Sri Lankan rupee’s unreliable peg at 203 per dollar leads to dollar rationing and rates rise

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ECONOMYNEXT – Sri Lanka’s non-credible peg with the US dollar at 203 leads to dollar rationing, market participants said as monetary authority attempt to ration rupee production pushes market rates up , but has not yet fully succeeded.

Banks have prioritized sourcing food imports in dollars in recent days, especially items like milk, where the Consumer Affairs Authority has created a shortage with its price control gazettes.

Importers, including LPG and some building materials, are asking for dollars and banks are trying to help them, according to market participants.

Sri Lanka’s central bank printed large volumes of money, triggering credit and causing outflows greater than total inflows into the country and shattering the credibility of a dollar peg. In August, private credit on the rupee books of banks was Rs 104 billion.

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There had been off-market settlement of dollars at rates up to 230 per US dollar, but activity declined following a central bank order that led to more intensive rationing of the dollar.

However, some off-market settlements take place between friendly parties, at around 215-220 per US dollar, according to trade sources, with the central bank not offering full convertibility for the rupees it creates, although it does wants to maintain parity at 203 for the US dollar.

A buyout rule further undermines the anchor which is weakened by liquidity with negative convertibility creating more liquidity, analysts say. However, many third world central banks with volatile currencies, including Zimbabwe’s, have done so, analysts say.

Partial convertibility

A central bank cannot maintain an anchor without ensuring the convertibility of the currency it creates. However, some convertibility had been provided to food importers over the past week following an order from Prime Minister Mahinda Rajapaksa.

Sri Lanka has had external problems since the creation of a Latin American-style central bank in 1950, breaking down a credible anchor that had held the country stable during two world wars and a Great Depression.

Sri Lanka (then Ceylon) only had problems depreciating (against the pound-gold) when the price of silver started to fall after the “panic of 1893”, but the parity was holding. always, according to analysts.

When the credibility of the peg is undermined by artificially low interest rates, large spikes are needed to restore confidence in soft peg money. The “better” the economy is (stronger private credit), the more difficult it is to restore credibility.

Central banks that operate credible anchors are able to bring stability to those who use the currency, which ultimately results in low inflation (preservation of capital) and low interest rates.

Sri Lanka’s current problems and the rupee’s loss of credibility are due to extreme stimulus and the removal of rates all along the yield curve through price controls, despite the widening budget deficit by through tax cuts and hiring unemployed graduates amid a pandemic.

As long as money is printed to buy bonds from failed auctions, problems with the rupee will persist, analysts have warned.

“A partially failed bond auction is as good as a totally failed bond auction, as both result in cash injections that undermine the anchor,” said Bellwether, business columnist for EN.

“Failed auctions will also lead to a sterilization trap where the central bank is forced to sift through the pension auctions it creates through failed auctions.

“However, a float (full suspension of convertibility) will also not work if bond auctions fail or the Treasury borrows on government bank overdrafts that are refinanced with box office money.”

Bond yields soared on Tuesday as the government tried to roll over maturing bonds and pay a coupon at a Rs100 billion auction.

A 2023 bond that has been auctioned at an average yield of 9.36% is estimated to have a threshold of 9.80%. The bond was listed at 9.50 / 10.00 on Wednesday.

A 2017 bond that had an average auction of 11.14% and a 2030 bond that delivered an average auction of 11.23% would have thresholds of around 11.90%.

An 86 billion rupee treasury bill auction is scheduled for Wednesday. Market rates are catching up with the budget deficit, but deposit rates must also increase.

For investors to feel comfortable holding bonds, rates must rise to levels that allow any hike in key rates to catch up.

But partially failed bond auctions that inject liquidity can lead to excessive rate hikes even as monetary instability persists, analysts say.

A monetary policy decision is due to be made public on October 14.

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Sri Lanka bond auction yields increase by around 100bp across all maturities

Sri Lanka’s bond auctions have failed since national economic activity improved and the country’s note-issuing bank began issuing too many banknotes to keep rates low.

The failure of auctions of domestic bonds, the price of which is artificially supported by central bank purchases (in reality an inability of the government itself to service the domestic debt) leads to an inability of the government to ensure the debt. external debt service.

In Latin American countries like Argentina, where public budgets are much better, the external fault stems from the loss of credibility due to the non-renewal of sterilization certificates at auction.

Aggregate demand bubble

The US Fed is printing money despite a post-Covid recovery creating all kinds of distortions around the world, including a commodities bubble.

Sri Lanka’s policymakers last year pointed to Jerome Powell’s silver print as a justification for domestic policy mistakes.

The International Monetary Fund says the post-Covid recovery was unusual and has unique characteristics.

“There are both labor shortages and unemployment,” IMF chief economist Gita Gopinath said in October 2021, releasing the agency’s report on the Outlook for the future. ‘Mondial economy.

Related Sri Lanka 2021 GDP growth lowered to 3.6% by IMF, global growth lowered

Critics say the economic disruption is one of the results of triggering blind aggregate demand bubbles, also known as the Keynesian Stimulus Policy or the John Law Policy.

Nobel laureate Friederick Hayek explained how it was done.

“Just as there cannot be a uniform price for all kinds of labor, equality of demand and supply of labor, in general, cannot be ensured by managing aggregate demand,” he said. he wrote.

“The volume of employment depends on the correspondence of supply and demand in each sector of the economy, and therefore on the structure of wages and demand between sectors.

Finally, as inflation stops accelerating, unemployment is higher than before. (Colombo / Oct 14, 2021)


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