Sri Lanka says stand by loan a test of IMF objectivity

July 1, 2009 (LBO) – A decision on a loan from the International Monetary Fund (IMF) for Sri Lanka expected in “four or five weeks” will be a test of the objectivity of the organization, a government minister said.

In March, Sri Lanka floated the rupee, as a prior action for the loan ending a sterilized intervention cycle that was hemorrhaging foreign reserves of the Central Bank.

Since then Sri Lanka’s central bank has bought more than 300 million US dollars from forex markets, sold down its domestic asset (government treasuries) stock in a textbook IMF-style program.

Balance of payments crises are mainly a consequence of a central bank that tries to target the exchange rate and control interest rates (or domestic money supply) at the same time.

When defending a currency, a central bank sells dollars and prints money (buys treasury bills in money markets) which weakens the exchange rate.

After breaking the cycle with a float, under an IMF program the central bank buys dollars from forex markets and simultaneously buys rupees from money markets by selling treasury bills.

The process is contractionary and it strengthens the currency.

The stock of Treasuries which peaked at around 220 billion rupees at the height of the balance of payments crisis came down to 179 billion rupees this week.

Officials say the Central Bank has outperformed the original monetary targets set in the program that was discussed in March.

However Sri Lanka’s fiscal picture has deteriorated with revenues falling on absolute terms.

Official says Sri Lanka is now updating the technical memorandum of understanding covering the IMF loan and setting fresh benchmarks.

Foreign reserves are not needed in a country that has a flexible exchange rate. But most foreign investors look to stronger reserves for confidence as well as the discipline that could come from an IMF program.

Deputy finance minister Sarath Amunugama said technical negotiations were positive for a 1.9 billion bailout when the United States and Britain started to make negative statements on Sri Lanka’s loan application.

US and Western nations were tangled in a battle over the treatment of civilians in the last stages of a campaign against Tamil Tiger separatists which ended in May.

Amunugama said Sri Lanka was caught in international politics.

“It is not an economic issue. In the next four or five weeks we would know what the response would be,” he told a forum in Colombo organized by Ceylon Chamber of Commerce, the country’s most influential business association.

“It is the big test of the objectivity of the multilateral agency whether they are going to deliver the 1.9 billion package.”

Central Bank Governor Nivard Cabraal said the technical discussions had been completed successfully and the IMF will “have an embarrassing situation in their hands” if the loan was not granted.

“We are confident that the IMF will do the right thing,” Cabraal said.