Sri Lanka forex reserves down 28-pct in Jan

Mar 27, 2012 (LBO) – Sri Lanka’s forex reserves fell 28 percent to 5,806 million dollars in January 2012, from a peak of 8,098 million US dollars reached in July 2011, around the time a balance of payments crisis started, official data showed. The currency board had helped keep inflation low and allowed Sri Lanka to keep a stable exchange rate from 1885 and helped make Colombo a financial centre, where even foreign countries including from Malaysia raised capital.

Sri Lanka’s current balance of payments crisis began around June 2011 shortly before a billion dollar bond was sold, due to high credit growth, partly from the state, which was not balanced with higher interest rates to raise needed deposits and cut consumption.

Rates have since moved up and the rupee has fallen to around 130 rupees from around 109 before the crisis began.

Once triggered, Sri Lanka’s balance of payments crises accelerate rapidly due to the double whammy effect of sterilized sales of foreign currency and unsterilized purchases of large forex inflows by the central bank.

The combined actions of sterilized sales and unsterilized purchases forces the currency down further than necessary causing an ‘overshoot’ and also requires higher than needed interest rates to end the balance of payments crisis.

However since February action had been taken to reduce state borrowings by raising energy prices and Treasury bill rates have also moved up.

Commercial banks have also raised deposit rates, which helps generate the deposits needed for credit from the domestic banking system and cutting aggregate consumption to re-balance the economy.

From mid March however liquidity has remained in the banking system which analysts say may indicate lower credit growth.

Lower credit growth will help maintain the currency peg.

Corrected – Reserves fall 28-pct Measured in terms of months of imports, Sri Lanka had reserves of 3.4 months, Sri Lanka’s Central Bank said.

But analysts say measuring reserves in terms of months of imports has no meaning, as a balance of payments crisis is triggered when reserves are used to pay for imports and maintain a dollar peg and the ensuing domestic currency shortages are ‘sterilized’.

Sri Lanka’s foreign reserves in January were more than the monetary base, indicating that the central bank could meet all domestic monetary liabilities provided no fresh money was printed to ‘sterilize’ interventions.

Balance of payments crisis are an economic disease associated with so-called ‘soft-pegs’ where a central bank tries to maintain a fixed peg while also printing money to control an interest rate by spending reserves and ‘sterilizing’ liquidity shortages with fresh money.

Soft pegs were created by interventionist US economists as part of the failed Bretton Woods system of unstable pegs which collapsed in 1971.

Sri Lanka has had ‘foreign exchange shortages’ and balance of payments crises since 1951 when a soft-pegged central bank was created to join the Bretton Woods system after abolishing a currency board or hard peg.