Sri Lanka to review forex curbs in April: Central Bank

Jan 05, 2009 (LBO) – Sri Lanka would review restrictions imposed on foreign exchange use in April 2009, the central bank said as the rupee continued to weaken against the greenback on liquidity injections made by the monetary authority. The central bank tightened limits on overnight trading positions of commercial banks, imposed penal interest rates on exporter financing and raised deposit limits on import letters of credit, on October 31.

Soft Peg

The measures came as the Central Bank lost more than a third of the country’s reserves in a failed bid to defend a soft rupee peg at 108.00 rupees to the dollar and later at 110.00 rupees while printing billions of rupees to sterilize its actions.

The rupee was quoted at 113.80/114.00 to the US dollar on Friday.

“With the increased flexibility of the exchange rate, the Central Bank introduced several temporary prudential measures such as margin requirements for imports as well,” Central Bank Governor Nivard Cabraal said in his annual policy speech on January 02.

“These measures, which are temporary, are due to be reviewed by end April 2009, and once the situation stabilises, we expect to gradually ease these restrictions.”

Under the exchange curbs, credit given to exporters were be slapped with a 1,000 basis point penal interest rate if they were not settled after three months and 200 basis points after the expiry of every additional 30 days.

Car imports were charged a deposit of 200 percent.

History Repeats

The curbs were almost identical to those imposed during a severe balance of payments crisis in 2000/2001, when excessive money printing and peg defense amidst an intensifying war, put severe pressure on the rupee.

On December 30, limits on overnight trading positions of banks were cut further.

The rupee gained in the day as dealers cut down dollar positions, but fell back to earlier levels within days.

Analysts say curbs will not prevent the adjustment of the rupee, which is falling due to the fundamental excess of rupees printed each month by the central bank compared with the inflows, and not any speculative activity.

Initially the monetary authority was printing money to make up for a liquidity shortage caused by dollar sales, a process known as sterilized intervention, which a third world central bank usually stops when it runs out of reserves.

The official reserve numbers for November and December has not yet been released. Authorities were also forced to repay foreign loans of about 150 million dollars, the central bank said in December.

In the first week of December the central bank allowed the rupee to float, after reserves fell to an estimated 2.0 billion dollars from the 3.4 billion dollars before active ‘sterilized intervention’ began in September.

The Central Bank’s treasury bills stock which represents the volume of printed money and reserve appropriations used to settle state loans, went up to 130 billion rupees on January 01.

Unsustainable Pegs

So-called soft-pegs which are defended with sterilized intervention (as opposed to hard pegs which are defended with non-sterilized intervention in so-called currency boards) have led to repeated currency crises in Latin America, Russia and East Asia.

Though sterilized intervention has largely ended, from December, analysts say active money printing then began, causing excess liquidity, signaling a new phase of exchange rate pressure.

A liquidity crisis at a commercial bank also forced the central bank to print more money.

Sri Lanka’s rupee began to depreciate after a hard peg was abandoned in 1950 and a central bank with money printing powers was created.

But authorities have frequently mis-led the public saying oil imports ‘exerted pressure on the exchanger rate’ when it was excess rupees printed by the central bank that really put pressure on the dollar peg.

Now the excuse can no longer be doled out, as oil prices are plummeting.

Analysts say one of the curbs put in October 2008, also worsened pressure on the system. The central bank stopped imports using documents against acceptance or payments (DA/DP) terms.

Some analysts have suspected that a part of the DA/DP payments were being settled outside the banking system through the unofficial ‘dollarized’ economy of the country.

By halting the practice, the payments were also brought into the rupee banking system forcing the central bank (during the peg defence period) or other players to shell out official dollars to pay for such transactions.