Sri Lanka rupee weakens to new life low

April 01, 2009 (LBO) – The Sri Lanka rupee traded at a new low of 116.10 rupees against the greenback Wednesday dealers said, heightening expectations of a successful deal with the International Monetary Fund (IMF). In a pegged country rate cuts are achieved by further monetizations of deficits (printing money) unless the government reduces spending. This will increase the pressure on the exchange rate and foreign reserve losses.

Countries that want to fix a balance of payments crisis either have to curb government spending and raise taxes, or put up with high interest rates.

Spendthrift Sri Lankan rulers have displayed a market reluctance to curb spending, but have started to raise taxes of late.

Currency crises are a problem associated with countries that have ‘soft-pegs’, which are also known as managed floats.

Update 2 A float of the currency to break a peg defence cycle of simultaneous interventions in forex markets and domestic money markets (sterilized interventions) is vital for an IMF bailout to succeed.

In most IMF bailouts, called a ‘stand-by arrangement’ where peg defence is the key cause of the crisis, a float is a ‘prior action’ before the first tranche is disbursed following board approval.

Authorities have resisted a flexible exchange rate, but money printed to sterilize reserve outflows has pushed the rupee down from 108.00 in September to current levels even as imports and the oil bill plummeted.

On Tuesday the rupee traded as low as 115.80 against the US dollar, dealers said.

A quick ‘staff level’ agreement could result in IMF board approval about two weeks later.

Sri Lanka has asked for 1.9 billion dollars from the IMF and the island needs to curb spending to stop monetizing debt to halt a balance of payments crisis.

With 12-month inflation falling to 7.6 percent in February and 5.3 percent in March, the central bank has also cut interest rates aggressively.