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Sri Lanka among Asian countries struggling with capital inflows: IMF official
26 Feb, 2011 10:34:28
By Asantha Sirimanne
Feb 26, 2011 (LBO) - Sri Lanka is among Asian nations struggling with capital inflows driven by excessive money printed in advanced nations, raising the risks of high inflation and asset booms, a senior International Monetary Fund official said.
"Sri Lanka is one country that has faced a surge in capital flows," IMF deputy managing director, Naoyuki Shinohara, told a forum of Asian central bankers in Colombo.

Sri Lanka faced a balance of payments crisis in late 2008, but it then floated the currency and came out of the crisis in April 2009.

An IMF bailout a month later also helped restored the credibility of the peg with the US dollar, drawing inflows allowing the central bank to buy large volumes of forex to re-build reserves.

"On the other hand, intervention has led to excess rupee liquidity and attendant risks of a credit boom and high inflation, and the central bank, like many of its counterparts in the region, is grappling with how to manage these issues," Shinohara said.

He was addressing central bank chiefs at the South East Asian Central Banks (SEACEN) which received a shot in the arm this year with the entry of China.

In addition to Sri Lanka, Brunei, Cambodia, Fiji, Indonesia, Korea, Malaysia, Mongolia, Myanmar, Nepal, Papua New Guinea, Philippines, Singapore, Taiwan, Thailand and Vietnam are members.

Unholy Trinity

Both balance of payments crises and excess capital inflows are problems associated with so-called 'soft-pegged' central bank regimes.

A soft-pegged central bank tries to target exchange rates and interest rates at the time, which is inherently contradictory, resulting in currency shortages, high inflation, high interest rates and restrictions in the liberty of citizens to move their savings in an out of the country.

Economists refer to the inherent contradiction in soft peg central banking policies as the 'unholy' or 'impossible' trinity of monetary policy contradictions.

Such central banks are a legacy of the ill-fated post World War II Bretton Woods system of unstable soft-pegs which collapsed in 1971-73 making 'advanced' nations to move to free floating regimes. Free floating central banks only target the interest rate.

Before 1950, when a dollar pegged central bank was created Sri Lanka, the island was part of the so-called 'Sterling area' made up largely of currency boards or 'hard pegs' which have remained resilient for more than a century.

A currency board only targets the exchange rate and interest rates float free. The domestic currency remains fully backed by foreign reserves and there is no need for exchange controls. Discount window facilities are limited, and there is no monetary lender of last resort.

Contractionary Sterilization

A soft-pegged country faced with capital inflows will 'sterilize' or absorb the local money generated from foreign exchange purchases by the Central Bank.

This prevents banks from lending the money to the broader economy, and 'locks up' the foreign exchange in the central bank.

The local money supply therefore grows at a slower pace than the inflow of money.

"So far, most countries have relied on a combination of currency appreciation and reserve accumulation to accommodate capital inflows," Shihonara said.

"Evidence suggests that reserve accumulation has absorbed a large fraction of the pressures from a return of capital flows, especially in the case of Asia but this masks significant variation of the response between countries."

Shihonara says there has been greater sterilization in Asia, resulting smaller increases in broad money growth.

Such 'contractionary' sterilization also keeps interest rates high and attracts more foreign inflows.

Stable Regimes

In a currency board regime however, inflows makes rates falls quickly discouraging further speculative inflows.

In Asia Hong Kong, operates such a consistent system. Its exchange rate has been fixed from 1982 and did not move even during the Asian financial crisis, though overnight rates shot up.

Singapore also has a modified system where interest rates are not targeted by the exchange rate is allowed to move. Brunei effectively runs a currency board with the Singapore dollar.

Sri Lanka had a currency board from 1885 to 1950, when a soft pegged regime was created, starting a long period of currency depreciation, high inflation and balance of payments crises.

Draconian exchange controls came within two years of the creation of a soft-peg.

Countries with free floating regimes which do not intervene in forex markets also do not have to sterilize inflows because there is no 'reserve pass-through' of external flows through the domestic monetary base.

Money will be 'printed' through open market operations only at the policy rate and the money supply will be backed by domestic assets. In terms of reserve money growth in relation to the balance of payments such regimes are said to have a 'reserve pass through' or 'sterilization co-efficient' of zero.

A currency board will have a 'sterilization co-efficient' of one or reserve pass-through of one hundred percent, where reserve money will move exactly in step with the balance of payments. A sterilizing soft peg will have one in between.

In a soft-peg money will be created either at the policy rate through domestic securities purchases or through forex interventions, essentially at zero interest.

As a result a soft pegged central bank has no real control of the money supply through its policy rate either, which is the core problem with 'capital inflows'.

To get over the problem permanently, a soft-peg will either have to float, or make itself to a currency board. India has chosen to move towards a float.

"On the one hand, India has abstained from intervention since end-2009, allowing the exchange rate to take the brunt of the adjustment; on the other hand, intervention was rapid in other countries, not to mention Sri Lanka."

How Long?

Other countries however have chosen the sterilization route.

"[C]ompared with other regions, Asian policymakers have been particularly effective at controlling money growth in response to reserve accumulation, as evidenced by the relatively low sensitivity of money supply growth to the build-up in central bank foreign assets," he said.

"Going forward, greater exchange rate flexibility can offer an important buffer against the risk, which I described earlier, that large capital inflows may undermine efforts to tighten the monetary stance.

"With global interest rates likely to remain low, countries with tightly managed exchange rates in effect import easy global monetary conditions, unless they tighten capital controls."

"While sterilization policies in the region appear to have worked so far…the question going forward is whether the structure of central banks’ balance sheets and the limited size and depth of domestic fixed income markets can support a significant further expansion in sterilization operations.

"This may require introducing new instruments, such as allowing central banks to issue their own paper where this is currently not possible."

Sri Lanka's central bank also has the ability to create its own securities. But it is also unsustainable.

This can worsen inflows or the incentive for market participants to engage in 'carry trade' and also bankrupt the central bank because its earnings on foreign reserves will be lower than the cost of sterilization.

Late last year Sri Lanka's central bank stopped permanently sterilizing excess liquidity, allowing excess liquidity to build up to unprecedented levels. Of late the volume has been slowly going down, with credit growth picking up.

Among SEACEN members, Vietnam is one country that is not facing a problem with inflows. It is facing currency depreciation and reserve losses. In a balance of payments crisis, the sterilization cycle runs in the opposite direction.

Dollars are sold, which creates a liquidity shortage in the banking system. To maintain a policy rate new liquidity is injected (domestic money is printed) creating fresh demand for dollars.

This 'expansionary' sterilization cycle continues until the central bank runs out of reserves and either devalues or floats the currency. Earlier this month Vietnam devalued by almost 9.0 percent and also jacked up policy rates.

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