Sri Lanka rupee floats to new level

August 24, 2007 (LBO) – The Sri Lanka rupee closed Friday with bids at 112.70 against the greenback with the highest deal at 112.67 in spot trade in a day that it floated freely with no intervention from the authorities, dealers said. The week closed with bids for the spot dollar at 112.70 and offers at 112.75.

Official intervention was relaxed on Thursday.

The Sri Lanka rupee has largely held steady against the greenback in recent weeks while most regional currencies, including the Australian dollar, lost ground sharply.

Yesterday the Japanese Yen fell to 116.28 against the dollar from 115.31 a day before. The Sri Lanka rupee barely moved 20 cents in a full day of trading.

Economists point out that Sri Lanka’s exports are strong and remittances – which are independent of the domestic economic conditions – are also strong and steady.

Meanwhile a trade contraction also seems to be underway, which while indicating weaker domestic conditions, points to less downward pressure on the exchange rate.

Sri Lanka is sitting on more than 2.5 billion dollars of foreign reserves in the context of a possible trade contraction.

Though foreign rupee bondholders could be a potential source of instability, unless there are buyers for the bonds they would not be able to sell out or contribute to any instability, analysts said.

They say that investors in Sri Lanka’s high yielding sovereign rupee bonds have so far been better off than those who held bond in countries like Australia in terms of exchange rate risk.

However since credit risk premiums have widened in global securities especially in the speculative grades, bond yields have to be allowed to go up to reflect the structural change in global financial markets through higher interest rates.

Analysts say if Sri Lanka is currently going through an adjustment of the exchange rate, interest rates also need to be kept high and access to discount windows should be limited to helping the payments system to prevent avoidable overshoots and corrections in the exchange rates.

They point out that the biggest pressure on the exchange rate would come from exporters, who are given subsidized electricity on one side and a better exchange rate on the other.

This gives unnecessary incentives to delay conversions and is not suited to a country that is market determining its exchange rate.

The rating agency Standard and Poor’s who lifted Sri Lanka’s rating outlook largely on the expectations of market pricing of energy has underlined the importance of quick pass-throughs of energy costs to the real economy.

Economic analysts say this is especially applicable to the export sector that is benefiting from an adjustment of the exchange rate.

Market perceptions of a possible overvaluation of the domestic currency is around one to two percent, dealers said. Analysts say this is very small compared to the volatility of global floating exchange rates.

However to solidify these expectations, analysts say concrete steps must be taken on the fiscal front.