Sri Lanka’s central bank surprised by runaway inflation

ECONOMYNEXT – Sri Lanka’s central bank has been taken by surprise by the sharp rise in inflation, Governor Nivard Cabraal said after inflation hit 15.1% in February 2022, after two years of printing record currency to keep interest rates low.

The central bank also accused banks of failing to raise deposits after pumping hundreds of billions of new rupee reserves into banks despite applying an indexed regime, to keep policy rates artificially low as budget deficits were increasing.

Sri Lanka’s 12-month inflation rose from 5.7% in September 2021 to 15.1% in February 2022 after two years of unrelenting money printing, 40% growth in broad money and growth 40% reserve currency despite two years of balance of payments deficits under a peg.

Sharp rise

“We were surprised by the sharp rise in inflation,” Governor Cabraal told reporters after raising interest rates by 100 basis points to 7.50%.

“We think we also need to give signals to the country and the economy that we want to fight inflation.”

However, by then the central bank had generated 15.1% in February, a 13-year high, just behind the State Bank of Pakistan’s 12.1% for the same months.

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“It (inflation) has increased beyond our normal norms,” ​​Cabraal said. “Thirteen years of single-digit inflation have been broken. And we are worried about it, because it is our responsibility to ensure price stability which has been partially undermined.

Sri Lanka has followed the Federal Reserve in printing money for the past two years, ignoring warnings and pointing to modern monetary theory. Overt price controls were imposed to seal bond auctions in order to cripple them.

In past currency crises, auctions have been closed by rejecting market bids and printing money by writing them to the central bank’s balance sheet to stimulate imports and blow up the currency.

Governor Cabraal removed price controls, allowing market rates to rise, but policy rate hikes were slow, effectively providing rupee reserves to the banking system at low cost.

Sri Lanka and Pakistan have the worst central banks in South Asia. The Pakistan Rupee depreciated 4.70 against the US Dollar (both are derived or pegged heavily 1 to 1 against the Indian Rupee), 179 against the US Dollar by Feb 2022.

The Sri Lankan rupee has been depreciated by the central bank from 4.70 to the dollar to 203 since its inception with dual peg disputes, and parallel exchange rates are around 249 rupees now with the latest money printing.

The currency crashes as the central bank attempts to maintain a peg (external peg) and also prints money to maintain a key rate in the mistaken belief that it can target inflation (a domestic peg) without a rate floating exchange rate.

Over the past two years, 1.7 trillion rupees have been printed to keep interest rates artificially low, putting pressure on the exchange rate and causing balance of payments deficits.

Some of the printed money is for direct appropriation of foreign exchange reserves to pay off debt, as the cash injections have created currency shortages and the central bank has not been able to recover them as per the past because of too low rates.

Supply side

The central bank continued to blame “supply” and “imports as monetary aggregates soared.”

“We observe that supply is one of the main contributory factors to these price pressures,” economic research director Anil Perera said, repeating claims made in the past by Sri Lanka’s central bank and also the Federal Reserve after generating high inflation.

Federal Reserve chief Jerome Powell also engaged in similar propaganda claiming inflation was “passing” and was due to supply chain constraints. In Sri Lanka, it is strongly believed that an indeterminate part of inflation is non-monetary or cost-induced.

Sri Lanka’s exports and imports (traded goods) however react to Federal Reserve money printing through the pegged exchange rate and items such as tea, rice or oil prices may increase.

Powell made history last year by claiming there was no connection between money supply and inflation.

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Sri Lanka’s broad money measured by M2b grew by 40% from 7.6 trillion to 10.6 trillion in the two years ending December 2021.

The food price index increased by 42% over the period.

Sri Lanka’s reserve currency rose by 40% from December 2019 to December 2022 as the central bank continued to inject money to maintain its key rate after selling reserves for imports.

The central bank sold more than $900 million in reserves for imports from October but the reserve currency did not contract.

However, after selling dollar reserves and pumping rupee reserves back into the banking system (to sterilize interventions) allowing banks to engage in unchecked lending without lifting a finger to raise deposits, the central bank blames now commercial banks.

“We observe that deposit rate adjustments still remain slow,” Perera said. “And that’s been the cause of low deposit growth in the banking system and that’s causing excess circulation of currency to stay in the system.”

Sri Lanka’s reserve currency (currency in circulation plus statutory reserves) fell from 1,296 billion rupees in September to 1,339 billion rupees in February 2022, despite over $900 million in foreign exchange reserve sales over the course of of the period.

About 662 billion rupees of reserve are injected into the banking system overnight. Its cost to banks jumped 1% overnight as the policy rate was raised.

In an extraordinary move, the central bank in September 2021 raised its legal reserve ratio to levels it had before the start of MMT-style monetary policy and reprinted the full amount through takeover operations. term pension.

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The 12-month inflation in Sri Lanka galloped from 5.7% in September, to 7.6% in October, to 9.9% in November and to 12.1% in December.

In January, inflation galloped to 14.2% in February, inflation galloped to 15.1%.

Economists and the media had warned the central bank against money printing and modern monetary theory. The IMF also warned of what could happen unless money printing is not stopped quickly.

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Analysts and economists have called for a change in the law governing the central bank to restrict the domestic operations department, reduce the discretionary powers of the Monetary Board to prevent high inflation, currency unrest and social unrest. (Colombo/Mar07/2022)

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