Sri Lanka pegs strongly to US dollar in May

ECONOMYNEXT  – Sri Lanka’s central bank has pegged strongly to the US dollar in May 2019, buying 45 million US dollars from the interbank forex market to stop the rupee from appreciating, official data show.

The central bank bought 45 million US dollars from the interbank market in May 2019, deploying a strong-side convertibility undertaking and had sold 40.5 million US dollars to enforce a weak-side convertibility undertaking, central bank data showed.

Sri Lanka’s overnight rates were hitting a policy corridor floor of 8.00 percent in May, due to weak private credit showing that short term rates were kept higher than the free market rate by the central bank in a cautious move.

When overnight rates hit the policy floor and overnight rates are kept up artificially the exchange rate peg is strong and tends to appreciate.

Despite having a floor rate of 8.00 percent the central bank mopped up excess liquidity at rates as high as 8.50 percent in May in a cautious move though overnight and term repo rates, amid fears of capital flight in the wake of Easter Sunday bombings.

When credit weakens the central bank can buy dollars to stop the rupee from appreciating, allowing the overnight rates to hit the floor of the policy corridor, creating dollar-backed liquidity.

Interbank forex transactions with the central bank do not show dollar purchases from the Treasury, which can also boost liquidity.

Sri Lanka has a soft-peg to the US dollar, with multiple convertibility undertakings, including a forex reserve target set by the International Monetary Fund and a declared undertaking to prevent excessive volatility.

One of both them may have been deployed in May. The central bank has a explicit convertibility undertaking to target a Real Effective Exchange Rate at 100. It is not clear whether the CU had also been deployed to keep the exchange rate around 176 to the US dollar.

On May 30, the central bank cut the floor policy rate to 7.50 percent from 8.00 percent.

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The central bank has been mopping up overnight cash at rates around 7.85 percent after the rate cut.

If Sri Lanka’s government spending picks up and revenues fall, overnight rates may start to move up.

Though operating a peg with multiple convertibility undertaking operationally (external anchor), it also targets an inflation index (a domestic anchor) and generates balance of payments crises, as soon as inflation falls to low levels.

Analysts have pointed out that inflation falls to low levels about an year or more after the last balance of payments crises ends. This coincides with a pick up in the credit system and rise in rates towards the ceiling policy rate. Under ‘inflation target’ the central bank then prints money (generates rupees backed by Treasury bills) and triggers a balance of payments crisis (pushes peg to the weak side of its convertbility undertakings).

Imports, the merchandise trade account, the current account, capital flight, gold and the budget deficit is then blamed for the crisis. (Colombo/June17/2019)