By Arujuna Sivananthan –
A liquid market is defined as there being willing buyers and sellers at all times, and, the expectation that the next trade will be executed at a price equal to the last one. On the other hand, illiquid markets cannot accept large buy or sell orders without significant price movements. The resulting volatility will induce market participants to reduce participation making thinness and volatility joint self-perpetuating features irrespective of the fundamentals of the market. The use of moral suasion and the reduction in reserves which commercial banks can hold overnight has caused precisely this situation to arise in Sri lanka’s foreign exchange (forex) markets.
These actions also increase the tail risk to market participants. Rather than use normal distributions to measure their market risks, they will use heavy-tail distributions. And, the shifts in these tails will be conditional upon the fluidity of the regulatory and trading environment; and, the commitment to defend the value of the rupee at its deemed fair value of ‘around’ 125 to the US dollar.
In a 2006 National Bureau Economic Research working paper Ricardo Caballero and Arvind Krishnamoorthy conclude that such actions distort incentives to market participants and intensify the effects of the prevailing crisis. They argue that “policies that exacerbate the domestic credit squeeze during sudden stops, or constraints that limit the authorities ability to relax domestic financial constraints, lead to socially imprudent private sector actions”. We can already see this in exporters and importers seeking to hoard forex to immunise themselves against further steep falls in the value of the rupee.
Usually, during balance of payments crises and ‘sudden stops’ the private sector carries very little international liquidity. In Sri Lanka’s case, its regulatory environment aggravated this with its Central Bank (CB) hoarding most it. It includes the direct absorption forex generated by the CB involving sales of stakes in listed companies held by the state administered Employees Provident Fund and the forced reduction in commercial bank forex reserve limits in one-off defences of the value of the rupee.
Caballero and Krishnamoorthy argue that rather than hoard forex, the CB should inject reserves and reduce international liquidity constraints confronted by the private sector. Such an action would not only lower some of the distorted incentives but also help stabilise the exchange rate. And, contrary to conventional wisdom state that such an injection of reserves should also be sterilised to expand the monetary base and alleviate the burden on the private sector. However, they condition this response on the CB having earned its credibility among market participants; and, without it the CB will not be able to float the exchange rate and expand the monetary base. In fact, they suggest that without this earned credibility the CB will be forced to tighten monetary policy during balance of payments crises and sudden stops. And, such an action will be very costly because it induces the private sector to hoard forex.
In Sri Lanka, the CB is both hoarding forex and tightening monetary policy. For a CB which claims to have excellent inflation fighting credentials such policy responses are counterintuitive. It has also sapped the liquidity out of markets. The recent inquisitions held by policy makers on the actions of so-called rupee ‘speculators’ have not been helpful. Contrary to myth, speculators perform the essential market function of providing liquidity. They play a critical role in taking on the other side of transaction when there is no one else keeping bid/offer spreads tight, and, thereby, reducing volatility and the costs of transacting. However, they also perform the function of being harbingers of economic reality.
Many CBs including the Bank of England and European Central Bank have tried to keep reality at bay but have managed to do so only over the short term. When the CB can no longer afford to defend the value of its currency, markets will return it to its equilibrium value; but not before a disorderly and painful adjustment process with the associated adverse economic and social consequences.
The Sri Lankan rupee’s trajectory will be determined by whether its CB is acting in good faith or simply seeking to mask unpleasant economic realities.