Central Bank yet to embark on shrinking its over Rs.2.3tn balance sheet

Despite the expectations to end monetary financing and start shrinking its balance sheet, which has now grown to a size of nearly Rs.2.4 trillion, the authorities are yet to make good on their intentions, although they act with much restraint in expanding their assets after they raised rates by 700 basis points in April.   

In a special issuance of Treasury bills, the Central Bank last Friday gave the Treasury Rs.1.69 billion to finance debt service payments by the government due on that day, taking the face value of the bill stock held by the Central Bank on behalf of the government by Rs.27.32 billion to a total of Rs.2,383.84 billion by the end of last week.

This process is referred to as money printing in general economic parlance. 

At the bill auction held last week, the Central Bank failed to sell the entirety of the offered amount of Rs.90.0 billion, as it accepted only up to Rs.60.3 billion. 

When the Central Bank delivered the jumbo policy rate hike in early April, in a long overdue correction in the money policy, there were expectations by the authorities to practice restraint before ending its balance sheet expansion 
and embarking on shrinking its size.

The Central Bank had about Rs.78 billion in assets just prior to the pandemic and this had reached just under Rs.1.9 trillion two years later, when the economy collapsed amid runaway inflation and acute shortage of foreign currency.

Until such time, the bill auctions went largely undersubscribed, resulting in the Central Bank having to purchase the bills in return for printed money, causing a large expansion in its balance sheet, which partly caused the current bout of runaway inflation and the balance of payment crisis. Sri Lanka’s bill and bond auctions remained largely dysfunctional when the Central Bank imposed yield controls to keep rates on check while purchasing the unaccepted bills and bonds through printed money at those ceiling rates, before the practice was abandoned in September last year. 

However, when the rates were raised dramatically this year, the auctions were seen largely becoming functional and the government was seen raising its funds mostly from the market without the Central Bank having to buy large amounts of bills and bonds. 

The higher rates have already crushed private credit and thereby the money supply in the authorities’ attempt to tame inflation. Shrinking the Central Bank’s assets, which is also referred to as balance sheet runoff, is another form of tightening monetary conditions further on top of the rate hikes.  Further, as other fiscal reforms are also falling in place to contain the budget deficit, which hit double-digit levels in 2020 and 2021 as a percentage of gross domestic product, the government’s financing requirements will also decline.

After sharply raising interest rates, Sri Lanka brought in sweeping tax reforms since June onwards, in both direct and indirect taxes, to raise revenues and thereby cut the budget deficit, which will lessen the authorities’ reliance on the Central Bank liquidity.