ECONOMYNEXT – Sri Lanka’s excess reserves deposited in the central bank above required reserves under a statutory ratio has reached 230 billion rupees, close levels that existed before a currency crises gathered pace in 2021, official data show.
On Thursday excess reserves topped 246 billon rupees, about 20 billion rupees shy of the peak reached under President Gotabaya Rajapaksa in 2021, when private credit started to recover as the country emerged from a Coronavirus crisis.
At the time money was printed by so-called direct market operations where Treasury bill auctions were scuttled with price controls (floor auction rates) imposed by the central bank.
Initially the excess liquidity piled up un-used, due to weak private credit and did not hit the balance of payments.
In 2024 excess liquidity is coming mostly from a surplus balance of payments (dollars purchased to maintain a pegged exchange rate), amid weak credit.
However the central bank is also injecting about 40-50 billion rupees in term money and about 30 billion rupees overnight to keep excess liquidity up.
On some days more money than needed under its forecasts are offered, with banks appearing to be placing dummy bids, analysts have warned.
The extra money, on top of a BOP surplus appears to be printed to suppress call market rates.
The central bank shifted to a so-called ‘single policy rate’ similar to targeting a mid-corridor rate which critics say allows the agency to mis-target rates more easily than though a ceiling rate regime, where banks are forced to manage liquidity more prudently.
Sri Lanka’s private credit is starting to pick up and any credit that is financed by excess liquidity will tend to pressure the currency as they are not linked to cash inflows in to the banking system at the time (new deposits and loan repayments).
In December however there is a cash drawdown from the system due to a festival needs (a real money demand). In the past, Sri Lanka’s BOP troubles had tended to emerge around February, when state salary hikes are also made and droughts push up fuel imports.
Rate cuts enforced by direct or open market operations in April, then trigger a full blown currency crisis after May.
The point-of-no-return rate cut was dubbed the ‘unkindest cut of all’ by analysts in 2015. (Sri Lanka knocks hard at BOP crisis door: Bellwether).
While most of the current excess liquidity is coming from a surplus BOP at the moment, the central bank does not have a commitment to defend the currency against unsterilized excess liquidity under its ‘flexible exchange rate’ of uncertain pegging when the economy and credit recovers.
The use of liquidity – even from a surplus BOP – could drive up prices of goods which cannot be readily imported due to trade controls.
Part of the excess liquidity is with foreign banks, which are careful about lending in the market. Foreign banks have a history of prudent liquidity management and not funding their credit through central bank windows and creating forex shortages.
Sri Lanka has exchange and trade controls, which shows that the operating framework of the central bank is already deeply flawed and the flaws are covered up by limiting economic freedoms of the general public and businesses.
Rate cuts enforced by open market operations without regard to the BOP is done either to target potential output (a type of full employment doctrine under a different label) or higher cost of living (a Phillips Curve doctrine under a different label) (Colombo/Dec09/2024).