May 16, 2013 (LBO) – Sri Lanka’s rupee strengthened to 125.70/80 to the US dollars in the spot in mid morning trade Thursday, amid tight liquidity but a two week liquidity auction has been announced, dealers said. The Central Bank cut its policy interest corridor by 50 basis points to 7.00 and 9.00 percent last week, after killing liquidity and selling down its Treasury bills stock steadily for around two weeks, keeping the system tight.
Selling down Central Bank held bills and withdrawing liquidity creates a ‘shortage or rupees’ eventually reducing import demand.
The rupee closed yesterday at 126.00 to the US dollar from around 126.50/70 levels before the rate cut.
Sri Lanka has a soft pegged exchange rate system where the central bank engages in extensive sterilized intervention withdrawing or injecting large volumes of liquidity and the policy rate itself has little bearing on the strength the of the exchange rate.
Cash injections, usually by outright purchases of Treasury bills (permanent cash injections), has weakened Sri Lanka’s exchange rates, generated balance of payments crises repeatedly and pushed up inflation despite very high interest rates in the past.
The monetary authority has called for a 5.0 billion 14 day cash injection Thursday (a term reverse repo auction), dealers said. The Central Bank had only injected overnight cash since the rate cut.
A cash injection generates demand and credit in the economy that is greater than the dollar inflows to the economy and the deposits received by the banking system during a given period, eventually weakening the currency peg.
Analysts say the Central Bank could achieve the same objective buy purchasing dollars in the market to weaken the peg and generate liquidity, whilst building up foreign reserves at the same time.