July 3, 2007 (LBO) – Sri Lanka’s call rates moved above 35 percent with liquidity disappearing from the banking system despite the monetary authority pumping billions of rupees of new money into the system. Ministers told the media that the government may lose up to ten billion rupees through cuts of value added tax on imported food this year.
Sri Lanka’s inflation has been falling since the beginning of the year with the central bank largely pursuing prudent monetary policy. The Central Bank’s t-bill stock moved up by almost 20 billion rupees over less than a week another 4.5 billion rupees was injected to the market through reverse repo window through which money is printed for the banking system at 12.00 percent.
The current turmoil in the financial markets started last week with the monetary authority trying to halt a slide in the rupee and canceling a Treasury bill auction raising a red flag in the market.
The central bank’s treasury bill stock – a closely watched number as it is the principle source of macro-economic instability to the country – edged up to 40 billion rupees from 33 billion Friday and to 53 billion Monday.
With no increase in liquidity in the interbank market despite the unprecedented cash injections, economists say it points to a reserve outflow with large dollar outflows sucking money out of the banking system.
Sri Lanka has raised funds from selling rupee bonds to foreign investors which is a potential source of pressure on the system, when they start to cut losses in the face of rising interest rates.
Large government procurement deals would also have the same effect.
However economists warn that matching such dollar outflows to maintain base money by printing rupees into the system (sterilizing the outflow) without allowing rates to increase and the system to contract, fuels inflation and creates new pressure on the balance of payments.
This would eventually seriously undermine the monetary system.
Critics say Sri Lankan authorities had in the past by tried to control rates and base money by adding liquidity in the face of a reserve outflow on at least three occasions with unfortunate results for the country.
Analysts say a sale of foreign held rupee bonds may require the central bank to tighten its reserve money targets or allow the rupee to fall further, or engage in a combination of the two, if economic stability is to be maintained and demand pressure kept in check.
Sri Lanka has a technically overvalued rupee which exporters have said needs to depreciate to account for last year’s inflation and money printing, while a lack of fiscal discipline also creates a need for high interest rates.
Last week the government raised fuel prices after a long delay, which analysts say would allow the economy to stabilize somewhat, but cut taxes from a range of imported foodstuff and dealt another blow to government finances which are already under strain.