Sri Lanka rupee may move if IMF forex reserve targets are not met

July 28, 2009 (LBO) – Sri Lanka’s tight peg with the US dollar, which is now backed by complementary monetary policy may move under an International Monetary Fund program if foreign reserve targets are not met, an official said. The 20-month IMF program is underpinned on a flexible exchange rate, and is based on specific foreign reserve collections defined as net international reserves (NIR).

Forex Reserve Target

“The program targets reserves,” Brian Aitken, who headed the IMF mission to Sri Lanka for a 2.6 billion US dollar bailout, told reporters.

“And, depending on the supply and demand for foreign exchange to meet those reserve targets, then the exchange rate will be the one factor that equilibrates the supply and demand.”

A fall in the exchange rate slashes the purchasing power of resident individuals in an economy allowing a central bank to buy dollars in the market as the depreciation effectively ‘rations’ foreign exchange to importers.

At the moment the rupee is tightly pegged at 114.90/95 levels against the greenback, with monetary policy to back it.

On Monday following the 2.6 billion US dollar IMF loan, the rupee opened with wide quotes of around 114.60/90, reflecting market sentiment to appreciate as well as uncertainty about the central bank’s stance.

But a state bank that usually acts for the monetary authority signaled the usual pegged rate, giving direction to the market narrowing the quote to 114.90/93 to the dollar.

A central bank which does not print money or withdraws rupees by selling down its Treasury bill stock has unlimited control over the exchange rate as monetary policy and exchange rate policy is complementary in such a situation.

It loses control of the exchange rate when domestic monetary policy (interventions in the money market) contradicts its exchange rate interventions, as it prints money and injects liquidity to money markets and tries to defend the exchange rate at the same time.

Flexible Rupee

To prevent another balance of payments crisis, the IMF has put in specific conditions in its economic program to prevent peg defence, especially if inflows reduce due to an external slowdown, there are capital outflows or weaknesses in remittance inflows.

“If these risks materialize, the Government stands ready to adjust its policies, in close consultation with IMF staff, to ensure the achievement of a sustainable external position by the end of the program period,” the IMF program said.

“Finally, in the event of a potentially disruptive movement in the nominal exchange rate against the U.S. dollar in either direction, the authorities will consult with Fund staff on the appropriate policy response.”

So far the central bank has collected around 500 million US dollars by intervening in forex market.

Under the program this year, net international reserves have to be brought up to the beginning of the year level, though there are provisions to adjust it based on foreign buying of Treasury bills and other criteria.

The 20-month program envisages building up foreign reserves to 3.5 months of imports, in an economy which is likely to be considerably larger and have healthy imports by the time it ends.

Central bank’s chief economist Nandalal Weerasinghe says Sri Lanka is likely to meet the reserve target before the program ends.

Exchange Anchor

Analysts say the stress on a ‘flexible’ rupee by the IMF and the lack of emphasis of monetary policy in the program shows the lender’s concerns of an overvalued rupee, which is hurting exporters.

Significantly, the IMF program also lacks net domestic asset ceilings of the central bank as performance criteria, indicating a preference on the part of the IMF for Sri Lanka to collect reserves through depreciation rather than treasury bill sales.

Takatoshi Kato, IMF’s deputy managing director said last week that’s its program “aims to rebuild reserves to prudent levels while allowing the flexibility in the exchange rate necessary to boost the competitiveness of Sri Lanka’s exports.”

“At the same time, the central bank’s policies will aim to control inflation while ensuring adequate credit to the private sector,” he said.

In an external deflationary environment, there is little risk of adding to domestic price pressures from a depreciation.

Countries that conduct razor sharp monetary policy, such has Singapore has allowed the exchange rate to go down to give leeway to domestic producers and impose a temporary real wage cut instead of forcing them to adjust through outright job losses.

The IMF program also uses an implied exchange rate of around 154 rupees for its program in the second year.

“This is just a very indicative projection,” mission chief Aitken said in response to a question from LBO.

“So I wouldn’t place any weight on this. That’s not a target or anything. I would place very little weight on that.”

Update (V)