Sri Lanka's central bank can intervene in forex markets without negative effects through unsterilized reserve sales which will kill some excess liquidity and help keep the exchange rate stable without putting further pressure on credit and imports.
The central bank can preserve its forex reserves by killing liquidity by selling its Treasuries stock outright.
On Monday the Central Bank sold 2.5 billion rupees of its bill stock in an outright sale with 17 days to maturity at an average yield of 8.65 percent, potentially killing a similar amount of bank credit and imports.
Another 31 day auction of 2.5 billion rupees of bills was also made at an average yield of 8.9 percent. From February 7 to 14 about 16 billion rupees of Treasuries were sold from the Central Bank's stock through outright sales.Last week there was a surge in liquidity with no decrease in the Central Bank's Treasury bill stock, which led market participants to speculate that some state debt may have been monetized.
Analysts had warned that regardless of Sri Lanka's overnight policy interest rates the rupee can be weakened and inflation will go up if the Central Bank injects liquidity into money markets through term auctions or purchases of Treasury bills.
The rupee can weaken even if total imports falls or the trade deficit narrows.
Analysts who use classical economic principles rather than Mercantilism have repeatedly warned that exchange rate weakening is a monetary phenomenon related money and credit and imports are simply a symptom.