In December 2023, Sri Lanka’s central bank purchased $113 million from forex markets, bringing the total collected in the year to $1.895 billion, supported by a deflationary policy, according to official data. This move came after allowing rates to rise from April 2022, marking the initial step in rectifying a balance of payments crisis triggered by rate cuts enforced through aggressive open market operations utilizing various liquidity tools.
Such rate cuts, coupled with liquidity injections by a reserve-collecting central bank, sparked forex shortages, followed by a rapid erosion of confidence as the ‘flexible’ exchange rate regime faltered and attempts to float ensued as the first line of defense. Subsequently, a substantial confidence shock, including credit downgrades, steep rate hikes, and economic contraction to suppress credit, was necessary to restore confidence in the currency and stabilize the monetary system.
By August/September 2023, Sri Lanka’s monetary stability was reinstated, allowing the central bank to acquire dollars and absorb the liquidity generated by these purchases. This effort was aided in part by counterparty limits on bank access to central bank-printed money through standing facilities. However, in Sri Lanka, most banks rely heavily on central bank windows due to longstanding loose monetary practices, with only a few foreign and local banks typically possessing excess rupee liquidity and acting as net sellers in the interbank forex market.
Critics argue that Sri Lanka’s standing facilities fail to provide intra-day liquidity at a premium to the policy rate, unlike practices in the UK and Vietnam, thus encouraging banks to overtrade and trigger forex shortages and monetary instability. This week, Sri Lanka’s central bank lifted the counterparty limit, a move analysts believe may have helped alleviate the worst currency crisis since the central bank’s establishment in 1950, driven by aggressive ‘macro-economic policy’ undermining monetary stability.
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Despite the monetary stability achieved through deflationary policy, the economy began to rebound in 2023, with interest rates declining. Although both the central bank and private banks amassed significant reserves, and the economy experienced a cyclical recovery, the central bank also permitted the exchange rate to appreciate. During the first year of an IMF program, with reserves being accumulated during the deleveraging phase, upward pressure on the exchange rate was observed, allowing for appreciation.
Throughout 2023, the central bank allowed the exchange rate to appreciate from around 362 to 320-330 levels, reaching approximately 315 in the first month of 2024. Analysts cautioned that following the end of a 30-year war, the central bank, in its second year of an IMF program, began to induce forex shortages by reverting to inflationary policy as the economy rebounded. Critics argue that the IMF’s encouragement of such practices, under the guise of ‘monetary policy modernization,’ ignores classical economic principles and promotes the adoption of floating-rate style liquidity operations, which are ill-suited for reserve-collecting central banks.
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Unlike floating-rate central banks with a positive inflation target, reserve-collecting central banks facing mis-targeted rates risk not only forex shortages from inflationary rate cuts but also price inflation and, if prolonged, asset price bubbles, particularly in property, leading to banking crises.
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