ECONOMYNEXT- Sri Lanka is keeping its policy interest rate at 9.0 percent despite low inflation and weak growth to counter pressure on the rupee and foreign reserves, Central Bank Governor Indrajit Coomaraswamy said.
The central bank which cut rates in April and injected tens of billions rupees in to the banking system to enforce it, found the currency coming under pressure from May.
"There's pressure on our reserves and exchange rates," Governor Coomaraswamy said after delivering the central bank monetary policy roadmap for 2019.
"To reduce rates at this point can be counterproductive," he said.
He said some macroeconomic indicators pointed to rate cuts, while others call for rate hikes.
"Right now the pressure on the external sector is most urgent and we have to take that into account and the monetary board placed significant weight on it."
Sri Lanka has printed large volumes of money to sterilize interventions, while defending a pegged exchange rate regime.
In November 90 billion rupees were dumped into the banking system through a reserve ratio cut. Coomaraswamy said rates were raised 50 basis points to counter the effect of the SRR cut.
Sri Lanka is claiming to run a 'flexible exchange rate' which analysts say is a highly unstable or non-credible foreign reserve collecting peg with multiple convertibility undertakings which is prone to balance of payments crisis.
Analysts who track the central bank closely had warned from December 2017 (Sri Lanka's Central Bank should sell own securities in new credit cycle) that it was likely to cut rates when inflation was low and credit recovered and drive the country in to a balance of payments crisis as it had done in 2015, by running policy incompatible with maintaining a peg.
In February the central bank stopped mopping up inflows through term repos deals in February. In March it terminated term repos to print money as private credit spiked.
In April the central bank pumped money into the banking system quantity easing style, running up excess liquidity of 41 billion rupees overtaking seasonal demand for money to enforce a rate cut undermining the credibility of the peg.
In August/September after the rupee stabilized at a lower level excess liquidity was run up to 55 billion rupees, including through Soros-style swaps to against weaken the peg, data shows.
A legacy forex swap also matured. There may have been a legacy swap maturity involved in the April episode as well.
The International Monetary Fund has set the central bank forex reserve targets implying a de facto sterilizing peg where domestic assets of the central bank has to be sold down to mop up dollar purchases and foreign assets increased.
But there were no strict ceilings placed on domestic assets of the central bank to stop it from acquiring Treasuries to print money and pump excess liquidity into money markets and undermine the credibility of the peg.
Any central bank where domestic and foreign asset components grow in opposite directions runs an archetypical soft or non-credible peg that is prone to prone to balance of payments trouble.
In addition to a reserve target, which implies pegging to prevent appreciation, another convertibility undertaking was operated in terms of a targeting a real effective exchange rate index.
Critics had said it implying forced depreciation when currencies of bad central banks which have a large weighting bust their own currencies effectively importing monetary policy of the lowest denomination.
By October a real effective exchange rate index was at 98, below the target of 100, but the rupee is still under pressure.
But a central bank with a fixed policy rate cannot effectively control an exchange rate at will.
In November half a billion dollars were spent trying to stop the currency from falling further.
Yet another convertibility undertaking was set as preventing a 'disorderly adjustment' of the exchange rate.
Soft or non-credible pegged central banks that intervene in forex markets and print money to keep rates down rapidly run out of foreign reserves until credibility in the peg is restored by a float or higher interest rates or both.
Analysts had warned the central bank not to print money as any printing of money generates forex shortages which may lead to dollar sovereign default. (Colombo/Jan04/2018)