The International Monetary Fund has asked for a recapitalization plan for the central bank after an extension of maturities of central bank held Treasuries to meet the lender’s gross financing need (GFN) targets led to valuation losses.
“The government needs to advance without delay the modalities of the CBSL recapitalization,” an IMF report issued after the latest review said.
“After assessing the impact of the DDO on the CBSL’s balance sheets, done in close consultation with external auditors and IMF staff and by applying good accounting standards and valuation frameworks, the government should stand ready to inject capital into the CBSL, as soon as fiscal buffers allow it, so as to reach positive equity from 2025, which would increase to 2 percent of GDP by 2031.”
Based on longstanding principles before inflation and peacetime currency collapses became routine from the last century with the defeat of sound money by state-run central banks running on Anglo-American post-Keynesian inflationist doctrine, note-issue banks typically bought 90 to 95 day bills, generally known as the ‘bills only policy’, analysts say.
The bills only reduces credit risks, interest rate risks and also liquidity risks at exit.
Sri Lanka’s central bank also usually buys Treasury bills to ‘print money’ and mis-target the policy rate and trigger currency crises, though rule had been partly broken during the post-war currency crises to mis-target gilt yields, critics have shown earlier.
When rates are corrected to stop the crisis, maturing bills are rolled over at a profit, and are easily sold down to the market, in the private credit collapse that follows, to rebuild foreign reserves, usually in a falling interest rate environment.
However, the re-structure of bills to meet gross financing needs target, with coupons lower than market, results in book losses to the central bank, which may turn into actual losses if the securities are sold at market rates.
“The swap of CBSL T-bills holdings for long-term T-bonds reduces the government’s near-term GFNs and refinancing risks at the cost of reducing CBSL capital,” the IMF report said.
“In estimating the capital impact, staff cautioned against valuing the T-bonds using a discount rate that is disconnected from the current market yield curve (such as the theoretical risk-free discount rate).
“To avoid undesirable implications such as weaker demand for CBSL liabilities (e.g., cash in circulation), higher inflation risk premia, and rising dollarization risks, which could ultimately undermine CBSL independence and effectiveness of monetary policy, staff emphasized the urgency of recapitalizing the CBSL.”
According to published data the central bank has re-stated its September balance sheet.
The monetary authority was initially sitting on large profits with equity of 723 billion rupees in August which was reduced to 493 billion rupees by September.
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The number was later re-stated at 72 billion rupees.
The IMF report said a buffer of 0.5 percent GDP has been reserved for the recapitalization of the central bank in 2024 which was assessed “as sufficient to bring CBSL equity to positive levels based on IMF staff’s estimate of CBSL’s NPV loss from DDO and its equity position at the time of bond exchange in September 2023.”
A soft-pegged or flexible exchange rate central bank earns interest on its domestic assets as well as foreign reserves.
Under the old monetary law, the central bank was barred from transferring profits if it acquired large holdings of bills to trigger instability.