Sri Lanka mulls extending IMF deal amid soft-peg trouble

ECONOMYNEXT – Sri Lanka may extend an International Monetary Fund program which due to end in the first half of 2019, as the central bank has again enters a period of balance of payments trouble, while operating a highly unstable soft-pegged exchange rate regime.

Sri Lanka is on a reform oriented 3-year extended fund facility (EFF) which was due to end in April 2019.

"There is a provision for the EFF to be extended by a year," Coomaraswamy said. 

"The government could negotiate if it wants to."

"It is an option, and what we have to see is how much more money we need and what are the terms and conditions.

Sri Lanka was about to sign the last section of a three year program when President Maithripala Sirisena triggered political crisis by appointing ex-President Mahinda Rajapaksa as Prime Minister and dissolving parliament leading to credit downgrades.

Coomaraswamy said he believed downgrades could have been avoided if a staff level agreement agreed in late October could have been signed.

Now however the administration is in election mode.

"The government can take a decision to make a request," Deputy Governor Nandala Weerasinghe said.

"Based on that request we can negotiate."





Central Bank Governor Indrajit Coomaraswamy said it would be useful to have a program extension.

The IMF forced Sri Lanka to operate a pegged exchange rate regime with a forex reserve target but the central bank was allowed to behave like a monetary authority with a free floating exchange rate rate, involving cutting interest rates when inflation fell.

The IMF program was suspended in September after the central bank failed to collect reserves in 2018 after it started injecting money in to the banking system from March, amid a private credit spike, loosening a peg which was kept tight until the first quarter of 2018 with sterilized purchases.

The central bank then cut rates in April and injected tens of billions of rupees in the banking system in quantity-easing style putting pressure on the rupee and undermining the credibility of the peg.

From May, foreign investor in bonds started to leave.

The central bank was also targeting the exchange rate along a real effective exchange rate index, without having the tool to control the exchange rate, which is a floating policy rate.

Another de facto convertibility undertaking was given in the form of preventing a ‘disorderly adjustment’ of the exchange rate.

A soft or non-credible peg involves defending an exchange rate and printing large volumes of money to keep interest rates down, which allows bank to give credit preventing an adjustment of the credit system, putting further pressure on the peg.

A float is usually required to re-establish confidence in the exchange rate and prevent further injections of new money (sterilized forex sales).

Sri Lanka had repeatedly gone to the IMF as large volumes of reserves were lost in a short time amid sterilized forex sales in the past half century, since a currency board (hard peg) was abolished in 1951, eliminating a hard budget constraint.

Over the past three months, 1.1 billion US dollars were lost as interventions were followed by money printing. New money was also released into the banking system by cutting a reserve ratio in November.

Sri Lanka and its citizens had paid a heavy price for running a soft-peg in the form of capital controls, trade controls, inflation, export of labour abroad, demand for subsidies and deficit spending.

The current administration’s free trade strategy was also torpedoed to try to maintain the peg, which has no credibility.

The administration hopes to make Sri Lanka a financial centre, while the soft-peg has made it difficult for people to even buy a car or three wheeler due to credit and import restrictions.

The soft peg has also kept nominal interest rates high, as investors demanded a premium to account for chronic depreciation, despite partial opening of the capital account. (Colombo/Jan02/2018)

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