Sept 08, 2011 (LBO) – The International Monetary Fund is not in favour of mounting an interest rate defence of Sri Lanka’s currency peg, but would like to see exchange rate flexibility instead, an official said. Sri Lanka’s interest rate policy has been largely passive since a currency crisis ended with the float of the rupee in April 209, which ended a cycle of sterilized intervention – where liquidity shortages from dollar sales are filled with freshly printed money.
Soft Peg
Sri Lanka runs into frequent currency crises because the country has a so-called ‘soft peg’ – an unstable monetary system which targets both the interest rate and exchange rate, where policy rate errors result in high inflation and currency weakness, or balance of payments crises.
After the April 2009 float, credit growth was weak and external inflows were permanently locked up by absorbing rupee liquidity with the central bank selling down is domestic securities portfolio.
Some rupees from some dollar purchases were some have built up as excess rupee reserves after the Central Bank ran out of domestic securities.
As a result monetary policy has been somewhat passive with excess reserves being deposited