Nov 04, 2008 (LBO) – Sri Lanka’s grey market rate for US dollars has spiked sharply as the central bank continued to intervene in forex markets and print money to prevent a contraction in the monetary base, putting pressure on the rupee. In the grey market in Sri Lanka’s capital Colombo, US dollars are trading at 112.50 to 113.00 levels, compared to an officially intervened rate of 110.00 rupees in the Interbank forex market.
The central bank said Monday commercial banks were on average selling US dollars to retail customers at 110.77 rupees and buying at 109.41. Banks usually charge a higher spread for physical foreign currency notes.
In normal times, the grey market usually operates within the high commercial bank spread, profiting from the inefficiency of the official market and managing with spreads as small as 20 cents for regular clients.
As a result the grey market rate for US dollar notes, both for buying and selling is usually lower than that of commercial banks.
Two weeks ago Sri Lanka’s Interbank dollar rate was 108.00 to the greenback, held down with heavy official intervention.
Sri Lanka has a peg with the US dollar though paying lip service to a ‘floating rate’ but lacks the institutional framework to operate a sustainable or ‘hard peg’.
The central bank has been ‘sterilizing’ the effect of dollar outflows caused by dollar interventions by printing rupees into the banking system, an action which puts more pressure on the rupee.
Such ‘sterilized interventions’ are characteristic of a ‘soft-peg’ which eventually lead to currency and economic collapse, and has been well documented in East Asia (the East Asian crisis) and Mexico (Peso crisis) by monetary economists.
Since the crisis began in the middle of September 2008, the Central Bank has bought 89.5 billion rupees worth of Treasury Bills to print new money (814 million US dollars), data released on Monday showed. On Friday the bank had only 77.5 billion rupees of bills.
A further 7.5 billion rupees had been injected as a statutory reserve ratio cut.
The monetary base has also shrunk from 282 billion rupees in the first week of September to 273 billion last Thursday which analysts say is indicative of a loss of foreign assets backing the monetary base of 105.7 billion rupees (961 million US dollars) at least.
In order to break the cycle of interventions and money printing (sterilized intervention), the currency has to be floated. The central bank broke the peg last Thursday but failed to establish a float.
But the monetary authority has now cut access to a discount window that gave money at 12.00 percent from 10 times to three times a month. By yesterday 28 billion rupees (254 million dollars) were being injected through the window.
The bank has also put restrictions on international trade with higher margins for import letters of credit which were last used in the 2000/2001 currency and economic crisis.
Analysts say the crisis appeared to have been triggered by sterilization of dollar outflows from hot money that was originally brought in to bridge the budget deficit.
Meanwhile, the state-run Ceylon Petroleum Corporation also has to repay Iran for short term borrowings. It is also caught in a hedging contract that went against it.
A dollar outflow by itself does not cause a currency crisis (it causes the monetary base to shrink and interest rates to go up), but the crisis is caused by money printed to resist a contraction in the monetary base which is known as sterilization.
Sri Lanka’s foreign reserves were down to 2.6 billion dollars, Central Bank governor Nivard Cabraal said two weeks ago.
The International Monetary Fund has also urged Sri Lanka to break the dollar soft-peg to ‘ward off’ speculative capital. Analysts say maintaining the peg now only benefits foreign hot money, giving them more time to sell out of the island at a larger profit.
Economic analysts have also called for the re-establishment of a currency board to prevent high inflation and currency crises brought on by the soft-pegs operated by a sterilizing central bank.