Sri Lanka overnight rates at new high amid forex pressure

June 12, 2012 (LBO) – Sri Lanka’s overnight interest rates rose to a high of 10.50 percent Tuesday, the highest since a balance of payments crisis began in the middle of 2011, as the rupee sank to a new low against the US dollar. Excess liquidity (the aggregate clearing balance of the banking system) remained below a billion rupees for the third day and some banks borrowed up to 1.5 billion rupees from the Central Bank’s 9.75 percent reverse repurchase widow.

Overnight gilt backed repos rose as much as 9.29 percent.

Excess liquidity of around 20 to 35 billion rupees has been sloshing around the banking system throughout May, from unsterilized foreign exchange purchases, especially from a large inflow into a commercial bank that was swapped with the Central Bank.

Analysts had warned that liquidity should be mopped up permanently to prevent pressure from developing on rupee again as the exchange rate peg was a sitting duck for the tens of billions rupees sloshing around the banking system.

Analysts say the stability in the foreign exchange peg for several weeks despite large volumes of liquidity sloshing around the system indicated that the peg could be strengthened if only the Central Bank was willing to engage in aggressive open market operations (a sterilized purchase).

Sri Lanka’s imports fell in April and private sector credit fell to a 22 month low.

But analysts say the peg can weaken even with falling imports or a narrowing trade deficit if the Central Bank makes unsterilized foreign exchange purchases or sterilized foreign exchange sales, there can be no improvement in the exchange rate.

Now however with liquidity disappearing there was more danger from sterilized foreign exchange sales, though the spiking short term rates could help the peg as it indicated that forex sales were not fully accommodated by the Central Bank.

Sterilized foreign exchange sales are expansionary and is the key method through which soft-pegged central banks around the world weaken exchange rates and create balance of payments crises.

Volatility of the exchange rate has also increased after overnight open position limits of banks were cut. Trimming limits reduces the depth of the forex markets and forces banks to sell forex to the Central Bank generating more rupees for credit creation.