorities are expected to sell more bonds through subsequent bond auctions.
The Central Bank no longer gives Treasuries to those who deposit money at the standard liquidity window, but takes bills for money printed through reverse repo deals.
From June 01 to September 01, the Treasuries stock of the Central Bank, which is the main proxy for money printing, rose by 123.6 billion rupees, after unwinding existing reverse repo deals, giving an approximate guide to the volume of money printed in the period.
From published data it is known that provisional advances – another way money is printed to finance the budget deficit – rose by around 9 billion rupees in the first quarter.
In the last three months, excess reserves deposited in the banking system dropped from 97 billion rupees to 47, amid reserve outflows, despite the steady injection of newly minted money.
The monetary base also expanded by around 37 billion rupees amid low interest rates up to August 27, data show.
The deterioration of the credibility of the peg, which is shown by capital flight and exporter holdouts is a consequence of resisting market interest increases in the mistaken belief that the monetary authority is targeting a domestic anchor (a consumer price index), while actually targeting an external anchor (the dollar peg) analysts have said.
Indonesia, Malaysia, Thailand, Philippines and a number of Latin American countries have similar flaws in their central banks. But Hong Kong, and Singapore (modified currency board) has no policy rate.
The contradictory policy involved in a fundamentally flawed ‘dual anchor’ system is also described by economists as the ‘impossible trinity of monetary policy objectives’, where a central bank tries to control interest rate, and control cross border flows of money and fails on all counts.
Sri Lanka has limited capital controls now.
Credibility of Sri Lanka’s soft-peg was sharply undermined after an April rate cut, which analysts have compared to a policy rate cut in January 2011 which speeded up the 2011/2012 balance of payments crisis. In 2011/2012 there was no significant capital flight.
The rate cut and resistance to market interest rises came at a time of global uncertainty when the monetary system of the United States is also tightening.