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Sri Lanka should prepare to float, and promote parallel dollarization: Bellwether |

ECONOMYNEXT – Sri Lanka’s intensified forced dollar conversion rules of exporters and dollar salaries of residents is serious cascading policy error that will worsen the foreign currency crisis and the dollar liquidity crisis in bank funding books.

This will worsen the dollar funding crisis of banks that began to build up with credit downgrades in late 2020 as overseas banks cut limits to Sri Lanka and declined to roll-over maturing credit lines.

De-dollarization of deposits therefore is a soft-pegging cascading policy error.

Cascading Policy Errors

State banks in particular are exposed to Ceylon Petroleum Corporation loans, which have been taken during times of money printing by the central bank in another unusual cascading policy error, where it is barred from buying dollars in the market and is forced to borrow dollars.

This policy error has persisted for some time at least from the 1990s.

The practice of taking oil credits from Iran and now India when money printing creates forex shortages is an extension of the policy error.

The sudden rush to borrow abroad, instead of squeezing the current account, allows domestic economic agents to live off borrowings instead of their current earnings.

The financial account inflows widen the current account deficit. Central bank Mercantilists and other then complain of a widening current account deficit for BOP troubles.

Sri Lanka and third world central banks have an unfortunate tendency to make policy errors that worsens external troubles.

These policy errors can cascade into a mutually self re-inforcing vicious cycle that accelerates rapidly the last stages, as market participants get panicky.

When only one type of bank notes are in circulation, policy errors of the note-producer affects the entire credit system and therefore individuals and firms – which is generally called ‘the economy’.

Sri Lanka has to take quick action to restore the lost confidence in the rupee triggered by liquidity injections and cascading policy errors to avoid an acceleration of a monetary meltdown with serious consequences for all citizens and less affluent in particular.

Already inflation has risen to 9.9 percent far above the policy rate of 6.0 percent and difficulties in paying for imports are intensifying.

While getting ready for a possible float and a rate hike, the central bank should not engage in de-dollarization attempts but instead allow parallel dollarization.

Deposit Dollarization

With banks having loaned dollars to the government and the CPC, it is a mistake to stop dollar inflows going to dollar accounts of residents or any other person.

Banks had already reduced their negative net foreign asset position from 4.4 billion US dollars in October 2020 to around 2.8 billion by October 2021.

Banks had cut their dollar borrowings from around 5.3 billion dollars at the end of the third quarter of 2020 to about 3.8 billion dollars by the third quarter of 2021.

It was in part financed by foreign currency deposits which went up to 10.9 billion dollars by the end of September 2021 from 9.3 billion US dollars a year earlier.

Since banks have dollar loans to the government it is a mistake to stop dollar deposits.

The steep negative swap rates are an overt sign of this problem.

A part of these moneys will now be parked outside, reducing inflows, expecting a devaluation.

Bill stock musical chairs

Sri Lanka’s crippled bond markets are now limping back and the central bank has sold down some of its Treasuries stock held outright to market participants.

To permanently get rid of bills there has to be an interest rate that curbs domestic credit, which will reduce and generates and excess of dollars through a working spot or forward market for dollars.

However neither the spot nor forward markets are working.

In sharp contrast, due to the interest rate mis-match with dollar yields higher than rupee rates, implied forward rates in swaps are steeply negative.

As a result, any Treasury bills sold from the outright stock are taken back to the balance sheet of the central bank, through standard liquidity facility (SLF) window.

In October the central bank’s Treasury bill stock as published went down from 1,433.9 billion rupees to 1,466 billion rupees.

However in the same month, overnight injections made against Treasury bills went up from 261 billion rupees from 368 billion rupees.

After discounting the 31.5 billion rupees mopped up through repo auctions, the estimated Treasury bill stock had gone up from 1,755 billion rupees to about 1830 billion rupees ignoring any haircuts.

Sterilized Interventions

The reason this liquidity is injected is to maintain the policy rate of 6.0 percent.

Any dollar interventions made in the forex market to give dollars for oil or other imports will also be similarly offset with new liquidity injections.

This is the typical currency crisis that happens in a Latin America style central bank, even without a budget deficit.

Mexico for example defaulted in 1994 as the Fed hiked rates, with a budget surplus due to this sterilization of the balance of payments.

Sterilization of the balance of payments is the siren song of Latin America style central banks which try to maintain a policy rate despite strong domestic credit and external outflows.

Turkey is now in a similar situation.

Because of these liquidity injections outflows will continue to be higher than inflows creating parallel exchange rates.

Due to the parallel exchange rates, any central bank sanctioned imports will require more dollars from the central bank and more liquidity will be injected.

In short, the credibility of the peg where everyone will be willing to part with their dollars at the fixed rate will not come back, unless rates are very high.

Therefore authorities should be prepared for a float to end sterilized interventions, but in the meantime should allow parallel dollarization, not discourage it.

Jumping through the non-credible peg gap

Due to the legal tender monopoly in a soft-peg, Sri Lanka’s government finds it very difficult to get hold of dollars that come to the country to repay its dollar debt.

In a soft-pegged country (or hard pegged country), taxes are paid in domestic currency and domestic transactions happens in local currency due to legal tender laws.

The government first has to get hold of some rupees from taxes or borrowings and again exchange the money to US dollars, either by purchasing dollars in the forex market with the rupees (the raising of which should have reduced consumption, investment and therefore imports) or through a roundabout process via the central bank where reserves are appropriated against T-bills issued to the central bank.

In Sri Lanka while state agencies like Ceylon Petroleum or private importers can get dollars directly from exporters jumping through one hoop of the pegged system (buying dollars), the government has to jump through the hoop twice as the Treasury does not directly…

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