Sri Lanka overnight money markets dry up as soft-peg drives up counterparty risks


ECONOMYNEXT – Sri Lanka’s overnight call money markets have dried up in rising counterparty risks contradictory money and exchange policy continue and authorities fail to establish a working peg or floating exchange rate amid interventions.

Though policy rates have been raised the central bank has continued to print money to accommodate various activities with its Treasury bills stock representing permanently injected money rising to 2,269 billion rupees from 2,234 billion a week earlier.

Over trading banks which gave loans without deposits are borrowing another 766 billion rupees overnight from the central bank while more cautious plus banks have deposited 315 billion rupees in the monetary authority instead of lending in the interbank market.

Cash plus banks are reluctant to lend to banks which are facing liquidity shortages. Many banks which face rupee liquidity shortages are also facing dollar liquidity shortages.

The central bank has no limit per individual bank to restrain central bank credit. There have been calls to tame the central bank domestic operations through strict limits.

Sri Lanka has a Latin America style central bank where reserve sales are sterilized as a matter of course to maintain an artificial policy rate leading to a balance of payment deficit.

Latin America style sterilizing central banks were set up rejecting basic classical money anchoring theory including those of David Ricardo and David Hume and giving tools to state bureaucrats to destroy sound money to keep interest rates down.

The central bank attempted to float the currency to end money and exchange policy contradictions (suspend convertibility) but the attempt failed amid a surrender requirement and the rupee fell from 200 to 360 to the US dollars.

Overnight call market lending by plus banks to short banks which were around 50 to 60 billion rupees at the time the float started has now declined to around zero.

The central bank has now run out of reserves to intervene in forex markets and is borrowing dollars from India to continue to finance imports which analysts say leads to worsening loan to deposit ratios of central banks.


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

Foreign banks are among the cash plus banks. Cash plus banks have little or no risk limits to counter parties making it difficult for them to trade, market participants say.

Sri Lanka’s central bank started aggressive open market operations after the end of a civil war and they worsened after the third quarter of 2014 in a bid to maintain artificially low interest rates as domestic credit recovered in the post-civil war period, leading to three forex crises is seven years, heavy foreign borrowing and eventually default.

Most Latin America style sterilizing central banks trigger sovereign debt default repeatedly in cycles after printing money to suppress rates despite having lower deficits and national debt than Sri Lanka.

Sri Lanka, is following the failed policies of Robert Triffin-Raul Prebisch, John H Williams, John Williamson which drove both the US and the UK into severe monetary difficulties and political turmoil until 1980, critics have said.

In a draft monetary law, Williamson style BBC/REER targeting policy is to be legitimized through a reserve collecting soft-peg called a flexible exchange rate (a permanently depreciating non-floating exchange regime).

As the US tightened policy from the 1980s, economies in countries in which central banks were set up or issue departments were made more aggressive through Prebisch-Triffin reforms collapsed and defaulted like Sri Lanka.

In Sri Lanka a Latin America style central bank was set up by a US money doctor giving the ability to economists to engage in monetary financing of imports and deficits and trigger currency crises from 1950.

Persisting currency crises and high rates from the failure to establish a float or re-pegging where credibility is restored, then lead to banking crises.

Drying up of call markets represents risk perceptions at an institutional lender level which have not yet permeated to the general public, showing there is still a window to restore a credible monetary regime, analysts say. (Colombo/July20/2022)

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