Sri Lanka rupee ‘a little’ undervalued: Central Bank Governor
ECONOMYNEXT – Sri Lanka’s rupee is a ‘little undervalued’ Central Bank Governor Indrajith Coomaraswamy said as the currency fell after a rate cut and liquidity injections to meet a real spike in seasonal festival demand for currency in and to enforce overnight rates below the lowered policy ceiling rate.
Sri Lanka’s real effective exchange rate index, which measures the composite movement against a basket of currencies adjusted for inflation was slightly below 100.
"The currency is a little undervalued," Coomaraswamy said. "As a rule of thumb we would like the Real Effective Exchange Rate Index to be around 100."
"We do not see any reason for exchange rate volatility."
Sri Lanka’s REER rose as much as 105.24 in November 2017 despite the currency being weaker than better performing East Asian nations in recent months. In the first quarter however Sri Lanka’s inflation also fell.
The last published number for February shows the REER index at 101.38.
Multiple Anchor Controversy
Sri Lanka’s targeting of the REER is also controversial, with analysts saying it is inconsistent with a domestic anchor inflowing an inflation target and it also make policy hostage to the likes of the Reserve Bank of India which is hardly an example to follow. (Sri Lanka may be heading for a triple anchor ‘inflation targeting’ oxymoron: Bellwether)
Analysts say Sri Lanka’s REER will tend to rise when East Asian nations with better monetary policy including China depreciates, but the rupee eventually follows the worst regional central banks like those in the Philippines, Indonesia and especially India and will not appreciate with the best Asian central banks.
The countries with the best monetary policy in Asia includes Singapore and Japan which have permanently appreciated since the break-up of the Bretton Woods and Taiwan, Malaysia, China since the early 1990s and Korea since the mid-1980s.
Hong Kong, Brunei and Macau have currency boards or a true fixed exchange (a floating ‘policy’ rates) like Sri Lanka had before the country’s monetary and fiscal troubles began when a soft-pegged exchange rate was set up in 1950.
The rupee fell from 155.50/70 to the US dollar at end March to 157.70/90 to the US dollar on April 26 following a rate cut and liquidity injections
The ceiling policy rate was cut from 8.75 percent to 8.50 percent and liquidity injections were made to enforce overnight rates at around 7.90 percent.
Sri Lanka is now allowing the exchange to be market determined Deputy Central Bank Governor Nandalal Weerasinghe said.
The central bank was holding back firepower despite having almost 10 billion US dollars in reserves, he said.
"There is more volatility in exchange rate than before," Weerasinghe said.
"This is a sign of a market determined exchange rate. If we think it is too much movement we can intervene."
Sri Lanka had collected about 9.8 billion US dollars in reserves by April after a 2.5 billion US dollar bond sale, which was almost the highest in is history.
He said the Indian rupee, the Indonesian rupiah, Philippines peso and the Australian dollar have also weakened of late.
Analysts say Sri Lanka’s exchange rate policy is now consistent with its monetary policy, where the rupee is floating with no intervention responding to the lower rates which were enforced with liquidity injections.
When the currency moves down inflation may respond faster analysts say, eventually triggering a policy correction if necessary provided a suitably narrow headline inflation number is targeted.
Targeting high inflation target will delay any response which analysts say helped create the 2015/2016 balance of payments crisis. Targeting a core inflation rate may also delay or mislead policy and fire asset price bubbles like it happened to the Fed.
But interventions in the forex market will mop up liquidity and tend to push interest rates higher creating a conflict with the interest rate target.
Analysts say such a move can also trigger a true balance of payments crisis involving vicious cycle of sterilized forex sales (more dollar sales and more liquidity injections) and capital flight, if rates are not allowed to move up especially credit demand is strong.
Speculators can only hit a central bank with its own currency, and new money has to be created by the same agency to fire at it. No speculator can break a central bank with a foreign currency, however many billions of foreign currency they have.
Before mid-March however the central bank was buying dollars and was sterilizing purchases by mopping up liquidity to keep the forex reserves and also stopped rates from falling below the floor policy rate of 7.25 percent.
Sri Lanka has bought almost two billion US dollars and sold down 290 billion dollars of Treasury bills to draw rupee reserves away from banks and keep the reserves since the end of a balance of payments crises.
Some dollars were also retained by an expansion of the monetary base.
Such a policy is consistent with a sterilizing central bank that is maintaining a pegged exchange rate, targeting an external anchor.
The central bank also prevented the peg from moving up by purchasing dollars at increasingly weaker rates.
It is not clear how a long floating rate will be maintained as the central bank is compelled to collect foreign reserves under an International Monetary Fund program, which forces it to behave like a sterilizing central bank.
Dollar purchases will expand the reserve money base, and unless sterilized or mopped up will also push the currency down just like an expansion of the monetary base by liquidity injections does as banks loan the money out. (Colombo/Apr26/2018)