Sri Lanka central bank makes Rs22bn forex loss:

Negative Seigniorage
16 Apr, 2009 07:36:26
Sri Lanka central bank makes Rs22bn forex loss

Apr 16, 2009 (LBO) - Sri Lanka's central bank, which has a monopoly on money issue in the island, has made a 5.04 bullion rupee loss in 2008, badly hit by a 22.8 billion rupee forex loss, despite running a dollar peg which has to be backed by US assets.
In 2007, the central bank made a profit of 29.8 billion rupees.

Monopoly Rents

A central bank, which has a state monopoly on money issue, has a captive opportunity to sit back and rake in profits or seigniorage as the cost of issuing fiat paper money is always lower than its face value.

A central banking monetary regime essentially makes profits by financing governments and inflating the economy using the mechanism of legal tender laws which eliminates competition in money.

If mis-used, the state money monopoly can easily lead to economic collapse, as has happened in the case of the US Federal Reserve and more disastrously in the case of Zimbabwe and other hyper-inflating economies.

After going through a bout of hyper-inflation, Zimbabwe has now allowed central bank competition and several foreign currencies have been made legal, giving citizens the economic freedom to choose.

In Sri Lanka, foreign currency banking units have started to dent the money monopoly.

In 2008, Sri Lanka's central bank earned 7.0 billion rupees on interest from its Treasury bills bought with printed money. Until September 2008, the central bank sold down its treasury bills portfolio and collected foreign reserves.

The process reversed thereafter, as the monetary authority engaged in an ill-fated peg defence exercise, which eventually put it at doors of the International Monetary Fund.

From August to December 2008 the central bank's net reserves fell from 3.0 billion US dollars to 1.4 billion dollars.

Foreign Earnings

In monetary authorities that have pegged exchange rates, the yield from investing foreign reserves outside the economy, form a large percentage of profits.

Sri Lanka's central bank reported 19.9 billion rupees as earnings from foreign reserves in 2008, (19.8 billion rupees in 2007) including interest and capital gains, as global market interest rates fell.

A pegged central bank would normally invest the majority of its foreign reserves on government securities of the anchor currency country, which is used as the intervention currency in the domestic forex market.

Sri Lanka's intervention currency is the US dollar.

But in 2008, Sri Lanka's central bank has reported a record 22.8 billion forex loss, indicating that it has had significant investments in assets which were not denominated in the anchor US dollar currency.

In 2007 the central bank made an exchange gain of 8.8 billion rupees. A Third World pegged central bank that inflates the economy and depreciates the currency, can usually make gains every year as the exchange rate moves only in one direction. However they are usually passed through the balance sheet instead of the profit and loss account via an asset fluctuation reserve.

In the latter part of 2008, the US dollar zoomed as banks refused to lend to each other and to customers and money was parked in the Federal Reserves as excess reserves.

Meanwhile other floating rate central banks, which were not suffering from central bank impotence, were able to push down their currencies by cutting rates.

Sri Lanka's central bank says the reserve fall in the latter part of 2008 was accelerated by global currency movements against the dollar, to which the rupee is pegged.

"That is because other currencies also went down in price," governor Nivard Cabraal told reporters last week.

"If the pound which was trading at two dollars comes down to one dollar forty something, you take a hit."

Its liabilities to countries in the Asian clearing union, which include Iran and India, also increased to 91.3 billion rupees from 48.4 billion rupees during the year.

Yield Chase

In recent years many pegged central banks in the world increased Euro reserve assets as well as other currencies which were stronger than the dollar due to stricter inflation targeting, far beyond precautionary liquidity needs, forgetting that they were not actually pegged to such currencies.

In doing so, pegged central banks engaged in currency speculation instead of focusing on the responsibility of backing the convertibility of its domestic monetary base and giving confidence to foreign exchange markets.

Discarding lessons earned through the centuries, central banks also shifted from liquid anchor currency government securities, to higher yielding private investments.

Sri Lanka's central bank had disclosed earlier that it had moved money out in the nick of time, before banks such as Lehman collapsed.

The Chinese central bank went so far as to buy equity, and suffered billions in losses as the value of investments such as Blackstone capital tanked. The losses are isolated through a separate agency.

Pegged central banks that amassed massive reserves by sterilizing inflows at interest rates higher than that of the anchor currency country were also caught in a negative yield trap and were looking hither and thither to increase the yields on foreign assets.

Such pegged central banks have also forgotten another old lesson from the currency board era - that foreign reserves far above the domestic monetary base, serve no practical purpose and is costly to itself and to the domestic economy.

Meanwhile in another twist, a part of the domestic assets of Sri Lanka's central bank known as 'provisional advances' which is made up of money printed and given interest free to the Treasury, climbed to 76.3 billion rupees from 60.7 billion rupees.

The central bank has to either sell down interest bearing Treasury bills, or issue its own interest bearing securities to sterilize such advances if it wants to keep inflation low, putting additional costs on the bank.

Though it is a short term 'revolving credit', provisional advances have not been repaid for decades, and critics have pointed out that for all intents and purposes the advance is behaving like the biggest and longest running 'non-performing loan' in the country.

Critics have said the auditor general, who passes the central bank accounts, has so far failed to comment on the issue.

Analysts have called for Sri Lanka's monetary law to be changed to stop provisional advances.

Converting existing advances to interest bearing marketable securities which can be sold down, would also help prevent the issue of fresh central bank securities.

The Central Bank's equity meanwhile fell to 120.9 billion rupees in 2008 from 131.3 billion rupees in 2007. It has made an 8.0 billion rupee transfer to the government during the year.

Updated. Corrected financial year