Sri Lanka starts dollar swaps to absorb rupee liquidity

Nov 03, 2009 (LBO) – Sri Lanka’s central bank has started auctions of dollar-rupee swaps to withdraw excess domestic currency liquidity in the market and develop a new instrument to intervene in the market, an official said. Foreign reserves which fell to around a billion US dollars in March are now close to five billion US dollars, Central Bank governor Nivard Cabraal said last Thursday.

On Tuesday commercial banks had submitted bids of around 20 million US dollars for one-month swaps, in tranches of one to two million US dollars, dealers said.

The Central Bank will sell value-tomorrow dollars to the market and agree to buy them back in one month and return the dollars to market participants in a sell-buy swap.

The Central Bank will be able to ‘earn’ monthly dollar interest on the swapped foreign currency, while ‘paying’ the one month rupee rate for the rupees it generates through the swaps.

In a straight sterilization operation, the Central Bank has to bear the full rupee interest cost through Central Bank securities.

Dealers say the one month London Interbank Offered Rate is around 0.37 percent, but the Sri Lanka interbank dollar market is not active.

But banks have foreign currency banking units which actively solicit forex deposits and lends to qualified domestic borrowers, the government and foreign firms especially in the Maldives.

The first auction drew 64 million US dollars in bids Tuesday.

Dealers say the central bank would be able withdraw liquidity from the market at rates of slightly over 5.0 percent through the swap as opposed to about 8.0 percent through straight sales of Central Bank securities. Sri Lanka’s Central Bank has steadily sold down its portfolio of government Treasury bills to absorb rupees generated from dollar purchases and then started selling its own securities.

“We are using an alternative instrument to absorb excess liquidity,” deputy governor D Wijesinghe said.

“We have been steadily buying dollars from the market.”

Bankers also had some issues with Central Bank securities as they cannot be used as security to borrow from the reverse repo window unlike government Treasuries, or used to back an intra-day liquidity facility in the real time gross settlement system.

Sri Lanka’s central bank buys dollars to maintain a peg to the US dollar at around 114.90 rupees. The peg strengthened following a float in March 2008 which ended an expansionary cycle of liquidity injections and dollar sales.

Under an International Monetary Fund program plan the Central Bank is reversing the cycle through contractionary sterilizations to build up reserves.