Sri Lanka central bank intervening for stability: Governor

Oct 10, 2008 (LBO) – Sri Lanka’s central bank is intervening in forex markets to maintain stability and the monetary authority has bought more dollars than it sold this year, Governor Nivard Cabraal said amidst concerns that the rupee is under pressure. “Our intervention is still on the positive side,” Cabraal said. “We have intervened to purchase more than sell [dollars].”

Over the course of 2008 the central bank sterilized externally generated liquidity and purchased more than 300 million dollars in the inter bank market.

By July, Sri Lanka, which runs a pegged exchange rate, had a ‘balance of payments surplus’ of 510 million dollars.

Soft-pegged Surplus

This is shown through an increase in central bank foreign reserves from the beginning of the year which grew to 3,557 million dollars in July 2008 from 3,063 million in December.

Foreign reserves change due to central bank trading activities in the inter bank market, but can also fluctuate independent of local money supply, through interest earned on foreign reserves as well as transactions such as those with the International Monetary Fund.

Sri Lanka operates a reserve money targeting framework while at the same time maintaining a peg with the US dollar, which is more correctly called a ‘soft-peg’ as it can be easily de-stabilized by central bank injections of liquidity.

A reserve money targeting framework with a peg or external anchor can backfire on the country when the net balance of payments turns negative.

The latest central bank data reveals that the Central Bank has lost 202.68 million dollars in September alone, in currency defence.

In the first 10 days of October, currency defence has continued.

The US dollar which was at 107.7/80 levels is now quoted at the odd rate of 107.99/05 in forex markets amidst heavy intervention from authorities at 108.00 to the US dollar.

Liquidity Pressure

Meanwhile, the monetary authority has been injecting liquidity to top up cash shortages created by the interventions, a process known as sterilized intervention, priming the monetary system for further currency pressure in the coming weeks.

Over the past three weeks, the Central Bank’s Treasury Bill stock, which is a measure of the liquidity injections (or reserve appropriations), has shot up to 32 billion rupees from almost nothing in mid-September.

In the entire month of September however, the central bank has been on the selling side of the market, which analysts fear is an indication that aggregate demand is in fundamental disequilibrium, and has been for more than a month.

By adding new liquidity the disequilibrium worsens, despite overall reserve money or the monetary base, remaining unchanged.

Such liquidity injections – which are essentially central bank accommodations of capital outflows – can swiftly push an economy in to a currency crisis-like situation, which last happened in 2007.

In the past, Sri Lanka’s central bank has happily created currency crises, following the same type of action.

Iceland which has been fruitlessly defending it peg with the Euro, abandoned it yesterday, but not before serious damage was done to the economy and its banking sector.

A float is needed to break the vicious cycle of currency defence and liquidity injections (money printing).

India has also been engaging in currency defence and has also cut reserve ratios releasing liquidity and giving further ‘central bank accommodation’ to capital flight. It could however be slightly better than an outright rate cut as some of the money could be mopped up again through the policy rate system and open market operations.

India also has a strong record of creating currency pressure, with the worst seen in 1991.

The Indian rupee has plummeted in recent days amid interventions.

Short term hopes

But Governor Cabraal insists that Sri Lanka’s currency defence is temporary and the exchange rate will get corrected in a couple of weeks.

“We have been maintaining stability of the exchange rate,” Cabraal said. He says stability is all-important at a time of global volatility.

Cabraal said Sri Lanka’s central bank started tightening early and had “pricked the bubble” much earlier than other central banks by bringing down monetary aggregates and tightening loan loss provisions.

He said such actions were standing the country in good stead now.

Global financial markets have received a battering in recent days, with signs emerging that a ‘deflationary collapse’, long predicted by hard money advocates when the dollar started to go off the gold standard, is taking place.

Cabraal said a credit arrangement for petroleum payments to Iran has also been extended till December, which will help the exchange rate.

But officials have said that the Iranian credit to the state-run Ceylon Petroleum Corporation (CPC) has largely been busted on delayed receipts from state entities.

Analysts say, that by increasing the spending power of the government, and therefore aggregate consumption in the economy, the delayed payments increase domestic consumption by a like amount.

This wipes out most, if not all, the temporary gains originally achieved by the oil credit in forex markets.

By getting credit and not settling bills on time the CPC has freed foreign exchange for other market players in the intervening period and run up a liability in excess of 500 million dollars, which was an avoidable overhang.