July 19, 2012 (LBO) – Sri Lanka’s recent spike in inflation following a steep depreciation of the currency is mostly a structural change in prices, and not continuous monetary inflation, an International Monetary Fund official said. As foreign reserves are sold down by the Central Bank, the trade gap widens and the current account deficit of the balance of payments expands to unsustainable levels running beyond the net capital inflows to the country.
Flexibility in the exchange rate, which stops sterilized foreign exchange sales is needed to arrest the vicious cycle as happened in February 2012.
But during a balance of payments crisis, when liquidity tightens due to less-than-100-percent sterilization of central bank sales of foreign exchange, interest rates also move up, even as credit volumes increase.
Rising interest rates will eventually slow credit, which can slow new inflation after the crisis is ended.
Persistently high interest rates can trigger a banking crisis, which can even result in deflation (actual falls in prices) as bank credit turns negative, and the currency appreciates.
Sri Lanka had similar experiences after the 2000/2001 and 2008/2009 balance of payments crises, where risk free rates h