Sri Lanka rupee in ‘trading band’

Nov 27, 2009 (LBO) – The Sri Lanka rupee started trading in a band Friday after a state bank that usually acts for the monetary authority quoted a wide two way price, dealers said.

Many high inflation countries which are prone to macro-economic instability and balance of payments crisis, have experimented with soft pegs of various kinds, including trading bands and crawling pegs, and peg that are hit by sudden ‘step devaluations’.

Most stable pegs (especially in East Asia) have come from maintaining consistently higher policy interest rates than the anchor currency (usually the US dollar) which results in large foreign reserve accumulations.

A state bank that was largely quoting a buying price amid dollar inflows into money markets in recent months offered a wide two way price of 114.35/60 against the US dollar in the style of a ‘trading band’ for the Sri Lankan currency.

Market quotes for rupee was around 114.50/55 in mid-morning trade.

Sri Lanka has a ‘soft-peg’ against the US dollar in the sense that the monetary authority has powers to fill liquidity losses coming from dollar sales made to defend a peg, a process which makes the peg inherently unstable.

But a flexible peg, which moves can help keep a country stable by allowing the exchange rate to weaken when there is pressure for foreign exchange outflows, which also prevents the need to make liquidity injections.

Until 1950 Sri Lanka had a ‘hard’ peg which does not break as liquidity injections (money printing) does not take place and any dollar sales causes a contraction in local money supply, which however can lead to higher interest rates.

Under a ‘hard peg’ the monetary authority has no policy rate and only the exchange rate is targeted.

The inherent instability of ‘soft pegs’ comes from a monetary authority that tries to target interest rates and the exchange rate at the same time.