How did Sri Lanka manage to boost Forex Reserves by almost $500mn in March?
Is it an increase that happened regardless of the IMF first tranche?
Having been stuck with official gross reserves of less than $2 billion for the last year, Sri Lanka has managed to increase it to $2.7 billion* by end-March 2023. In March the LKR also appreciated by about 11% against the USD, from around 360/$ to 320/$, on the official middle spot rate. While on the surface this appears to have happened due to the first trance of the IMF program (about $333 million) following Board level approval, there were lot more things happening in Sri Lanka that supported a relatively big jump in reserves.
*Of course, while the reported gross reserves is $2.7 billion, about $1.4 billion of it is the PBOC RMB 10 billion currency swap which remains unusable with reserves still below the 3-months of imports level that is apparently one of the conditions for its usability.
Figure: Gross Official Reserves, $ million
Imports contracted further in February
Given goods imports had already contracted sharply over the past year on the back of lower domestic demand, to average around $1.3-1.5 billion in recent months, it was interesting to see a drop to $1 billion in February, lowest since the height of the COVID-19 pandemic lockdown in mid-2020. It was clearly driven by a drop in intermediate imports which provide inputs to domestic activity.
Figure: Monthly Goods Imports by category, $ million
This appears to have been on the back of a contraction in fuel and textile related intermediate imports. The Energy Minister has been indicating they have built up sufficient stocks of petroleum stocks and there is supposed to be a slowdown in apparel export demand and a moderation of prices of inputs. The monthly PMI and exporters have been reporting a reduction in export orders. However, exports remained resilient in February just below $ 1 billion. As a result the monthly trade deficit dropped to a very narrow $39 million in February 2023, the lowest since a marginal trade surplus in June 2022.
Figure: Monthly Imports of Fuel & Textile Intermediate goods, $ million
Figure: Monthly Trade balance, $ million
Remittances & Tourism have continued to recover
As two of the largest forex inflow sources, their recovery in recent months have helped the local economy. Estimated monthly tourism earnings* have increased above $150 million, but remain low compared to pre-pandemic earnings. Remittances increased to over $500 million in March for the first time since early 2021, though this increase could be seasonal on regard of the local new year celebrations in April. Overall, March saw the highest combined remittance-tourism inflows since Dec 2020.
*Sri Lanka’s estimated tourism earnings data is not fully reliable and might be overestimated as highlighted by this brief by Verite Research.
Figure: Monthly Remittance & Tourism inflows, $ million
Combined with the contraction in imports in February, this has helped boost forex liquidity in the domestic financial system. Overall, Sri Lanka recorded small current account surpluses of $145 million & $120 million in the third and fourth quarters of 2022, respectively. And seems on the way to doing the same in first quarter of 2023.
Figure: Quarterly Current Account balance, $ million
A pick up in foreign holdings in rupee treasury bonds/bills
After a long hiatus, foreigners or non-residents appear to have increased their holdings of rupee denominated treasury bonds/bills. Between 16 February and 04 April, it increased 290% - LKR 48.4 billion or about $ 140 million. This too has added to forex liquidity.
Figure: Weekly Foreign Holdings in Rupee Treasury bonds/bills, LKR million
These factors had already helped CBSL to step up its net purchases of forex into reserves since December, reaching $253 million in February. But the big pick up appears to have occurred in March, for which data is not out yet.
Figure: Monthly Net Purchase of Forex by CBSL, $ million
LKR appreciated sharply in early March, even before the IMF program announcement
On 27 February, CBSL announced that it would be relaxing the exchange rate guidance band it had been maintaining since May 2022, which had kept the exchange rate stable just above 360/$ until then. Over the next week the band was relaxed further and on 03 March CBSL Governor announced it was being removed completely from the following week. Removal of a forex surrender rule on banks of 25% of forex inflows also supported this trend.
This coincided with the announcement on 01 March that the International Finance Corporation (IFC) of the World Bank Group would be extending a 1-year $400 million cross-currency swap to three Sri Lankan private banks. This surprise ‘new foreign financing facility’ ahead of the anticipated IMF program helped boost domestic sentiment and confidence within the financial system.
Figure: Average Daily Interbank Forex transactions volume by week, $ million
With the overall external sector developments discussed earlier contributing to a boost in forex liquidity, the guidance band relaxation and news of the IFC swap appeared to have helped increase activity in the domestic forex market in early March. With forex supply increasing amidst suppressed import demand, the official spot rate appreciated sharply in the first weeks of March from around 363/$ to 318/$ by 10 March, though some volatility has persisted as the market gets used to the lack of a guidance band. This appreciation was sustained by news of the IMF Board Approval being scheduled for 20 March, after the second Chinese financing assurance letter was confirmed on 07 March to be in line with IMF needs.
Figure: LKR-USD exchange rate - Official Spot Middle Rate
Further appreciation was contained by the CBSL stepping into aggressively purchase forex from the market into its reserves. Reportedly, it bought around $500 million in those first weeks of March which would be the largest in a single month in a long time. That means that in the first three months of 2023, CBSL has purchased around $900 million on a net basis, helping to raise reserves from around $1.9 billion at end-2022 to $2.7 billion at end-March.
The IMF tranche disbursement helped sustain this
With Board Approval confirmed on 20 March, the $333 million equivalent IMF first tranche was received. However, unlike in previous programs where the tranche went straight to the CBSL for reserves buildup, this time the tranche went to a Treasury account for use in budgetary financing. Given the need to quickly end the government’s dependence on CBSL monetary financing, the IMF has allowed the government to use the entire IMF financing for budgetary financing.
So, its unclear how much of this tranche ended up in the forex reserves of CBSL. The State Minister of Finance did mention that $121 million from the IMF tranche was utilized to repay an emergency credit line obtained from India in 2022*. Thus, the IMF tranche reduced the use of forex reserves for the limited debt repayments Sri Lanka continues to do.
*The IMF staff report confirmed that these Indian credit lines disbursed in 2022 would be exempted from debt restructuring and Sri Lanka is repaying this short-term credit line. Multilateral debt is also exempted from debt restructuring and continue to be serviced.
The IMF first tranche and the positive sentiment about the anticipated IMF Board Approval helped. But it wasn’t the only reason behind the almost $500 million boost to forex reserves in March. There was more going on in terms of Sri Lanka’s external sector and domestic forex liquidity that facilitated CBSL to purchase forex into its reserves in March. It is important to keep in mind that on the other side of these improvement in macro indicators is a contracting economy and suppressed consumption, with the most vulnerable groups the worst off.
What to expect from Macro Colombo in the weeks ahead?
I am hoping to dig deeper into the 2022 balance of payments data that was released recently, both in terms of the current account and the financial account, with a focus on the important role of Indian emergency financing.