June 8, 2009 (LBO) – Sri Lanka’s central bank has bought 160.25 million US dollars from foreign exchange markets since a float of the currency in late March 2009, with 123.0 million collected in the month of May.
As soon as the ‘quantity easing’ stops, the peg tightens. A float is necessary to break the cycle of intervention and quantity easing.
The idea that a monetary authority could target both the exchange rate and interest rates (create money out of both net foreign assets and net domestic assets) and maintain currency stability and inflation was peddled by the US authorities in a bid to persuade other countries to adopt dollar pegs and buy US assets to back the currency issue.
The IMF was created to help countries get ‘back on track’ when excessive monetary growth caused by domestic asset acquisitions (money printing) forced the pegs to break.
Unstable or ‘soft’ pegs have caused high inflation, balance of payments crises and economic instability in many ‘developing’ countries, and also triggered exchange controls, preventing the free flow of capital, and helped keep the populations of such countries poor.
Sri Lanka broke a hard peg with Sterling and moved to an unstable peg with the US dollar after 1950 on the advice of a Federal Reserve official. The country had been wracked by repeated high inflation and balance of payments crises since then.
During the 2008 balance of payments crisis, the country’s gross foreign reserves fell from 3.4 billion dollars to about 1,272 million US dollar in March. Of that about 200 million was already lent to local banks, the central bank said.
The central bank’s net foreign assets, that backs currency issue fell to 830 million US dollars in the period from over 3.0 billion dollars before the crisis.
In April the monetary authority collected 37.25 million dollars, after floating the currency and breaking a cycle of ‘sterilized intervention’ in the last week of March as a prior action ahead of an International Monetary Fund bailout.
Though the bailout has been delayed amid political wrangling from the US and Britain, the float of the currency has achieved the objective of stopping reserve hemorrhage.
After the float the rupee dipped to 120.00 to the US dollar, but the currency appreciated after the central bank stopped liquidity injections.
The rupee came under pressure in September 2008 after the central bank started selling dollars in forex markets and simultaneously intervened in money markets to ‘sterilize’ liquidity shortages, which is expansionary.
To lock up foreign reserves, the sterilization has to turn contractionary, or the currency has to depreciate.
In the past month, the Central Bank’s treasury bill stock – which is a proxy for liquidity injections – has remained steady at just over 200 billion rupees, after falling from an April peak.
Though Sri Lanka has policy rates and market interest rates much higher than the United States and a peg could be easily maintained, the link comes under pressure when the monetary authority tries to sterilize outflows.
Despite the high policy rate bias (about 11.50 percent in Sri Lanka against near zero in the US anchor currency) sterilizations act as a type of ‘quantity easing’ putting pressure on the currency.