Sri Lanka rupee weakens amid ‘quantity easing’

Feb 10, 2010 (LBO) – Sri Lanka’s central bank has become a net seller in foreign exchange markets as monetization of the government’s cash deficit has increased amid private credit expansion, the latest data shows.

The currency was later re-pegged at around 114.50 to the US dollar with the help of liquidity withdrawals.

Sri Lanka’s high spending government, which was hit by lower tax revenues as the economy slowed in 2009, was also able to raise money from domestic markets without pushing up interest rates due to ‘flight to treasuries’ behaviour among banks and savers.

Private sector credit stopped shrinking in September and in November it started to expand.

Quantitative Easing

Though no budget data has been released after September 2009, fiscal strains can be seen from the monetization of government debt by the Central Bank.

From September, the monetary authority’s Treasury bill stock started to rise, indicating that central bank credit was being used to finance the cash deficit of the government budget in the manner of a ‘quantitative easing’ exercise.

The Central Bank started to sell dollars from October, though purchases still outstripped sales.

The central bank’s foreign reserves, which were rising as Treasury bills were sold to mop up rupees generated from foreign inflows has stabilized around 5.2 billion US dollars after rupee injections began.

In January the Central Bank became a net seller in forex markets selling 34.15 million US dollars and buying 27.25 million US dollars.

Injections

In a pegged exchange rate environment the monetary authority has to both sell and buy foreign exchange to maintain the peg. When excess liquidity builds up due to foreign inflows a period of net sales can also be expected.

But when new rupees are injected steadily through Treasury bill purchases, dollar sales by the monetary authority picks up pace and reserve losses increase especially when credit expansion picks up and the new cash is actively loaned out.

To halt reserve losses, the rupee injections have to stop or the currency has to fall to re-balance demand pressures in the economy.

Such ‘quantitative easing’ can also push inflation up. Sri Lanka’s quantity easing is happening as global central banks are exiting loose monetary policy measures adopted when banks and credit collapsed.

Sri Lanka’s inflation has already picked up to 6.5 percent in January from 4.8 percent in December. The most widely watched Colombo Consumer Price Index has risen about one percent a month during the past few months.

Updated The rupee closed at 114.73/77 on Tuesday. On Monday the rupee was traded around 114.80 above the monetary authority’s indicative upper band of around 114.70 to the US dollar, dealers said.

The latest data also showed that the Central Bank became net seller in forex markets in January.

Soft Peg

Sri Lanka emerged from a balance of payments crisis in April 2009 with a float of the currency after an ill-fated attempt to maintain a soft dollar peg pushed down foreign reserves to around a billion US dollars.

The float, which broke a cycle of rupee injections and dollar sales (expansionary sterilized intervention) initially pushed the rupee down close to 120 to the US dollar.

The rupee then strengthened as an International Monetary Fund backed program restored the credibility of the peg and the central bank started to withdraw liquidity from the banking system in a quantitative tightening exercise amid stronger inflows.