ECONOMYNEXT – Sri Lanka’s central bank is studying whether to hike a 25 mandatory dollar conversion requirement in the wake of cabinet decision on the matter, Deputy Governor Dhammika Nanayakkara said amid record low rupee rates and excess liquidity in money markets.
Exporters have increased their dollar deposits and are funding expenses with rupees, he said.
“So what we see here is exporters who used to converts substantial amount of their export proceeds into LKR now prefer holding on to dollar balances,” Nanayakkara told reporters on June 08.
He said there was a cabinet decision asking the central bank to consider increasing the 25 percent limit “to a higher level” after a study.
Meanwhile importers were also borrowing rupees and stocking up, putting pressure on a 200 to the US dollar non-credible rupee peg, which has been maintained for some time.
“The pressure is coming because there is front loading of imports,” Nanayakkara said.
“The importers think that at any time the government would come and place some restrictions on some imports, especially on essential imports.
“And they also think given the developments whet her the exchange rate would depreciation will depreciate to a very low level.
“To avoid that they import as much as possible they borrow in rupees and they demand for dollars for these imports.”
A central bank cannot maintain a credible peg as long as long liquidity injections are made through lender of last resort windows or outright monetization of debt to drive new credit.
Sri Lanka has imposed sweeping import and exchange controls on the small windows that were opened at one time in a closed capital account as liquidity injections hit the dollar soft-peg.
In addition to import controls, Sri Lanka has also closed most of the minuscule windows opened in the closed capital account with new exchange controls.
Central bank officials however belief that the credibility of the peg will improve in the future, especially since the 200 rate has been kept for a while.
“People will start believing that there is no need for rushing for imports or delaying export proceeds conversions,” Nananyakkara said. “Those will materialize and whatever restrictions that are currently in place will be take out when the position improves.”
Credible pegs have floating short term rates which are slightly above that of the anchor currency usually the Fed, but some Baltic state have had credible pegs with the Euro.
Nepal and Bhutan maintain pegs with an unusually high credibility for over half a century with the Reserve Bank of India, though RBI policy has deteriorated sharply over the past decade, according to some critics.
Sri Lanka’s forward exchange rates are also trading at steep discounts in another perverse effect of money printing.
The liquidity injections have led to a steady drain on forex reserves mainly through the financial account triggering record balance of payments deficits.
Sri Lanka is under the worst import controls since the 1970s when also large volumes of money was printed and import substitution rent seekers were promoted to sell goods (usually low quality) at higher than world prices.
Sri Lanka saw severe monetary instability and weakened credibility of the peg from 2015 onwards with a so-called flexible exchange rate (non-credible external anchor) and high domestic inflation target spiking up to 7 or 8 percent (non-credible domestic anchor) critics have said.
The non-credible conflicting anchors triggered two currency crises from 2015 to 2019 and Sri Lanka is now on the third one. (Colombo/July08/2021)