Sri Lanka rupee at one year highs, forward premiums narrow

Feb 01, 2008 (LBO) – The Sri Lanka rupee hit 13-month highs of 107.65/70 against the US dollar as foreign bond buying and tighter monetary policy strengthened the rupee, dealers said.

On January 01, 2007 the rupee had closed at 107.60/70 against the US dollar and on Jan 02 at 107.67/77, dealer said.

The rupee gained yesterday amid foreign bond buying continuing a trend seen since late November when the Central Bank raised the limit for foreign bond holdings.

Meanwhile forward premiums were also narrowing.

Three month dollars were quoted at 110.65/72 which implied a rupee interest rate of 14 percent while 3-month money was quoted in the market around 19.00 percent.

In theory this presented an arbitrage opportunity for dealers to generate rupees via swap contracts, which should then bring down rates, but bank limit problems prevented their wider use, a forex trader at a major bank said.

“The rupee has now become very precious,” one trader said. “No one wants to hold dollars at these rates.”

Dollar yields continued to fall with the 3-month rate at around 3.00/3.10 percent dealer said as the Federal Reserve cut policy rates and the greenback also weakened against major currencies.

However Sri Lanka has a large government, with rising expenditure. Massive resources are needed to bridge its deficit requiring high interest rates in the country.

The current strength of the rupee is partly due to carry trade activity where foreign hedge funds were buying into high-yield Sri Lanka government rupee bonds.

Sri Lanka has traditionally had a crawling peg against the US dollar with independent monetary policy that had tended to be loose due to fiscal dominance, resulting in permanent depreciation of the domestic currency over the past half a century.

Until now forward cover has been priced on interest rate differentials as genuine exporter selling has not been widespread.

Most importers also preferred to be exposed to exchange risk as forward prices represented by interest rate differentials turned out to be generally higher than the actual Sri Lanka rupee/US dollar rate at the expiry of the contract.

However the narrowing of forward premiums indicates genuine exporter forward selling, dealers said.

With the exchange rate no longer a one way bet of depreciation, other derivatives such as rupee-dollar options were also slowly coming into use.

Updated