ECONOMYNEXT – Sri Lanka net foreign reserves moved to positive territory in October 2024, with about 63 million over its reserve related liabilities, official data shows, after two years of deflationary policy with interest rates to match.
Sri Lanka’s central bank’s reserves became negative by 4.6 billion after rate cuts were enforced by inflationary direct and open market operations.
The central bank also borrowed reserves through swaps, and also busted a special drawing rights allocation (a type ‘reserve’ created by the International Monetary Fund) in the course of mistargeting rates through a policy rate which ended in a sovereign default.
A ‘transmission mechanism’ then spreads the mis-targeted rates along the yield curve.
When reserves were hitting negative territory during the last currency crisis, the central bank already had loans from the International Monetary Fund taken during currency crises triggered by earlier rate cuts.
When the currency eventually collapses due to the effect of inflationary open market operations, through which interventions made with swaps proceeds are sterilized, the central bank ends up with massive losses.
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Central bank swaps were invented in the 1960s by the US Fed as part of policy errors that led to high inflation in the 1960s (full employment/inflation growth trade off doctrine) and the eventual collapse of the Bretton Woods in 1971 firing commodity bubbles in the process (oil shocks).
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Sri Lanka has no laws banning central bank swaps, especially to domestic counterparties to prevent future quasi fiscal losses or monetary instability at the moment.
The initial swaps were negotiated by New York Fed forex desk chief Charles Coombs. The US eventually forced counterparty central banks to assume some of the losses, but Sri Lanka has no such political clout, analysts say.
Age of Inflation and OMO
Open market operations which ushered in the ‘age of inflation’ and repeated peacetime currency crises, was invented by the US Fed, initially for deflationary policy.
But they were used to create inflationary policy and trigger the Great Depression (a stabilization crisis), by New York Fed Chief Norman Strong to fire a massive economic bubble in the 1920s as the government ran budget surpluses.
From April 2022, after a surrender rule failed a float in March, rates were raised by the central bank’s new leadership, curbing domestic credit. Taxes were also raised to reduce demand from state credit.
When rate cuts enforced by inflationary open market operations undermine the credibility of the exchange rate triggering capital flight and multiple exchange rates, very high rates are required to restore credibility of the notes of the money monopoly by killing credit.
Many businesses that were effectively re-financed with borrowed or other reserves end up with bad loans and the country with higher unemployment, in what classical economists call a ‘stabilization crisis’.
Incumbent governments get thrown out both during the inflation crisis during the original rate cuts and also during the stabilization crises.
Reserves were collected by buying dollars and mopping up the liquidity created from dollar purchases, by selling down the central bank’s Treasuries stock.
Under deflationary policy – which is operated in the most successful East Asian export powerhouses – it is possible to fix or appreciate the currency and collect reserves.
Private credit is now recovering steadily but government and state enterprise credit is muted.
In Sri Lanka, private credit recovery and rate cuts converge under so-called data driven monetary policy for ‘flexible’ inflation targeting.
Rates are usually cut on the doctrine that historical 12-month inflation is low and therefore it is possible to cut rates and also enforce them through printing money or inflationary open market operations.
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There have been warnings that inflationary open market operations and credit recovery are converging again. Volumes have come down slightly since then. Last week rates were cut and a single policy rate, similar to mid corridor targeting was introduced. (Colombo/Dec03/2024)
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