Bond Sell off
Foreign buyers have been selling out of Sri Lankan rupee denominated securities in line with the latest sell-offs in global financial markets.
In mid 2008 foreign bond holders had held about 600 million US dollars of Sri Lanka government rupee securities.
"We had about 600 at the peak and about 200 has gone," says Governor Cabraal.
"If at all the maximum that can depart will be another 200 or so."
Sri Lanka, which 'floated' the rupee in early 2001 after getting into its worst currency crisis in recent times, later slipped back in to a dollar peg, more correctly called a soft-peg, which are notorious for creating currency crises.
Sri Lanka ran into repeated small currency crises in 2004, 2006 and 2007 by trying to defend the dollar peg or by printing money to finance a budget deficit when fiscal policy deteriorated after 2004 and monetary policy was loose.
In the first half of 2008, monetary policy was tight and the central bank was selling down its treasury securities to drain money from the economy or 'sterilize' external inflows, helping strengthen the exchange rate and push up foreign reserves.
In August Sri Lanka's foreign reserves were at 3,424 million US dollars, up from 3,062.5 million in December 2007.
But from September the balance of payments had turned in the other direction.
"Foreign reserves have declined to 2.6 billion dollars this month as result of the capital flight," Cabraal told reporters on October 24.
"Our total reserves were in the region of 3.1 billion now it has dropped to about 2.6 billion."
Governor Cabraal says the central bank is confident it can continue to provide liquidity in the foreign exchange market and has enough foreign reserves to accommodate foreign bond sales.
"At the time that we opened out we consistently assured everyone that we are building a reserve for it and that reserve is still there, we have used a part of it to enable the people to take the money out," says Cabraal.
"And that decision was something that we took consciously because we do realize in time of uncertainty there is a natural tendency for these things to move out."
However economic analysts warn that the central bank belief that it could 'build up' foreign reserves to pay off bond sales is based on a mistaken understanding of how monetary systems work in practice.
While a central bank could 'accommodate' a bond sale by directly acquiring a bond into its balance sheet without any negative effects on the domestic economy, it cannot 'accommodate' a sell-off to domestic entities.
A direct central bank purchase from a foreign bond seller, which is settled by liquidating a foreign asset (central bank reserves) tends to be like an International Monetary Fund transaction.
This is an 'external' transaction which will replace US treasury securities with Sri Lankan securities in the central bank balance sheet.
It does not affect the reserves of the domestic commercial banking system. However if a foreign bondholder sells to a local player, existing domestic money (a part of the monetary base or reserve money) is used to buy the bond.
When this money is given to the central bank to buy dollars, domestic reserve money contracts, creating a liquidity shortage in the Interbank market.
The central bank then responds by buying treasury bills and injecting (printing) new money into the banking system, by 'sterilizing' the intervention.
Since early September the central bank has injected 67 billion rupees to cover or 'sterilize' such liquidity shortages. The statutory reserve ratio was cut, releasing another 7.5 billion rupees to the market.
Such sterilized interventions create inflationary pressure and also puts extra pressure on the balance of payments by preventing a contraction in imports.
The increase in demand can be set off by a fall in currency, which happens if a country had a 'floating' exchange rate.
It can also be offset if the central bank engaged in 'non-sterilized' intervention and refused to accommodate the original liquidity shortage. Currency boards work on that principle.
Sri Lanka's reserve money has only fallen to 277.5 billion rupees in October 23, from 282 billion on September 04.
A currency board, or a 'hard peg' has no legal capacity to sterilize and can defend its fixed exchange rate indefinitely allowing reserve money to contract or expand in step with forex interventions.
A sterilizing central bank on the other hand cannot defend such a peg, and it is therefore known as a soft-peg.
Soft-pegs and sterilized intervention of currency eventually leads to steep currency falls, which can result in banking sector and economic collapse as had happened in East Asia, Sri Lanka in 2000 and is now happening in Iceland, Ukraine, Belarus and Pakistan.
Error Corrected 600 million dollars.