Sri Lanka continues monetary financing of imports, pegging after ‘running out’ of reserves

ECONOMYNEXT – Sri Lanka’s central bank has spent 222.73 million US dollars defending a peg and engaging in monetary financing of imports in June 2022, three months after apparently ‘running out’ of reserves, official data show.

Sri Lanka defaulted in April 2012 after two years of money printing to suppress interest rates combined with tax cuts in the worst currency crisis triggered by the central bank in its history.

At the time officials said the country had run out of reserves.

In March the rupee collapsed from 200 to 360 to the US after a botched attempt at floating (suspending convertibility) with a surrender rule (forced dollar sales to the central bank) and too low policy rates to curtail credit.

However the central bank continued to intervene in forex markets in both sides of a peg (now around 360 to the US dollar).

In June the central bank had bought 68 million dollars from banks, which are experiencing severe forex shortages due to a dysfunctional peg, down from 76.6 million US dollars a month earlier, putting pressure on the peg.

The central bank then sold 222.74 million dollars to defend the peg, engaging in monetary financing of imports.

The central bank gets deferred payments from the Reserve Bank of India and spends them on monetary financing of imports getting deeper into debt.

After giving dollars for imports, a pegged central bank then sterilizes the intervention injecting new money to maintain a policy rate and prevent reserve money from shrinking, effectively monetary financing imports by replacing lost rupee reserves in banks.

Howver June reserve money growth slowed amid high interest rates, and is appearing to be shrinking in July as the economy is smashed by high interest rates and forex shortages.

In Sri Lanka there is a strong belief among economists who have rejected classical theory and also the business community that reserves should be used to finance imports and help the country live beyond its means due to the rejection of classical economics.

Sri Lanka also tried to get 6.0 billion US dollars of ‘bridging finance’ for imports and other spending in 2022 after defaulting in April 2012.

Since defaulting in April and running out of reserves, 337 million dollars had been spent on interventions with energy sector officials in particular pressing the central bank for money to import oil via pegging (weak side convertibility).

Clean floating central bank do not give a cent for imports.

Economists in authority Sri Lanka got the ability to create currency crises on August 28, 1950 with the creation of a money printing soft-peg after abolishing a hard peg that had kept the country stable for almost 70 years.

Analysts had warned that contradictory policy and a botched float would lead to continued monetary instability and high interest rates with damaging effects on the banking system unless a working monetary regime is established. (Colombo/July18/2022)