Feb 13, 2012 (LBO) – Sri Lanka has tightened monetary policy and imposed a credit ceiling not only to counter balance of payments pressure but also to keep the island’s inflation low, Central Bank Governor Nivard Cabraal said. The central bank then sold dollars, initially mopping up excess liquidity and tightening the monetary system, but from September it started to ‘sterilize’ interventions in the money markets with freshly minted money.
The extra reserves added to the banks prevented interest rates from going up, which would have generated more savings to finance credit, cut consumption and rebalanced the domestic economy with the balance of payments.
Injections also pushed up credit growth, fired demand and pushed imports above the inflows, resulting in a steady loss of reserves in a vicious cycle of sterilized intervention.
After sterilized interventions began, credit growth went up even higher.
Balance of payments crises are a problem associated with so-called soft-pegs, where a monetary authority tries to target both the exchange rate and interest rates at the same time and invariably fails.
Soft pegs are also subject to high inflation, because the positive infl