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Sri Lanka cabinet approves two year forex cover for foreign investors

ECONOMYNEXT – Sri Lanka’s cabinet of ministers had approved swaps of up to two years to cover foreign exchange risks of investors in rupee bonds of up to a billion dollars, the state information office said.

The Monetary Board of the central bank had approved the provision of foreign exchange cover between one to two years for foreign investors in rupee government securities and unspecified other sectors.

The cover will apply for new investments between 25 million and 1,000 billion dollars.

The buy/sell swap will be carried out at the same exchange rate by the commercial banks selling and buying foreign exchange to the investor.

Any losses incurred by the central bank in the process will be set off against the future profit transfers to the Treasury, making it a fiscal cost.

Foreign investments in Sri Lanka rupee bonds fell from over 450 billion rupees to around 12 billion rupees over the past five years as the rupee depreciated sharply amid monetary instability coming from the lack of a stable anchor.

The rupee fell from 131 to the US dollar from 2015 under a so-called ‘flexible exchange rate (a discretionary external anchor) and flexible inflation targeting (a discretionary domestic anchor), which was enforced with call money rate targeting with excess liquidity as domestic credit picked up.

By allowing overnight rates to fluctuate within a wide band, depreciation can be reduced and without a ceiling rate completely eliminated.

By giving a swap the authorities will be providing a ‘convertibility undertaking’ for two years to foreign investors.

When the central bank of Sri Lanka was set up in the style of several Latin American soft-pegs ending a currency board (full forex cover for all domestic and non-resident economic players) it was not envisaged that the rupee will fall.

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An objective at the time was that the external value of the rupee will be maintained. However liquidity injections – especially pro-cyclical injections when domestic credit picked up – the rupee fell and forex controls were imposed. Economists call this the impossible trinity of monetary policy objectives.