Sri Lanka builds forex reserves by killing rupee liquidity

Sept 27, 2013 (LBO) – Sri Lanka’s central bank has called bids to sell down 10 billion rupees of its portfolio of Treasuries Friday after selling down 8 billion rupees of Treasuries earlier in the week, which will help build up foreign reserves. This year the Central Bank has to repay about 500 million US dollars to the International Monetary Fund, resulting in a net reduction of its foreign reserves.

Transactions with the IMF do not affect domestic credit markets as they do not involve liquidity generation, or a pass-through via the domestic reserve money.

On Friday the monetary authority offered to sell 1.25 billion rupees of Treasuries maturing in 18 days and 8.75 billion rupees of bills maturing in 32 days.

This week excess rupee reserves in banks rose as much as 88 billion rupees, after most of the proceeds of a 750 million US dollar bond sold by a state bank was converted to rupees by a central bank purchase.

The Central Bank said by end-July 2014 forex reserves were 6.3 billion US dollars but they had increased to about 7.0 billion by the fourth week of September.

Such purchases temporarily boost forex reserves, but the rupees generated are subsequently ‘redeemed’ by banks as the freshly created liquidity turns into loans and import demand.

By killing the liquidity, the monetary authority can prevent second round credit and permanently lock up the foreign reserves in a type of ‘quantity tightening’ exercise.

From September 24 to September 26 the Central Bank sold down 8.0 billion rupees from its Treasuries stock effectively building about 60 million US dollars of foreign reserves at an exchange rate of 132 to the US dollar.

If 10 billion rupees of Treasuries are sold down outright Friday another 75 million US dollars of foreign reserves could be built.

At Wednesday’s Treasuries auction authorities also accepted more bids than the maturing bills offered, which could also result in absolute sell-downs of central bank held Treasuries.

The monetary authority has also withdrawn large volumes of liquidity overnight and through 7-day open market operations, which however make liquidity available banks to create loans after the trades expire.

Permanently withdrawing rupee liquidity from money markets after purchasing dollars (a sterilized forex purchase) reduces future credit and imports (narrowing the trade and current account deficits) and generates a so-called balance of payments surplus in a pegged exchange rate country.