Mar 02, 2009 (LBO) – Sri Lanka’s central bank says it is negotiating two swap agreements with central banks to boost the country’s flagging foreign reserves, as interventions continue to pressure the rupee. Sri Lanka’s gross official reserves fell to 1,753 million US dollars in December.
The latest official data shows that the Central Bank has spent another 251.7 million US dollars on a net basis to intervene in forex markets in January 2009.
The Central Bank has been negotiating with foreign central banks for swap deals to get access to more foreign exchange.
In February the Central Bank said it had concluded a 200 million US dollar deal with Malaysia.
“Already one central bank has extended a Swap facility and negotiations with two others are at an advanced stage, and expected to be finalized soon,” the Central Bank said Friday after Fitch downgraded the outlook on Sri Lanka’s ‘B+’ credit rating to ‘negative’ from ‘stable’.
“At the same time, Sri Lankans living overseas are positively responding to opportunities offered to invest in government securities and enhanced return on non-resident foreign currency accounts.
“As a result, we expect substantial investment flows from these measures in the immediate future.”
On Friday the rupee fell to a low of 115.70 against the greenback in value tomorrow trades, dealers said, but a dose of moral suasion pushed the currency to 114.20/25 levels later in the day.
The Central Bank is now maintaining a peg at 114.25 rupees by selling dollars for trade-backed transactions.
A domestic currency is pressured by liquidity injections made (money printed) by the central bank to ‘sterilize’ cash losses in the domestic market when the monetary authority sells dollars against rupees to maintain a ‘peg’ with a foreign currency.
Such pegs are not ‘credible’ or ‘hard’ because it is not possible to target the exchange rate and have independent domestic monetary policy, in the form of either money supply or interest rate targets.
To conserve reserves, or end the currency crisis the cycle of dollar sales and liquidity injections (sterilized intervention) has to be halted.
In January the central bank has spent 272.2 million US dollar defending the currency and had only bought back 20.5 million US dollars.
“While it is true that reserves have declined, it should be noted that it is a reflection of the consequences of global financial crises which resulted in a global liquidity crisis leading to the drying up credit lines,” the Central Bank said Friday.
The monetary authority said it had to provide foreign exchange as foreign government bond holders sold out, to “prevent undue volatility in the foreign exchange market.
“In fact, reserves had been built up by the Central Bank to face this type of contingent events,” the monetary authority said.
Soft Peg woes
But other economists have pointed out that this is a common policy error found in countries with ‘managed floats’ or ‘soft pegs’ and is the type of behavior that triggers currency crises.
When foreign investors bought dollars, Sri Lanka’s central bank intervened in the market, sucked liquidity out (sterilized the inflows) and kept interest rates high, and prevented the exchange rate from appreciating, encouraging further speculative inflows.
Now the direction of sterilization has reversed, and Sri Lanka is in the middle of a balance of payments crisis.
“Until late last year, Bank Indonesia purchased U.S. dollars continuously, preventing the rupiah from appreciating,” economists
Steve Hanke and Ross McLeod wrote in the Wall Street Journal (link) last month.
“Paradoxically, the attempt to provide a war chest against balance of payments shocks had the perverse effect of heightening vulnerability to sudden, destabilizing capital outflows.”
Fear of floating
A ‘managed float’ central bank has a marked aversion to floating, buoyed by a belief that it is possible to intervene both in forex markets (target the exchange rate) and money markets (target domestic money supply or rates) simultaneously.
“Notwithstanding having nominally floated the rupiah in 1997, the central bank has never overcome its aversion to fully floating exchange rates,” Hanke and McLeod wrote.
Instead, Bank Indonesia has ‘managed’ the float, intervening simultaneously in the foreign exchange market and the domestic money market.
“In essence, it has both exchange rate and monetary policy targets, and these often contradict each other.”
Sri Lanka also nominally floated the currency in 2001 after a severe currency crisis, just like Indonesia did during the East Asian currency crisis, after a massive bout of sterilized intervention de-stabilized the country.
Sri Lanka has suffered high inflation and balance of payments crises after a central bank with money printing powers was created.
Before that, Sri Lanka had a currency board without money printing (or sterilizing powers), which maintained a ‘hard peg’ or a fixed exchange rate and kept the economy stable under colonial rule.