Sept 09, 2011 (LBO) – Sri Lanka’s central bank said its exchange rate policy on the rupee is “appropriate” amid sustained pressure on the currency which has required steady interventions in forex markets to keep a peg to the US dollar. The Central Bank said recent reserve sales were to offset higher oil imports and to absorb liquidity which came from a sovereign dollar bond sale.
The statement came after the International Monetary Fund warned against sustained interventions to maintain a dollar peg. An IMF mission went back this week without completing its review and said discussions would continue later this month in Washington.
The mission said the economy was growing strongly and the budget deficit was also on track but was worried about an exchange rate that was not responding to market pressure.
The central bank insists that the exchange rate is flexible and the surge in sales would be temporary.
“The exchange rate policy of the Central Bank has been consistent where Central Bank intervenes in both sides of the market to maintain stability while also allowing adequate flexibility,” the monetary authority said in a statement.
The central bank said there were foreign exchange flows due from projects in ports, telecoms, and tourism to government infrastructure projects and from bond and equity markets. Some commercial banks would also raise Tier 2 capital from abroad.
“These will lead to substantial increases in foreign exchange liquidity in the market,” the Central Bank said.
The statement came as the latest data showed that the monetary authority had actively begun to sterilize the balance of payments in an expansionary fashion.
Except for shortly before a billion dollar bond came, Central Bank dollar sales have been non-sterilized and has mopped up excess liquidity, reducing rupee liquidity. In July the central bank sold 416 million US dollars and mopped an equivalent amount in rupees.
Excess rupee reserves in the banking system fell from 77 billion rupees on August 01 to 40 billion in September 07, pointing to foreign reserve sales of over 300 million US dollars.
But data showed that on Thursday the central bank had started to inject rupee reserves to the banking system, resisting a rise in interest rates and a contraction in its balance sheet.
The Central Bank’s Treasury bill stock rose to 10 billion Thursday indicating that dollar sales are now being actively offset in the money market or ‘sterilized’ with fresh liquidity, which prevents a slowdown in credit and adds to fresh dollar demand.
Sri Lanka has a so-called soft dollar peg, where the monetary authority tries to target both the exchange rate and the interest rate. Any errors on the interest rate trigger a balance of payments crisis.
However the IMF advised against an interest rate defense of the peg, saying it may hurt economic growth.
“So if the government were to prematurely tighten monetary policy – for example through an increase in interest rates – we would feel that would necessarily slow the economy,” IMF mission chief Brian Aitken said.
“And if you are asking whether they should do that instead of allowing exchange rate flexibility – we think exchange rate flexibility is the tool to deal with the external market pressures.”
Analysts say past experience has shown that once ‘sterilized intervention’ starts it is difficult to pull a country out of the balance of payments trouble without a clean float of the currency.
On Thursday the spot dollar was quoted at 110.10 rupees with no spread amid by the monetary authority. The three month forward premium was 1.05 rupees, up from 60 cents levels a month earlier, dealers said.