Sri Lanka busts half a billion dollars on soft-peg during ‘coup’

ECONOMYNEXT – Sri Lanka has spent half a billion US dollars to defend a soft-peg on the rupee in November 2018, during a so-called ‘constitutional coup’ which de-stabilized markets and triggered credit downgrades.

Unlike a hard peg, a soft-pegged central bank prints money after defending the currency by injecting more new rupees in the banking system to maintain artificial interest rates, provide non-existent deposits for banks to give new loans, in contradictory policy.

Sri Lanka’s President Maithripala Sirisena triggered a political crisis on October 26, by appointing ex-President Mahinda Rajapaksa as Prime Minister violating Sri Lanka’s constitution in a ‘constitutional coup’.

"Our key task is to restore economic stability that has been lost since Black Friday October 26," Samaraweera said after being re-appointed Finance Minister Thursday.

Samaraweera plans to present a interim budget for four months to parliament on Friday.

In November the central bank sold 519.23 million dollars to defend a soft peg at 180 to the US dollar and printed money through an overnight window, term reverse repo deals, at rates below the previous months and dumped tens of billions of rupees through reserve ratio cut.

Samaraweera said before the crisis, budgets have been carefully managed. But yields on dollar bonds jumped after the ‘coup’ and put off the table plans to roll-over a maturing bond in January 2019.

Yields have eased again over the past few days.

"We managed the economy very carefully trying to put as little burden on the people as possible, because we inherited a lot of debt," Samaraweera told last month.

"But the political crisis has now put the country on the path of a crisis.

"As a result of these actions, Sri Lanka is on the brink of economic anarchy and chaos as never experienced before."

Sri Lanka was downgraded by three rating agencies to ‘B’ from ‘B+’ during citing the political crisis.

Sri Lanka’s official forex reserves, – which include those held by the Treasury – dropped 884 million US dollars or 11.2 percent during November to 7,018 million US dollars.

Sri Lanka is more vulnerable than countries with hard-pegs or floating rates because it operates an archetypical unstable soft-peg labeled a ‘flexible exchange rate’, which is prone to crises due to liquidity injections.

Under an International Monetary Fund program, Sri Lanka was forced to collect forex reserves on a net basis which requires a de facto peg tighter than a currency board.

Analysts warned early that a program with strict ceilings on domestic asset of the central bank was needed to keep the agency on the straight and the narrow given its tendency to precipitate crises with artificial interest rates.

"In the opinion of this columnist a limits need to be put on the Treasury bill stock (progressively lowered NDA or Net Domestic Asset ceilings) to stop runaway monetizing by the central bank, with some leeway in June and December to ‘sell’ foreign reserves to the Treasury to repay debt," EN’s economic columnist Bellwether wrote as far back as April 2016 (Sri Lanka needs monetary reform, not just fiscal plaster: Bellwether).

"The last SBA lacked explicit NDA targets, which allowed the central bank more leeway to monetize debt (print money to sterilize foreign exchange sales) in 2011 even before the program was ended and precipitate a second BOP crisis."

But the IMF program’s monetary policy was based on an inflation target, requiring a floating exchange rate, where an assumption was made that rates can be cut by money printing, when inflation numbers were low (Sri Lanka IMF program sets inflation ceiling as key target).

As a result the monetary system was de-stabilized despite Samaraweera raising unpopular taxes, cutting deficits and market pricing fuel at great political cost.

In November the central bank also dumped tens of billions of free rupees into the banking system through a reserve ratio cut giving free money to banks and also allowing more of future deposits collected to be loaned to customers.

In October 303 million dollars were spent to defend the peg, and more money was printed to enforce artificial interest rates. The central bank defended the move saying it was only maintaining reserve money.

Pegs with contradictory policy came into widespread use after World War II, when the Bretton-Woods system of failed soft-pegs was set up under US pressure, breaking hard and specie pegs in Asia and Latin America including Sri Lanka, which had a stable hard-peg until 1951.

Bretton-Woods style soft-pegs triggered trade and exchange controls, political instability, inflation and currency collapses, bringing once stable countries to their knees and driving people into poverty.

Even the UK, once the lynchpin of a global financial system, suffered so-called Sterling crises and the US Fed was also hit by a balance of payments crisis, leading to the collapse of the Bretton-Woods system in 1971 making the dollar a floating fiat currency.

Sri Lanka then closed the entire economy.

Like in the 1970s, Sri Lanka also imposed trade controls in 2018 to maintain the soft-peg and artificial interest rates, torpedoing and discrediting the core policy agenda of the current administration.

There have been calls to reform the soft-peg with tighter rules and an overhaul of the domestic operations of the central bank making it harder for the central bank to enforce artificial interest rates by printing money to generate balance of payments pressure. (What Sri Lanka can do to improve the credibility of its dollar soft-peg: Bellwether) (Colombo/Dec21/2018)