Dec 11, 2008 (LBO) – Sri Lanka’s central bank says it is allowing a “gradual depreciation” of the rupee, after staying out of the market in early trading on Thursday, as the rupee dipped against the US dollar and recovered. “The central bank is not quoting so far, and the market is quoting on its own so far,” a dealer said.
Quotes which were wide at about 30 cents earlier in the day, indicating more uncertainty had narrowed to 15 cents by mid-day.
If the central bank stays off the market in the coming days, an effective float would have been achieved, economic analysts say.
Weerasinghe said the November intervention volumes were lower than in October when the central bank lost 587 million dollars trying to defend its peg.
“We had collected some reserves and we used it to maintain stability when world markets were most volatile,” he said.
In late October foreign reserves had come down to around 2.6 billion dollars from 3.5 billion before intervention began.
Central Bank intervention in forex markets can also cause banking crises as liquid securities are bought back from banks, and loan to deposit ratios of banks worsen.
The problem arises from a well understood monetary phenomenon where a monetary authority is not able to continuously target both the exchange rate and maintain independent domestic monetary policy (in the form of interest rate or money supply targeting) at the same time.
It is not known why central banks engage in peg defence. “We have allowed a gradual depreciation of the rupee,” Central Bank chief economist Nandalal Weerasinghe said after the rupee dipped to 111.30/60 levels.
“Other currencies have also depreciated and we are also depreciating to improve competitiveness of our exporters.”
The rupee later recovered with quotes first narrowing and rising to 111.20/40 and later recovered to 110.85/111.00 levels.
Dealers say there were expectations that the central bank may intervene at 111.0 levels.
The rupee fell to 110.30 against the greenback Monday and 110.65 on Wednesday.
Up to mid-day Thursday the central bank was not quoting a rate. Analysts have said it is vital for the central bank to stay out of the market to avoid further pressure on the currency, and conserve reserves.
Pressure on the currency comes when a central bank intervenes and then injects liquidity to maintain the domestic monetary base. Such actions known as ‘sterilized intervention’ led to the East Asian crisis and numerous currency crises in Mexico and Argentina.
When the central bank stays out of the market, banks trade among themselves and the domestic monetary base is not affected. Such a situation is known as a ‘float’.
Central Bank is tight lipped about future actions, and the market participants are not yet sure whether the central bank will intervene again.