ECONOMYNEXT - Sri Lanka has used risky bank borrowings to repay maturing long bonds it has been revealed, raising questions on the role played by the move in an April shock to the monetary system from tens of billions of newly created money that hit the credibility of a dollar peg and sent the rupee crashing down.
The rupee which was 155.50/80 on March 28, had collapsed to 158.80 levels in the spot market by May after large volumes of money was printed to keep rates down as overnight rates spiked in April.
Meanwhile the monetary system turned from being a firm peg with where base money was driven by the acquisition of foreign assets up to March, to an unstable peg with liquidity driven by domestic assets, a problem associated with so-called soft-pegs which gets de-stabilized easily.
It has now been revealed that Sri Lanka has repaid tens of billions of rupees on April 02 by overdrawing state banks, in the belief by authorities that an earlier pay-down of an overdraft had created a 'buffer'.
The event is also raising questions whether the overdrafts were then re-financed by central bank liquidity injections and a rate spike in late March was from a state banks scrambling to find money to cover an overdraft amid a seasonal real demand for cash in a traditional New Year period.
One March 28, Sri Lanka offered 80 billion rupees of bonds, for settlement on April 02, sharply lower than the total maturing volume and interest coupons, which was estimated to be over 100 billion rupees.
On April 02, the balance maturing bonds and interest coupons were repaid by overdrawing state banks, turning a paper security in the hands of savers and bank balance sheets into loanable liquid cash.
The 'buffer'
The central bank, which is managing debt on behalf of the Treasury says it has sold Treasury bills from June 2017, in excess of daily cash needs to pay down pre-existing overdrafts at state banks, to create a 'buffer'.
"So for example last year, during the period of July to December we were able to build a 100 Billion buffer, especially for the debt service payments process," Deputy Governor C J P Siriwardene said.
"Similarly that process is continuing now. Even now for example, last month we have raised more than 20 billion additional funds from the market by issuing Treasury bills for the debt service payments."
Under a new liability management law, two accounts would be created to keep funds, including a dollar account, but in the meantime, overdrafts and the Bank of Ceylon and People's Bank were being paid down, he said.
State banks, including the Bank of Ceylon, was then free to loan the cash to other customers boosting credit. No cash was especially ring fenced or placed at the central bank to meet the sudden overdraft.
When tens of billions of rupees are overdrawn in to repay bonds later, the Bank of Ceylon or People's Bank may have to go to the central bank's liquidity windows get new cash, expanding reserve money and eventually pushing the rupee down when imports are paid for with the newly created cash.
Central Bank Re-finance
Deputy Governor Nandalal Weerasinghe says the question of whether the funds were separately earmarked would not arise if the Bank of Ceylon could borrow from other market participants and lend to the Treasury, without creating new money.
The original paying down of the overdraft with money raised from T-bill sales will not create new money either, he pointed out (unless a dealer went to the window to get new money to bid for the bill auction in the first place).
Under current rules, no bank has to keep funds in the central bank in excess of the statutory reserve ratio (SRR), he said. Analysts say however that prudent foreign banks routinely keep excess funds.
"It does not require Bank of Ceylon to have 50 billion readily available in their accounts," Weerasinghe explained (assuming for example that 50 billion was needed to repay a part of a bond maturity).
"They are coming to the window depending on whether they maintain surplus liquidity or a deficit.
"If they are below the SRR, it does not matter whether government comes or not they have to either borrow from the interbank market or us."
Weerasinghe said the central bank will inject (create new money) or withdraw money depending on whether there was a deficit or surplus in the interbank market.
A chronic benign overall interbank surplus develops in Sri Lanka usually when credit slows in the months following rate hikes made to end a balance of payments crisis and the central bank buys dollars (unsterilized or partially sterilized dollar purchases).
An overall cash deficit can develop when the central bank sells dollars to defend the currency (unsterilized sale) or when money goes out of the system due to a real demand for cash, such as in the Sinhala and Tamil New Year period.
Small daily variations can happen due to cash demand by bank customers. In general, the monetary base (notes in circulation and statutory reserve at the central bank) will expand with economic activity and inflation or both.
"If there is a deficit in the market and the Bank of Ceylon is in a deficit, then for the overall deficit we will conduct the (reverse repo) auction," Weerasinghe explains.
Monetizing
Analysts say a dangerous cash surplus can develop when the central bank buys Treasury bills outright to finance budget deficit (straight monetizing of debt), which if done persistently, when credit growth is strong, leads to a balance of payments crisis and high inflation.
If the central bank injects money through reverse repo auctions to finance banks which are lending irresponsibly without deposits, while responsible banks have deposits and excess money in the central bank's standing deposit window, also a surplus could develop.
Looking at the data in late March and April also raises more questions.
On March 27, the interbank market had an aggregate surplus of 31 billion rupees, with some banks borrowing 1.7 billion from the window and the central bank mopping up 25 billion rupees overnight.
On the same day, the weighted average overnight repo rate, where market participants give loans to each backed by Treasuries, was 7.64 percent, about 40 basis points above the7.25 percent repo window rate indicating the policy corridor floor.
The maximum rate at which market participants borrowed on that day was 8.00 percent.
On March 28, the overall surplus dropped sharply to 6.1 billion rupees for reasons that are not clear and banks with cash deficits were borrowing 6.79 billion rupees and excess banks were depositing 12.80 billion in the central bank's window.
On the same day, the weighted average overnight repo rate, was 7.66 percent and maximum rate was 8.00 percent.
Rate Spike
On March 29, the last market day before the maturing bonds were to be repaid, the overnight weighted average rate jumped suddenly to 8.21 percent and the maximum rate to 8.45 percent.
The ceiling policy rate at which market players could get newly created money from the reverse repo window was 8.75 percent.
On the same day the central bank injected 20 billion rupees in new money through a one-day auction into the banking system at rates as high as 8.75 percent, while another 1.79 billion rupees was borrowed from the 8.75 percent window.
The overall surplus was a marginal 0.47 billion rupees, with 25 billion rupees deposited in the excess cash window of the central bank, up from 12.8 billion rupees a day earlier.
On April 02, the day bonds were repaid, 30 billion rupees was injected at an average repo rate increased further to 8.21 percent with some borrowing at 8.6 percent.
On the same day central bank's Treasury bill stock also rose to 43.9 billion rupees from 12.9 billion rupees a day earlier based on the way data is released now.
The average repo rate was 8.40 percent and the maximum rate rose to 8.65 percent.
After the bond repayment excess banks - which could have included banks whose bonds were repaid - had deposited 30 billion rupees in the central bank's repo window and while others borrowed 2.52 billion rupees.
End of the day liquidity was a deficit of 2.14 billion rupees.
On April 03 the average repo rate rose further to 8.42 percent and the maximum rate to 8.65 percent.
The central bank injected 25 billion rupees for two days through a reverse repo auction on April 03 at an average rate of 8.6 percent after offering 50 billion rupees, which is about 5 percent of the country's entire monetary base (about the equivalent of 300 million US dollars).
End of the day excess liquidity rose to 11.67 billion rupees.
Clean money rates where banks deal also kept pace.
On April 03, 38 billion rupees were deposited in the central bank instead of being loaned to others.
Excess Liquidity and Counterparty Risk
Though some banks may be in excess, they cannot lend all the money to other banks, because risk limits prohibit them from doing so. Foreign banks in particular have strict limits with counter parties.
Instead they will have to lend to customers or buy bonds.
In Si Lanka after an oil hedging fiasco as well as turmoil in Treasury bonds markets in recent years, counter party limits have tightened.
On April 04, the central bank said it was cutting the ceiling reverse repo window rate to 8.50 percent from 8.75 percent, the first time since the balance of payments crisis ended.
On the same day another 12.85 billion rupees was injected at a sharply lower average rate of 8.07 percent.
Excess liquidity jumped to 31.2 billion rupees. Excess banks deposited 44 billion rupees in the window. Overall excess liquidity jumped to 31 billion rupees.
After the New Year the rupee started to fall, but the central bank did not intervene despite having injected tens of billions of rupees in the banking system or kill the liquidity quickly at the first time of trouble in the peg.
More money was injected in subsequent days for longer terms. In the New Year however in all years, money has to be injected to feed the real demand in cash.
Bank Borrowings
Questions asked what role the bond repayment played in a mystery rate spike in the last days of May, which was then followed by a rate cut and more liquidity injections, particularly since festival cash is a normal occurrence in Sri Lanka, which needs deeper study.
The situation is further complicated by a tax change in bonds that pushed up gilt yields.
However that central bank's tendency to create money creation to finance government debt and borrowings from the commercial banking system (monetizing debt) has long been identified as the primary factor de-stabilizing the banking system, and the economy.
While recent balance of payments crises have been caused by central bank acquisitions of Treasury bills with new money (rejecting bids at auctions), if bonds are repaid (government cash deficits met) with bank borrowings, which are then re-financed through reverse repo operations the effect on the credit system is similar.
Classical economist B R Shenoy warned Sri Lanka (then Ceylon) as far back as 1966 that that "borrowing from the Central Bank and commercial banks" finance the government's net cash deficit resulted in the creation of new money.
Borrowing real savings to finance deficits was not expansionary, he said.
"No additions to the money supply take place when the savings of the people are claimed by the government to finance its outlays; such operations merely shift moneys from the pockets of the savers into the pockets of the recipients of government disbursements," Shenoy wrote.
But borrowing from the central bank clearly created new money.
"This is obvious when deficit financing is effected through Central Bank borrowing either as Ways and Means advances or against sales of Public Debt to the Central Bank," Shenoy wrote.
"In either case, equivalent Central Bank money gets issued into circulation."
"Central Bank money gets issued into circulation, too, when budget deficits are covered by drafts on Cash Balances,"
Even if bonds were sold to commercial banks, which were then paid for by running down the SRR new money would be created, he pointed out.
Analysts a re-examination of using the overdraft 'buffer', and the way it is financed, may be required.
The rupee which was 155.50/80 on March 28, had collapsed to 158.80 levels in the spot market by May after large volumes of money was printed to keep rates down as overnight rates spiked in April.
Meanwhile the monetary system turned from being a firm peg with where base money was driven by the acquisition of foreign assets up to March, to an unstable peg with liquidity driven by domestic assets, a problem associated with so-called soft-pegs which gets de-stabilized easily.
It has now been revealed that Sri Lanka has repaid tens of billions of rupees on April 02 by overdrawing state banks, in the belief by authorities that an earlier pay-down of an overdraft had created a 'buffer'.
The event is also raising questions whether the overdrafts were then re-financed by central bank liquidity injections and a rate spike in late March was from a state banks scrambling to find money to cover an overdraft amid a seasonal real demand for cash in a traditional New Year period.
One March 28, Sri Lanka offered 80 billion rupees of bonds, for settlement on April 02, sharply lower than the total maturing volume and interest coupons, which was estimated to be over 100 billion rupees.
On April 02, the balance maturing bonds and interest coupons were repaid by overdrawing state banks, turning a paper security in the hands of savers and bank balance sheets into loanable liquid cash.
The 'buffer'
The central bank, which is managing debt on behalf of the Treasury says it has sold Treasury bills from June 2017, in excess of daily cash needs to pay down pre-existing overdrafts at state banks, to create a 'buffer'.
"So for example last year, during the period of July to December we were able to build a 100 Billion buffer, especially for the debt service payments process," Deputy Governor C J P Siriwardene said.
"Similarly that process is continuing now. Even now for example, last month we have raised more than 20 billion additional funds from the market by issuing Treasury bills for the debt service payments."
Under a new liability management law, two accounts would be created to keep funds, including a dollar account, but in the meantime, overdrafts and the Bank of Ceylon and People's Bank were being paid down, he said.
State banks, including the Bank of Ceylon, was then free to loan the cash to other customers boosting credit. No cash was especially ring fenced or placed at the central bank to meet the sudden overdraft.
When tens of billions of rupees are overdrawn in to repay bonds later, the Bank of Ceylon or People's Bank may have to go to the central bank's liquidity windows get new cash, expanding reserve money and eventually pushing the rupee down when imports are paid for with the newly created cash.
Central Bank Re-finance
Deputy Governor Nandalal Weerasinghe says the question of whether the funds were separately earmarked would not arise if the Bank of Ceylon could borrow from other market participants and lend to the Treasury, without creating new money.
The original paying down of the overdraft with money raised from T-bill sales will not create new money either, he pointed out (unless a dealer went to the window to get new money to bid for the bill auction in the first place).
Under current rules, no bank has to keep funds in the central bank in excess of the statutory reserve ratio (SRR), he said. Analysts say however that prudent foreign banks routinely keep excess funds.
"It does not require Bank of Ceylon to have 50 billion readily available in their accounts," Weerasinghe explained (assuming for example that 50 billion was needed to repay a part of a bond maturity).
"They are coming to the window depending on whether they maintain surplus liquidity or a deficit.
"If they are below the SRR, it does not matter whether government comes or not they have to either borrow from the interbank market or us."
Weerasinghe said the central bank will inject (create new money) or withdraw money depending on whether there was a deficit or surplus in the interbank market.
A chronic benign overall interbank surplus develops in Sri Lanka usually when credit slows in the months following rate hikes made to end a balance of payments crisis and the central bank buys dollars (unsterilized or partially sterilized dollar purchases).
An overall cash deficit can develop when the central bank sells dollars to defend the currency (unsterilized sale) or when money goes out of the system due to a real demand for cash, such as in the Sinhala and Tamil New Year period.
Small daily variations can happen due to cash demand by bank customers. In general, the monetary base (notes in circulation and statutory reserve at the central bank) will expand with economic activity and inflation or both.
"If there is a deficit in the market and the Bank of Ceylon is in a deficit, then for the overall deficit we will conduct the (reverse repo) auction," Weerasinghe explains.
Monetizing
Analysts say a dangerous cash surplus can develop when the central bank buys Treasury bills outright to finance budget deficit (straight monetizing of debt), which if done persistently, when credit growth is strong, leads to a balance of payments crisis and high inflation.
If the central bank injects money through reverse repo auctions to finance banks which are lending irresponsibly without deposits, while responsible banks have deposits and excess money in the central bank's standing deposit window, also a surplus could develop.
Looking at the data in late March and April also raises more questions.
On March 27, the interbank market had an aggregate surplus of 31 billion rupees, with some banks borrowing 1.7 billion from the window and the central bank mopping up 25 billion rupees overnight.
On the same day, the weighted average overnight repo rate, where market participants give loans to each backed by Treasuries, was 7.64 percent, about 40 basis points above the7.25 percent repo window rate indicating the policy corridor floor.
The maximum rate at which market participants borrowed on that day was 8.00 percent.
On March 28, the overall surplus dropped sharply to 6.1 billion rupees for reasons that are not clear and banks with cash deficits were borrowing 6.79 billion rupees and excess banks were depositing 12.80 billion in the central bank's window.
On the same day, the weighted average overnight repo rate, was 7.66 percent and maximum rate was 8.00 percent.
Rate Spike
On March 29, the last market day before the maturing bonds were to be repaid, the overnight weighted average rate jumped suddenly to 8.21 percent and the maximum rate to 8.45 percent.
The ceiling policy rate at which market players could get newly created money from the reverse repo window was 8.75 percent.
On the same day the central bank injected 20 billion rupees in new money through a one-day auction into the banking system at rates as high as 8.75 percent, while another 1.79 billion rupees was borrowed from the 8.75 percent window.
The overall surplus was a marginal 0.47 billion rupees, with 25 billion rupees deposited in the excess cash window of the central bank, up from 12.8 billion rupees a day earlier.
On April 02, the day bonds were repaid, 30 billion rupees was injected at an average repo rate increased further to 8.21 percent with some borrowing at 8.6 percent.
On the same day central bank's Treasury bill stock also rose to 43.9 billion rupees from 12.9 billion rupees a day earlier based on the way data is released now.
The average repo rate was 8.40 percent and the maximum rate rose to 8.65 percent.
After the bond repayment excess banks - which could have included banks whose bonds were repaid - had deposited 30 billion rupees in the central bank's repo window and while others borrowed 2.52 billion rupees.
End of the day liquidity was a deficit of 2.14 billion rupees.
On April 03 the average repo rate rose further to 8.42 percent and the maximum rate to 8.65 percent.
The central bank injected 25 billion rupees for two days through a reverse repo auction on April 03 at an average rate of 8.6 percent after offering 50 billion rupees, which is about 5 percent of the country's entire monetary base (about the equivalent of 300 million US dollars).
End of the day excess liquidity rose to 11.67 billion rupees.
Clean money rates where banks deal also kept pace.
On April 03, 38 billion rupees were deposited in the central bank instead of being loaned to others.
Excess Liquidity and Counterparty Risk
Though some banks may be in excess, they cannot lend all the money to other banks, because risk limits prohibit them from doing so. Foreign banks in particular have strict limits with counter parties.
Instead they will have to lend to customers or buy bonds.
In Si Lanka after an oil hedging fiasco as well as turmoil in Treasury bonds markets in recent years, counter party limits have tightened.
On April 04, the central bank said it was cutting the ceiling reverse repo window rate to 8.50 percent from 8.75 percent, the first time since the balance of payments crisis ended.
On the same day another 12.85 billion rupees was injected at a sharply lower average rate of 8.07 percent.
Excess liquidity jumped to 31.2 billion rupees. Excess banks deposited 44 billion rupees in the window. Overall excess liquidity jumped to 31 billion rupees.
After the New Year the rupee started to fall, but the central bank did not intervene despite having injected tens of billions of rupees in the banking system or kill the liquidity quickly at the first time of trouble in the peg.
More money was injected in subsequent days for longer terms. In the New Year however in all years, money has to be injected to feed the real demand in cash.
Bank Borrowings
Questions asked what role the bond repayment played in a mystery rate spike in the last days of May, which was then followed by a rate cut and more liquidity injections, particularly since festival cash is a normal occurrence in Sri Lanka, which needs deeper study.
The situation is further complicated by a tax change in bonds that pushed up gilt yields.
However that central bank's tendency to create money creation to finance government debt and borrowings from the commercial banking system (monetizing debt) has long been identified as the primary factor de-stabilizing the banking system, and the economy.
While recent balance of payments crises have been caused by central bank acquisitions of Treasury bills with new money (rejecting bids at auctions), if bonds are repaid (government cash deficits met) with bank borrowings, which are then re-financed through reverse repo operations the effect on the credit system is similar.
Classical economist B R Shenoy warned Sri Lanka (then Ceylon) as far back as 1966 that that "borrowing from the Central Bank and commercial banks" finance the government's net cash deficit resulted in the creation of new money.
Borrowing real savings to finance deficits was not expansionary, he said.
"No additions to the money supply take place when the savings of the people are claimed by the government to finance its outlays; such operations merely shift moneys from the pockets of the savers into the pockets of the recipients of government disbursements," Shenoy wrote.
But borrowing from the central bank clearly created new money.
"This is obvious when deficit financing is effected through Central Bank borrowing either as Ways and Means advances or against sales of Public Debt to the Central Bank," Shenoy wrote.
"In either case, equivalent Central Bank money gets issued into circulation."
"Central Bank money gets issued into circulation, too, when budget deficits are covered by drafts on Cash Balances,"
Even if bonds were sold to commercial banks, which were then paid for by running down the SRR new money would be created, he pointed out.
Analysts a re-examination of using the overdraft 'buffer', and the way it is financed, may be required.
