Contrary to popular Mercantilism, capital inflows into Sri Lanka does not necessary strengthen the exchange rate, because the Central Bank has a habit it of snatching it away from the forex market and creating liquidity through an unsterilized purchase.
The liquidity then puts downward pressure on the exchange rate.
This was clearly seen in May 2012. The liquidity from the Bank of Ceylon sent the exchange rate reeling down.
The Treasury also has a very bad practice of selling dollars from foreign borrowings, including sovereign bonds to the Central Bank (again by passing the foreign exchange market) and using the liquidity to settle overdrafts at state banks.
This type of action causes a shock loosening of the the monetary system and in addition to weakening the exchange rate and also push up inflation, when credit growth is strong.
It will be interesting to see what the government will do with billion US dollar bond.
In August 2011, this column showed how authorities accelerated the balance of payments crisis with the liquidity from the bond, which was taken out of the forex markets and dumped in money markets as rupees in a shock transaction.
According to market talk most of the bond proceeds (after keeping 500 million US dollars to settle a maturing bond) will be used to settle short term liabilities of the finance ministry. So the same mistakes may be committed again.
If the bond dollars were simply given to the CPC as a grant most of the balance of payments trouble would have been avoided.
It is sad.
There are also expectations that the bond proceeds will be used to settle T-bills held by the Central Bank.
It is better for the exchange rate since the liquidity will not damage it, but it is not necessarily good for economic growth or the budget deficit.
The Central Bank's T-bill stock has already done the damage to the economy. It is over and done with. A sudden contraction will not help undo any of the damage done.
It is true that if the bond proceeds are swapped for bills without passing through the reserve money system no economic damage will be done. However it will not to any good either.
If the intention of settling Central Bank held bills is to cut total interest costs, it is meaningless. Higher central bank profits will anyway accrue to the Treasury next year.
What the Central Bank and the Treasury should do is the following.
Keep the balance 500 million US dollars in dollars (and outside the economy) and forget the fact that you are running carry loss on the interest for a few weeks.
Sri Lanka is paying 5.9 percent anyway, the perception of a carry loss vs 12 percent rupee bill interest payment is simply an illusion.
Then each week sell 5 to 10 million dollars to the economy and get rupees from importers instead of the Central Bank and use the money to bridge the deficit.
The action will have two benefits. The exchange rate will strengthen because the dollars are passed through the forex markets and the finance ministry will get rupees without de-stabilizing the reserve money system.
The other benefit will be that the government can reduce the sale of new debt through bills or bonds. This will help bridge the budget deficit and bring down risk free rates faster.
If that happens all-rolled over debt will have lower interest rates either in the form of actual nominal interest rates falls or preventing further rate increases.
Avoid selling rupee bonds to foreigners until such time as the sovereign bond proceeds are exhausted and the rupee has substantially strengthened. Then start selling to foreign bond holders. This way very large savings will be made by the government.
A stronger exchange rate will also increase the profits of energy firms in another indirect benefit.
If authorities go ahead with swapping the bond proceeds for bills in the CB portfolio then it may well be a good idea to reverse the deal bit by bit later and do the same action outlined above.
If the money is actually spent by the Treasury, more economic activity will happen (if authorities want growth this should be done).
If bond proceeds are swapped for Central Bank held bills, it is in the nature of a transaction outside the economy and brings no benefit to the exchange rate.
If there are legal impediments to the action, the same objective can also be achieved by giving foreign reserves to the finance ministry for T-bills, to settle foreign loans, hoarding and selling incoming new loan proceeds into the forex markets slowly.
The central bank holding on to some bills for the time being is a good strategy because it will give room to keep monetary policy gently tight in the future and build up reserves.
Gently Does It
A steady sell down of the bills - say about two billion a week - can push the exchange rate up. A relatively small sell down of the CB bill stock will create a steady 'shortage of rupees' and a 'surplus of dollars' in the forex markets.
The sterilized purchases will help build reserves, and help keep inflation down.
Avoid giving shocks to the monetary system. Do whatever is done gently and if the procedure outlined above is followed rates will fall of their own accord especially if rulers can keep a lid on expenses.
In August 2011, this columnist said.
"To head off any 'balance of payments' problem the central bank has to weaken the rupee or allow interest rates to go up. If neither happens, credit expansion is on track to crash land in the balance of payments."
This columnist will now say the following: Don't worry about credit growth anymore. Credit that is financed by real deposits raised by banks cannot de-stabilize an economy.
Don't worry about the trade deficit either. It is completely irrelevant to the whole game. Cut vehicle taxes as soon as possible.
In the meantime conduct a review of domestic operations of the Central Bank and also how foreign loans proceeds of the government are handled.
The government is a big exporter of junk bonds. So allow it to act like an exporter and do not create liquidity with its 'export' earnings. Keep in mind that a prime culprit behind the trade deficit is government junk debt exports.
This country should not need double digit interest rates to hold the peg, even with a large budget deficit. No country with this level of access to foreign capital should have this high level of interest rates to hold the peg.