Central Bank of Sri Lanka $3.6bn net debt, large quasi-fiscal losses from March

ECONOMYNEXT – Sri Lanka’s central bank’s net liabilities had reached 734 billion rupees (US$3.6 billion) in February 2022, when gross reserves were reported at US$2,311 million in the same month as the agency borrowed dollars after running out of reserves.

The central bank has about $2.2 billion in swaps with the Reserve Bank of India, Bangladesh Bank, People’s Bank of China and domestic counterparties.

It also has a US$1.3 billion loan from China. The central bank also has an allocation of special drawing rights, after the sale of its SDR holdings.

The central bank has also postponed cross-border payments to India under the Asian Clearing Union.

Quasi-fiscal losses

When the central bank has net liabilities, it incurs large so-called quasi-fiscal losses.

In March, when the currency fell from 201 to 299 to the US dollar, the agency would have recorded a loss of at least 257 billion rupees, even though net liabilities did not increase during the month. The data showed gross reserves fell by more than $300 million in March.

The central bank does, however, hold over two trillion in treasury bills and bonds, which would generate profits via interest income, although there are also losses in market value.

Such quasi-fiscal losses and dollar debts can wipe out a central bank if it has not secured external assistance, such as from the International Monetary Fund, the currency can fall sharply and die unless loosely pegged authorities have the courage to float (overcome ‘fear of floating’).

Sri Lanka last week raised its key rate to 14.5%, which may reduce domestic credit and help the currency peg.

Analysts called for the removal of a repurchase requirement to prevent the rupee from dying a natural death.

Sri Lanka’s credit system became increasingly unstable under ‘flexible inflation targeting’ as politics became detached from the rules.

Mercantilism

A “flexible exchange rate” or loosely pegged central bank loses reserves when it prints money to finance the deficit or maintain rates (inflationary policy), domestic credit and imports exceed foreign receipts, which which puts pressure on its monetary peg.

When interventions are made to prevent the peg from falling (reserves are given for imports to maintain the peg), foreign assets fall.

That reserves can be used for imports is a popular mercantilist myth widely held in Sri Lanka.

Reserves are past savings. When reserves are used for imports (and intervention is sterilized with new money to maintain the policy rate), the external current account deficit increases and net central bank and government liabilities increase .

If the reserves are used to repay the debt, the assets and the liabilities decrease in proportion.

However, when money is printed to keep rates low in inflationary policy and domestic credit and imports rise, the central bank is unable to replenish the reserves (recollect savings) that were used to repay the debt, due to excessive domestic credit and consumption. triggering a monetary crisis and default.

State consumption also rose under “income-based fiscal consolidation,” critics said, as large volumes of taxes levied on the private sector went to state workers. and to politically favored pressure groups. (Colombo/April 11, 2022)

Ann J. Cox