By: Staff Writer
July 22, Colombo (LNW): Sri Lanka’s banking system saw a significant improvement in its net foreign assets (NFA) in May 2024. Official data showed the combined NFA of commercial banks and the central bank reached approximately $311 million, recovering from a negative $178 million in April. This turnaround is largely attributed to the current interest rate structure and domestic credit adjustments.
The NFA improvement comprises a positive $1.9 billion in foreign assets held by overseas banking units and a negative $811 million position, resulting in a net positive $1.13 billion for banks.
However, the central bank’s position remained negative at about $821 million, though this was a substantial improvement from a negative $4.5 billion during the peak of the previous currency crisis.
The central bank and commercial banks have accumulated reserves or repaid debts amounting to $6.7 billion since a significant interest rate hike in April 2022.
This movement contributed to a surplus in the external current account due to financial outflows for reserve collection and debt repayment. Specifically, the central bank gathered or repaid $3.45 billion, while other banks accounted for $3.2 billion.
Analysts caution that flexible inflation targeting may lead to external imbalances if private credit recovers and money is printed to lower rates. This approach could undermine the natural economic laws recognized by classical economists, potentially triggering currency crises.
Sri Lanka’s central bank encountered a negative NFA position starting in August 2021, spending borrowed dollars to cover imports and loan repayments while printing money to maintain low policy rates. This practice led to currency crises characterized by a cycle of credit expansion, dollar losses, and further monetary injections.
To stabilize and build foreign assets, the central bank needs to sell its domestic assets and purchase dollars from banks at appropriate interest rates, thereby moderating domestic credit. Modern practices by IMF-prone central banks often involve swaps to mis-target rates beyond their reserves.
The central bank’s negative reserve position peaked at around $4.5 billion in the third quarter of 2022, exacerbated by credits from the Reserve Bank of India. Borrowings from the IMF also contributed to this negative position, a result of repeated currency crises driven by money printing for rate cuts and growth targeting.
The external sector began to stabilize once credits from the Asian Clearing Union (ACU) ceased. The central bank has since been paying down the ACU credits steadily under the current interest rate structure. Notably, the use of a swap with the People’s Bank of China was restricted when gross reserves fell below three months of imports.
Sri Lanka’s private and state banks also faced negative foreign assets for years due to lending to the government via US dollar Sri Lanka Development Bonds and other credits, partially financed by foreign credit lines.
Following downgrades and worsening forex shortages, banks struggled to renew these credit lines, leading to the repayment of Sri Lanka Development Bonds in rupees and a shift of dollars to foreign accounts, ultimately improving the NFA position.
