Sri Lanka rupee weak, excess liquidity high

July 08, 2013 (LBO) – Sri Lanka rupee weakened Monday and quotes in the spot market dried up following moral suasion dealers said, as high levels of liquidity remained in money markets from a reserve ratio cut. In the spot market where trades are settled two days later, which is usually the most active segment, quotes dried up amid moral suasion, dealers said.

But smaller banks, who usually buy at high prices sold dollars at 130.60/70 rupees by a state name that usually acts for the monetary authority, dealers said.

In the spot next market, where settlement is made three days later there were trades at 130.85/90 rupee levels and quotes at 130.90/131.00 levels against the US dollar, dealers said.

The central bank flooded the banking system with around 45 billion rupees of cash on July 01, when it was already flushed with 13 billion rupees in excess liquidity and the rupee was weakening.

Only about 25 billion rupees of liquidity was withdrawn from the market by outright sales of Treasury bills. Another auction to withdraw 10 billion rupees was called but bids were not accepted.

Excess liquidity has ranged around 35 billion rupees since then, though dollar sales may help take in down. The pressure on the rupee comes as the liquidity is converted to credit, which is then spent and eventually draws imports.

Analysts had pointed out that the Central Bank will have to lose reserves of around 300 million dollars to absorb the liquidity by selling dollars after banks generate domestic credit (unsterilized forex sales), with the newly released money.

The monetary authority could also pre-empt credit and kill liquidity by selling down its Treasury bill holding to preserve foreign reserves.

The sell down of Treasuries in the Central Bank stock can also push up short term interest rates slightly.

Failure to do either will result in a weakening of the currency, inflation and expansion of reserve money.

LBO’s economics columnist had said that the Central Bank should follow a policy of not intervening and allow the currency to weaken only after liquidity has dried up and it should also refrain from buying capital inflows to the state and creating liquidity.

Both the practices contribute to making the Sri Lanka rupee a ‘crawling peg’.

Sri Lanka has a so-called ‘soft-pegged’ exchange rate regime that was set up when the country entered the failed Bretton Woods system.

Analysts have pointed out that chronic currency depreciation, balance of payments crises, pressure on dealers, spot quotes drying up, trading shifting to spot next are all part of the usual drama associated with targeting both the exchange rate and interest rate in Sri Lanka.

In bond markets a 5-year bond popular among foreign investors was quoted at 11.40/43 percent levels, from Friday’s closing was 11.35/38 percent levels, dealers have said.