ECONOMYNEXT – Sri Lanka cannot continuously defend an exchange rate, spending large volumes of forex reserves, Central Bank Governor Indrajit Coomaraswamy said, making a case for a flexible exchange rate.
Sri Lanka is vulnerable to so-called balance of payments or currency crises from 1951 after the creation of a central bank that tries to defend an exchange rate while printing money to stop interest rates from going up.
If money is printed to maintain a policy rate and artificially depress market interest rates, the exchange rate has to be allowed to fall or float.
"A smooth market-based exchange rate would prevent highly disruptive adjustments after a period of stable rates artificially maintained by continuous intervention by the Central Bank,…" Central Bank Governor Indrajit Coomaraswamy said.
He said, in 2011-2012, Sri Lanka rupee fell 14 percent after spending $4.0 billion to defend the currency.
In 2015, the rupee fell 6.5 percent after spending $2.1 billion to defend the currency.
"Wasting large amounts of the country’s external reserves, much of it borrowed, in a vain effort to defend the currency, which has to be ultimately depreciated anyway, is clearly unsustainable," he said.
"It is time to stop this pattern and commence building up external reserves through sustainable foreign exchange inflows."
He said Sri Lanka was exposed to capital outflows and the country also had large budget, and currency account deficits.
"Volatile global market conditions and Sri Lanka’s vulnerability as a twin deficit country underscore the vital importance of having a flexible exchange rate policy to adjust to external pressures," he said.
"Recent experience has clearly demonstrated that it is unsustainable to maintain an overvalued exchange rate at the expense of external reserves."
Coomaraswamy’s comments on the alleged ‘overvaluation’ of the rupee come despite an analysis by the International Monetary Fund before the latest balance of payment crisis, showed that the rupee was not overvalued trough several measurements.
But a currency that falls quickly in response to capital outflows such as bond sales by foreign investors, can reduce further speculation of a currency fall.
Sri Lanka’s currency peg has no credibility and is a so-called ‘soft’ or non-credible peg.
The central bank, by printing money to delay interest rate hikes, generate high credit growth.
After defending the currency by selling dollars and absorbing rules (a non-sterilized sale) a soft-peg then prints money to fill the liquidity shortage, preventing the credit system from responding to the outflow with higher rates and tightened credit.
Such offsetting forex and money market transactions quickly snowball into a never ending vicious sterilized intervention cycle, helped by speculative capital outflows and late exporter conversion and early import bill settlements.
"A properly designed and widely accepted framework for exchange rate management will also be introduced to establish a market- based exchange rate system in the country," Coomaraswamy said.
The exchange rate could be based on a basket of currencies, he said.
Many countries moved into unsustainable soft-pegs after the Second World War under the US-driven Bretton Woods system setting up central banks to pursue Keynesian style deficit spending policies.
Singapore and Hong Kong among countries that resisted the temptation. Several countries in the GCC, which mimic US policy rates, have had more success in maintaining stability and avoiding currency crises.
Australia, New Zealand and Japan had moved to floating rates after Bretton Woods system collapsed.
They use a variety of currency baskets to arrive at an exchange rate that can reduce speculative expectations. (Colombo/Jan04/2016)