Sri Lanka braces for rupee flood from dollar bond

July 22, 2011 (LBO ) – Sri Lanka’s banking system is braced for a flood of rupees following the sale of a billion dollar bond but Central Bank Governor Nivard Cabraal says the groundwork to temper a shock, has already been laid. Inter-bank call money rates have also edged up above 8.0 percent in recent weeks as the monetary system tightened and excess reserves in banks fell.

At least three key banks are now net borrowers in the interbank money market, dealers said.

Sri Lanka has a peg with the US dollar and if dollar sales are not sterilized with fresh liquidity to keep rates down, interest rates can adjust and serve as an automatic check against inflation higher than the anchor US currency and balance of payments pressure.

Excess liquidity in banks can cause spill over in to the money supply and cause high levels of inflation, though the peg – through non-sterilized dollar sales – acts as a safety valve.

Keeping excess money out of the domestic monetary system by ‘sterilizing’ is expensive and can result in losses for the monetary authority if foreign reserves are too high above the domestic monetary base.

Sri Lanka sold the dollar bond for 6.25 percent. But it costs the central bank 7.25 percent to temporarily ‘sterilize’ converted dollars through its overnight repo window.

But with the steep dollars sales in the week and months before the bond sale as well as the possibility of selling down the recently accumulated bill stock, the central bank would have less rupees to sterilize. Officials have already said that some of the bond proceeds will go to retire more expensive foreign debt and only a part of the dollars will be converted to rupees and spent domestically adding to bank reserves and raising the spectre of inflationary pressure.

Excess liquidity in Sri Lanka’s banking system – partly caused by a dollar bond sale in 2010 – has been falling over the past three months amid non-sterilized dollar sales by the Central Bank to maintain a peg with the US dollar.

“We have been following strategies to manage the liquidity infusion without causing too much of a shock to the system,” Cabraal said.

Excess liquidity in the banking system fell from 63 billion rupees on July 01 to 24 billion rupees on July 21 pointing to steep net sales of dollar reserves, in non-sterilized transactions.

In addition a key domestic asset portfolio of the central bank – government Treasuries – rose by about another 13 billion rupees pointing to further reserve losses.

It is not clear whether the central bank is sterilizing dollar sales to hold domestic interest rates down by purchasing Treasuries – which can trigger balance of payments pressure – or simply getting bills for dollar transfers to the state in book transactions.

The International Monetary Fund has already warned against excessive defence of the peg which may eventually contradict domestic monetary policy.