COLOMBO – Sri Lanka’s central bank has mopped up 546 billion rupees of domestic money, out of a total of 578.5 billion rupees created by the purchase of foreign exchange in the six months to June 2024, official data showed.

The central bank had generated 538.1 billion rupees from forex purchases from the market, a Market Operations Report showed.

The central bank had also generated 40.4 billion rupees net from buying official foreign loan proceeds after settling any loans.

Analysts have warned that one of the ways the rupee is pressured by the deeply flawed operational framework of an IMF-prone central bank is through the surrender by the Treasury of its dollar receipts, creating new money.

Government surrenders have a devastating effect on the currency, when the exchange rate is already under pressure, driving up credit and requiring an even greater contraction of the economy to end any external crisis triggered by mis-targeted short-term rates, analysts have said.

Any IMF loan, which is given to the Treasury in this bailout, would contribute to currency instability if they are surrendered to the central bank and proceeds not mopped up, or if unsterilized proceeds are not used to defend the currency when the Treasury or government suppliers use the generated rupees for imports.

Surrenders of export proceeds (to the central bank not to commercial banks) also weaken an exchange rate.

By mopping up or ‘sterilizing’ the rupees generated from dollar purchases (inflows) against permanent domestic assets transactions, like sell-downs of Treasury bills, or terminating reverse repo deals (not fx swaps or repo deals or overnight deposits which are renewed at the option of the counterparty), a central bank can permanently build foreign reserves which are not demanded back through imports.

Deflationary Operations

The central bank sold down 148 billion rupees worth of Treasury bills from January to June 2024 mopping up part of the liquidity generated from dollar purchases.

Up to June, the central bank’s FX swap operations had led to a net 29.2 billion reduction in liquidity.

Central bank swap with domestic counterparties which create money when initiated, also leads to money printing when private credit has recovered, as the liquidity is re-injected when there is a policy rate.

Other central bank transactions including through the statutory reserve ratio deposits had led to a reduction of 143.0 billion rupees in liquidity.

Termination of term reverse repo deals, led to liquidity withdrawals of 154 billion rupees.

From the end of December 2023 to the end of June 2024 the overnight interbank balance (the net of window operations and overnight reverse repo (and repo if any) rose by 32.79 billion rupees, from 87.6 billion to 120.39 billion rupees.

Since the crisis of the overnight cash is voluntarily sterilized by foreign banks in the central bank’s deposit window.

Analysts have pointed out that the central bank can continue to print money through various tools, including by initiating term or outright purchases of domestic securities to generate levels of inflation as high as 5 or 7%, even though the public has been told by macro-economists that the agency cannot print money under a new law.

For the duration of the IMF program, there is a b-monthly ceiling on domestic assets as a performance criterion.

The central bank can also trigger short-term pressure on the currency through term or overnight injections.

In 2023 the central bank hand-injected term money for up to 90 days and in 2024 up to 31 days to overtrading banks that lack sufficient deposits. There are also no known limits on injecting overnight money into overtrading banks anymore.

By the end of 2022, banks had borrowed around 600 billion rupees through the overnight widow while risk-averse ones deposited money.

2023 Operations

In 2023 the central bank had generated 558.7 billion rupees of liquidity through dollar purchases, 225.1 billion through swaps, 167.9 billion rupees through injections including SRR (any cuts in SRR inject money.

Hikes in SRR lead to an immediate reduction in liquidity in theory but an IMF-prone central bank will immediately inject the money through one or more of its tools.

Loan repayments led to a 66.4 billion rupee liquidity fall and currency withdrawals of 159.9 billion rupees.

The central bank sold down 584.6 billion worth of Treasury bills into liquidity generated from dollars purchased.

About 71 billion rupees had been injected through term reverse repo deals, 107.5 billion in provisional advances.

In the 12 months of 2023, a total of 1,129.6 billion rupees were injected through dollar purchases and domestic operations and 810.9 billion rupees were withdrawn through various contractionary transactions.

The overnight aggregate balance of the interbank system, inclusive of deposits and borrowings from central bank lending/deposit windows and overnight injections changed from a negative 231.25 billion rupees at the start of the year, to a positive 87.6 billion rupees by the year-end.

Though the balance is referred to as a ‘short’ in general parlance, banks borrow the money through overnight operations leading to a mis-targeting of rates.

Borrowings from the overnight window which were 561.64 at the end of 2022, and contributed to the mis-targeting of rates that led to a currency crisis and external default, were reduced to 72.16 billion rupees by the end of the year.

As long as net domestic operations are deflationary (net withdrawals made possible by an appropriate rate to balance domestic investments) there will be a rise in net forex reserves and a balance of payments surplus (as defined).

If the injections are inflationary there will be a balance of payments deficit and pressure on the currency.

From around September 2022, the impact of reduced private credit and halted injections started to show up in the balance of payments.

Most East Asian nations and Gulf Co-operation Countries run deflationary operations leading to strong or fixed currencies and monetary reserve collections which exceed reserve money.

Currency board arrangements are neither deflationary nor inflationary and reserve money goes in step with monetary reserve collections as there is no bureaucratic policy rate.

-economynext.com