June 18, 2012 (LBO) – Sri Lanka should be careful about the inflationary effects of liquidity created by large foreign exchange swaps with the Central Bank, an International Monetary Fund official said. Analysts have warned that liquidity created by all central bank purchases for foreign exchange – including outright purchases – would flow out through the credit system, generating fresh credit and imports unless the purchases were immediately sterilized.
Viewed from the point of view authorities excess liquidity in the banking system provides ammunition for dealers to ‘speculate’ against the currency.
After generating large volumes of excess liquidity authorities have tended to blame dealers for ‘speculation’ instead of sterilizing the liquidity immediately with outright sales of the Central Bank’s Treasury bill stock.
An unsterilized purchase would then require the dollar peg to be defended again with the same foreign exchange the central bank collected through the purchases.
If the peg was not defended through sales of foreign exchange, such pressure would then result in currency depreciation and immediate one-off inflation.
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