ECONOMYNEXT – A debate is raging in Sri Lanka over open market operations of the central bank, several years after wide acceptance was gained among the public and policy makers that primary market purchases led to monetary instability.
The debate in part appears to have been sparked by a column in EconomyNext which warned against the dangers of open market injections of money by the central bank as private credit starts to recover.
After several years of debate which started about almost two decades ago, there is general acceptance in Sri Lanka now that outright purchases of Treasury securities primary market (auctions) are bad and also that so-called ‘provisional advances’ by the central bank is bad.
In an outright purchase by the central bank of a new issue of Treasury bills, the money goes into the DST accounts of a state bank, which will be spent and end up in a private or state bank account customer, boosting rupee reserves of the bank, explains EN’s economic columnist Bellwether.
The money will then be loaned to a customer.
In an open market (outright) purchase, the new money goes directly into a private or state bank, which it may lend to a customer and to generate economic activity and imports. Private credit is important since they generate imports. Most non-project state spending domestic in the first instance.
If the central bank bought maturing bills in an auction (which was usually the case in the past) the money can go into either private or state banks, or to their customers who were previous owners of the bills effectively monetizing privately held securities from ‘previous’ budget deficits.
When the central bank gives a provisional advance (which the last draft central bank law attempted outlaw) the money goes into a state bank DST account. The money was expected to be repaid in six months, but in practice was rolled over like term reverse repo deals.
“Term reverse repo operations (purchase and re-sale) by the central bank, or overnight operations which are rolled over, are exactly like provisional advances,” says Bellwether.
“It can go either into a private or state bank. While the labels are different, the actions are the same. If you accept that one is a problem, so is the other. Either way these new moneys are eventually used by private borrowers, and then balance of payments troubles start.
“What we have seen in the past is that when attempts are made to push down short-term rates towards the floor through domestic operations, very large volumes of money have to be pumped into banks.”
As the debate started, some members of the public also started to blame the current administration for printing money through open market operations, not understanding that the central bank was supposed to be ‘independent’ of the government.
Because the central bank is a state agency and money is a government monopoly, people naturally hold the political leadership accountable for actions the central bank.
“This is an important lesson for all legislators,” says Bellwether.
“The same problem is seen in the US where Kamala Harris is blamed for inflation and the high cost of living, which was created by Jerome Powell and the Fed, through liquidity operations in both government and agency debt.
“Unlike in floating exchange rates, where price inflation in an index may be seen 18 to 24 months down the line, in a managed exchange rate (soft-peg), currency troubles happen quite fast when private credit is active.”
The last external default in Argentina was also triggered by balance of payments problems that started with BCRA’s OMO, specifically failing to roll-over a sterilization security called Leliq and dumping pesos into the banking system, Bellwether says.
This is an important lesson for Sri Lanka which is experiencing its first default.
As the debate picked up, the central bank also weighed in.
Please read the story here: Sri Lanka central bank defends open market operations as concerns rise
Some of the central bank’s recent OMO injections were to part-offset liquidity shortages coming from outright sales of securities by not subscribing to maturing bills.
This is not dis-similar to the repo facilities offered by the Fed as it continues quantity tightening, in the form of not subscribing to maturing bills.
However, the concern is about open market injections which lead to net increases in liquidity (money or circulating medium), made to suppress rates, especially as private credit recovers.
Since Sri Lanka has a pegged or managed exchange rate and not a clean float (labelled as other, managed by the IMF) and there is a foreign reserves target, such actions will lead to forex pressure when private credit picks up.
Open market operations as known today were originally invented by the Fed in the 1920s which led to the ‘Roaring 20s’ bubble and the Great Depression. Later such actions also led to the collapse of the US dollar and the Bretton Woods.
The entire housing bubble was also fired by open market purchases of securities by the Fed.