COLOMBO (EconomyNext) – Sri Lanka’s forex reserves dropped to 6,835.7 million US dollars in March 2015 from 7,420 million US dollars in February, the lowest since 6,774 million dollars reached in February 2012, official data showed.
The value of gold holdings dropped to 848.8 million US dollars in March from 866 million US dollars in February.
Sri Lanka’s balance of payments turned into deficit after August 2014 when domestic credit picked up.
Foreign reserves have been under pressure from repayments to the International Monetary Fund, – which take place outside the domestic credit system – as well as liquidity management errors, where the Central Bank has failed to permanently sterilize excess liquidity in the banking system.
Analysts have pointed out that as long as accumulated excess liquidity is allowed to be loaned out as bank credit, generating imports, forex reserves will be lost when unsterilized intervention are then made in the forex market to maintain the exchange rate.
If the liquidity is permanently mopped in the domestic market, all credit will be from freshly generated savings, automatically matching outflows to inflows and safeguarding reserves.
Sri Lanka’s Central Bank also settles foreign loans of the government using forex reserves acquiring Treasury bills in the process.
When the Treasury bills are sold into existing excess liquidity rather than into the banking system outside the liquidity, it is not possible to curb an equal amount of credit or demand and rebuild forex reserves, as has happened historically in Sri Lanka.
Analysts have warned from last year, before the current administration ratcheted up spending in a revised January 2015 budget that forex reserves were under pressure from repayments to the International Monetary Fund, errors in liquidity management and low interest rates (Sri Lanka may lose forex reserve beauty contest amid ultra-low interest rates – Bellwether).
Analysts have urged the Central Bank to permanently sterilize excess liquidity through outright sales of any Treasuries it holds, or using Central Bank securities and allow interest rates to go up, to curb demand and generate fresh savings.
Though it is sufficient to have foreign reserves a little more than the domestic reserve money (about 5 billion US dollars in Sri Lanka now) as long as the monetary authority is willing to free float interest rates, investors and rating agencies watch foreign reserves and get agitated when they fall.
The phenomenon known as a ‘beauty contest’ forces many pegged exchange rate central banks to maintain higher than necessary levels of forex reserves and still suffer from loss of confidence when they try to keep interest rates down despite rising state or private credit.