ECONOMYNEXT – Net foreign assets of Sri Lanka’s banking system turned positive in May 2024, official data showed, amid a steady reduction in the negative reserve position of the central bank helped by the current interest rate structure and domestic credit.
In May the combined net foreign assets position of commercial banks and the central bank was about 311 million US dollars by May, up from a negative 178 million US dollars a month earlier, central bank data show.
It was made up of positive 1.9 billion US dollar foreign assets position in overseas banking units and a negative 811-million-dollar position which gave a positive NFA position of about 1.13 billion US dollars for banks.
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The central bank still had a negative position of about 821 million dollars by May, down from about 4.5 billion US dollars in last currency crises triggered by deploying liquidity tools (printing money) to cut rates.
Since the rate hike in April 2022 the central bank had collected reserves or repaid debt amounting to 3.45 billion dollars. The other banks have built reserves or repaid debt amounting to 3.2 billion dollars.
The central bank has been collecting reserves for several months, except in June after a confidence shock from the flexible exchange rate and some injections made to keep rates down.
Analysts have warned that under flexible inflation targeting, where there are anchor conflicts, external imbalances will re-emerge when private credit recovers and money is printed to cut rates on statistical formulae, disregarding laws of nature explained by classical economists.
Printing after giving Reserves for Imports
Sri Lanka’s central bank ran up a negative foreign assets position from around 2021, by spending dollars borrowed from the International Monetary Fund and from other central banks and domestic banks through swaps to give reserves that it did not own to cover imports or loan repayments.
An ‘age-of-inflation’ (or age-of-BOP-deficit) central bank that spends reserve for imports, simultaneously prints money into banks, injecting excess rupee reserves to maintain an artificial policy rate, preventing the outflow of real resources to other countries being reflected in bank balance sheets.
The printing of money after spending reserves, or the sterilizing of an outflow, allow banks to give loans without deposits and trigger forex shortages, triggering a vicious cycle of credit, dollar losses, and more injections, which is generally known as a currency crisis.
To collect foreign assets, a central bank has to do the opposite, and sell its domestic asset portfolio down against dollars purchased from banks, at an appropriate interest rate, which will moderate domestic credit.
Modern IMF-prone reserve collecting central banks are able to mis-target rates beyond their reserves mostly with the aid of Central bank swaps.
Sri Lanka’s central bank also borrowed reserves from domestic banks through swaps, in a somewhat similar operation to the way Lebanon’s central bank borrowed dollars to show reserves instead of buying outright against domestic assets.
Borrowed Reserves
Central bank swaps were invented by the Federal Reserve to mis-target rates and avoid giving gold reserves as macro-economists printed money to target growth in the 1960s and the printed dollars boomeranged on itself from other Bretton Woods central banks that focused on stability.
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By March 2022, before rates were hiked, negative reserve position of Sri Lanka’s central bank was around 4.0 billion US dollars.
The negative position worsened to around 4.5 billion US dollars by the third quarter of 2022, helped by credits from Reserve Bank of India, which allowed Sri Lanka to run arrears on Asian Clearing Union balances.
In addition to the swaps, Sri Lanka also had borrowings from the International Monetary Fund which contributed to the negative foreign assets position.
The IMF borrowings came from serial currency crises triggered in the course of money printing to enforce rate cuts and target growth (potential output) and generate twice to three times the level of inflation found in monetarily stable countries through ‘flexible’ inflation targeting.
The external sector started to balance only after ACU credits were stopped. It has since been turned into a swap and the central bank is paying it down steadily in the current interest rate structure.
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Sri Lanka was unable to use a People’s Bank of China swap to mis-target rates and boost imports its use was barred after gross reserves fell below three months of imports.
Private and State Banks
Sri Lanka’s private and state banks also had negative foreign assets for many years, due to lending to the government through US dollar Sri Lanka Development Bonds and other credits. The dollar loans to the government were financed in part by foreign credit lines.
As downgrades hit the country, and forex shortages worsened from flexible inflation targeting/potential output targeting, banks could not renew their credit lines.
Some banks avoided rolling over Sri Lanka Development Bonds. After the default and debt restructure, they were repaid in rupees leading to banks covering their open positions. The dollars are banked abroad, leading a net foreign assets position.
An improvement of net foreign assets, reflects an outflow of dollars from the domestic economy to foreign accounts, similar to repaying debt for building foreign reserves.
The foreign assets position of banks excluding the central bank turned positive in February 2023 and reached around a billion US dollars by the year end and has remained broadly stable around those levels in 2024r.
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The stabilization of the NFA position in banks may allow the central bank to collect more foreign reserves than earlier, analysts say, at the current interest rate structure as long as money is not injected overnight or term injections to mis-target interest rates claiming inflation was low.
Any confidence shocks from the ‘flexible’ exchange rate or liquidity spikes, would also reduce the ability of the central bank to collect dollars and lead to mini ‘capital flight’ style episodes from importers and exporters. (Colombo/July20/2024)