Sri Lanka private credit down Rs255bn since May 2022

ECONOMYNEXT – Sri Lanka’s private credit contracted 30.9 billion rupees in November 2022 to 7499 billion rupees, taking the total contraction since May to 255.3 billion rupees, official data show.

Each time the central bank prints money to suppress interest rates, generating excess liquidity in money markets, triggering forex shortages, corrective policies lead to higher than required interest rates, which lead to a slowdown in private activity.

During the period of forex shortages, there is also a rise in foreign borrowings as the country loses the ability to settle foreign loans with domestic borrowings or revenues.

Sri Lanka has seen four currency crises since the end of a 30-year civil war and 3 since flexible inflation targeting started, where a reserve collecting peg is bombarded with liquidity injections through aggressive open market operations until it collapses.

A collapse in the currency further kills purchasing power and domestic demand, adding to lower growth and lower tax revenues, leading to wider deficits and higher domestic debt.

Government borrowings from the banking system in November was 114 billion rupees, on top of 135 billion rupees of credit in October. Government borrowings are expanding partly due to interest costs which are at record highs in the current crises due to the possibility of a DSA-driven default.

In previous currency collapses, interest rates have topped 20 percent, but this time rates topped 30 percent due to the possibility of default.

State enterprise borrowings which expanded 74.8 billion rupees in October to 1,777 billion rupees, fell by 17.4 billion rupees in November. In a currency crisis, state energy utilities run large losses as the rupee falls, requiring steep price hikes to reduce losses.

In Sri Lanka currency crises coincide with commodity bubbles fired by the Fed, and SOEs sometimes run losses and take credit to fix energy prices, contributing to the crises.

Usually, Sri Lanka floats the currency under as a prior action to an IMF program, after suppressing rates to maintain a policy rate and triggering the currency crisis.

In the serial currency crises since 2015, Sri Lanka was encouraged to depreciate the currency without hiking rates to correct credit in a policy called ‘exchange rate as the first line of defence’ despite operating a reserve collecting peg.

After the 2020/2022 crisis a new peg has been established at 360 to the US dollars after the rupee collapsed from 200 in a failed float. Over the past few weeks, liquidity has been injected to banks on a longer term to reduce an shortage which had been filled overnight.

A pegged regime develops a liquidity short due to forex interventions which are filled overnight, to offset the interventions and stop rates from normalizing.

Such injections which classical economists called ‘fictitious’ capital leads to credit without deposits and a run on forex reserves, which may lead to de-leveraging later through a private credit contraction as rates normalize. (Colombo/Jan17/2022)