Sri Lanka rupee shows life

Aug 17, 2009 (LBO) – The rupee strengthened against the greenback Monday with state banks that usually represent the monetary authority staying off the market amid a large dollar inflow, dealers said.

Speculators hit a currency when a central bank tries to keep a ‘soft’ peg. A central bank (especially one with exchange controls) through its repo window can keep interest rates high, giving incentives for further hot money to come in.

But it cannot keep the peg when money flows out, as interest and exchange rate policies turn inconsistent, giving rise to a balance of payments crisis, if it persists in defending the peg.

But a float in March, after which exchange rate and monetary policy turned consistent and the peg tightened has also made it less attractive for banks to hold dollars overnight, reducing the depth of the market, dealers said.

This also contributes to volatility.

In October 2008 the IMF said that the “de facto peg risks contributing to external instability by attracting speculative inflows that could reverse quickly.”

The country went into a deep balance of payments crisis soon after and eventually about 600 million dollars of hot money left the country, using a forward exchange hedge provided by the de facto peg with the US dollar.

In 2009, most of a 270 million US dollar inflow to rupee securities has come to bill markets, and dealers say some buyers have also bought forward cover.

Under an IMF program, a Central Bank is not allowed to run inconsistent money and exchange rate policies. The rupee which opened at 114.90/95 against the US dollar was quoted wide at 114.65/85 when state name quotes went off the market.

Dealers say a large inflow to securities markets put upward pressure on the rupee.

The quote later narrowed to 114.80/85 levels, dealer said.

On Friday the US dollar was quoted at 115.00/115.05 levels with deals done around 115.00 rupees with a foreign bank on the buy side, giving life to an otherwise dead market.

A flexible rate makes the currency less of a sitting duck for foreign speculative capital.

If a currency appreciates when there is an inflow the potential profits for hot money is less than if the peg was tight, providing an automatic forward exchange hedge for foreign rupee security buyers.

If the currency also falls when hot money flows out, the incentive for speculative hot money further reduces.

In a ‘hard peg’ or currency board, hot money automatically pushes down interest to near zero to discourage further inflows.