November 09, Colombo (LNW): Sri Lanka’s Central Bank (CBSL) is facing criticism for injecting excess liquidity into the banking system, which some analysts believe could undermine the stability of the interbank market and exacerbate inflationary pressures.
Dhananath Fernando, Chief Operating Officer of Advocata Institute, has warned that the central bank’s strategy of flooding the system with printed money might encourage unhealthy banking practices and disrupt the functioning of money markets. Instead, he advocates for lowering the floor rate of the policy corridor to bring rates down without resorting to large liquidity injections.
Recent data reveals that the central bank has been offering more money through open market operations than banks have been bidding for. Some banks have bid at exceptionally low rates, indicating a willingness to accept the funds regardless of the cost, which undermines the interbank money market’s efficiency.
Fernando emphasized that the CBSL should avoid becoming the first resort for banks facing liquidity issues and should limit its interventions to emergency situations only.
The controversy comes amid a recovery in Sri Lanka’s interbank market, which had essentially frozen during the 2022 currency crisis. At that time, inflationary rate cuts had led to a lack of interbank lending, and fears over the country’s debt restructuring further exacerbated liquidity concerns.
However, recent reports show that interbank volumes have improved, with daily call money market trades now averaging between Rs 10 billion and Rs 20 billion, and repo volumes returning to pre-crisis levels.
Fernando’s concerns are rooted in the long-term implications of the CBSL’s actions. If the liquidity injections are not withdrawn swiftly through sales of Treasury bills or foreign exchange, the increase in the money supply could be permanent, risking higher inflation and a balance of payments crisis.
Critics argue that if the central bank continues these operations without a clear exit strategy, the result could be similar to government borrowing, with adverse effects on currency stability and economic recovery.
However, the CBSL has defended its actions, arguing that these liquidity injections were necessary to address imbalances in the banking system. Foreign banks, in particular, have been cautious about lending in the interbank market due to Sri Lanka’s current “default” sovereign rating, leading them to deposit excess liquidity with the central bank instead.
While these measures are viewed as temporary, there is concern that they could create a more enduring issue if not managed properly.
Despite these concerns, Fernando acknowledged the Central Bank’s significant role in restoring monetary stability since September 2022. He praised the CBSL for its efforts but warned that maintaining stability in the face of external pressures remains the critical challenge moving forward.
The debate underscores the importance of cautious monetary policy in ensuring Sri Lanka’s economic recovery, with analysts stressing the need for transparency and discipline in the management of liquidity to avoid repeating past mistakes that led to the financial crisis. Fernando concluded that these discussions are essential for fostering an informed debate, not for assigning blame to any specific entity or individual.
