Sri Lanka rupee strengthens

Sept 27, 2012 (LBO) – Sri Lanka’s rupee strengthened above 130 to the US dollar in the spot market Thursday with banks being short of cash for six straight days while longer term market interest rates continued to ease. A sterilized purchase of foreign exchange (where domestic money is withdrawn by the central bank) results in steady upward pressure on a foreign exchange peg and a build up foreign reserves.

The spot US dollar which opened around 129.85/130.00 rupees strengthened to around 129.00/30 to the dollar later in the day.

A day earlier, Treasury bill yields fell up to 30 basis points on some maturities.

Sri Lanka’s rupee fell from 110.00 to 134.00 to the US dollar as the central bank sterilized foreign exchange sales with liquidity injections (printed money).

The rupee initially came under pressure from a spike in unproductive bank loans taken by energy enterprises to manipulate energy prices which were in turn accommodated by central bank credit.

The rupee initially fell to around 110 to the US dollar and continued to fall amid limited sterilized foreign exchange sales made to pay oil bills.

Analysts later pointed out that the rupee failed to strengthen after sterilized sales ended, as the Central Bank made unsterilized purchases of foreign exchange inflows, preventing the rupee from appreciating and allowing liquidity to build up in money markets.

LBO’s economics columnist has said that a sterilized forex sale (where money is printed by the central bank to cover liquidity shortages) forces an exchange rate peg to break by expanding credit and imports to unsustainable levels amid s steady drain of dollar reserves.

An unsterilized sale on the other had prevents a weakening of the peg by generating an liquidity shortage that is not accommodated by the Central Bank forcing banks to curb credit (and imports) to fill the liquidity shortage.

An unsterilized purchase of foreign exchange prevents the strengthening of the exchange rate by taking dollars away from forex markets and generating future loans and import demand which can be matched by an unsterilized sale of foreign exchange.