Sri Lanka rupee falls to new low below 168 to US dollar; cash injected to keep rates down
ECONOMYNEXT – Sri Lanka’s rupee closed at around 168.65/169.00 levels the US dollar Thursday down from 167.10/30 levels a day earlier, as the central bank injected cash to keep interest rates below the policy corridor ceiling.
The central bank injected 10 billion rupees overnight at 8.06 percent and 5 billion rupees for 5 days through a term repo auction at 8.15 percent higher than the 8.11 percent, a day earlier.
The central bank can allow rates to go up to 8.50 percent without a formal rate hike to reduce pressure on the rupee.
During the first run the rupee earlier this year, the central bank allowed rates to go up from June 06, to 8.50 percent to help end a run on the rupee which was triggered by tens of billions of rupees injected to the banking system during late March and April coinciding with a so-called ‘buffer’ strategy to repay bonds.
During the current run on the rupee, which coincided with tens of billions of rupee injected to the banking system from a currency swap, the rates had been held down at 8.0 percent pushing the rupee down faster.
The central bank also cut net open dollar positions (NOP) of banks, which analysts had earlier warned will worsen volatility of the rupee based on the experience of past episodes. (What Sri Lanka can do to improve the credibility of its soft-dollar peg: Bellwether). The rupee fell faster as expected after NOPs were cut.
A false narrative had been floated in recent years that Sri Lanka’s currency collapses come from time to time because it had been held fixed for a long time, though EN’s economic columnists had pointed out that the rupee will fall at time when money is printed to keep rate down against the market rate when credit picks up, regardless of past behavior.
In the current run on the rupee, tens of billions of rupees were printed through a currency swap.
"When a central bank engages in swaps, it is effectively providing a convertibility undertaking, and is pegging," explains EN’s economic columnist Bellwether. "Unless policy consistent with the peg is followed the rupee will fall."
If dollars are printed through an unsterilized action via an outright purchase, or the spot leg of a swap, the central bank has to either follow through with unsterilized dollar sales, or the new liquidity has to be killed (sterilized) to prevent it hitting the forex markets.
In the current run on the rupee, there is now a big liquidity shortage also due to other swap reversals (forward leg).
The central bank is now injecting tens of billions of rupees to sterilize the liquidity shortage and keep rates down.
"In sharp contrast to the rush to sterilize the shortage at 8.0 percent now with new money there was no rush to sterilize (mop up) liquidity in August when the liquidity shock hit the system," Bellwether says.
Both actions are against the stability of the currency.
The first term repo auction to mop up cash did not start until August 13, when overnight excess liquidity hit 57 billion rupees. No money was sterilized through a sell-down of bills either.
Bellwether had pointed out that it is easy to undermine the credibility of the peg by cutting rates and printing money and panic exporters but it is difficult to restore confidence.
In Sri Lanka the situation is further complicated because except in 2009, the rupee is not allowed to bounce back after currency pressure ends, which makes market participants desperate.
Analysts have pointed out that there are two problems with Sri Lanka’s central bank. One is common to all soft-pegs where an exchange and interest rate is targeted (by printing money) at the same time, which cannot be done in practice.
But in Sri Lanka there are additional inconsistencies.
While claiming to operate a flexible exchange rate (whatever that means) reserves are collected, or swaps are executed.
After printing money in emulating peg behavior, Sri Lanka then switches to a floating regime, sometime with tens of billions of rupees of excess liquidity remaining in the banking system. For a float to take hold quickly money markets have to be kept short.
In the current run on the rupee, money markets have been kept flushed with excess liquidity until September 14, except for one other day. Only in the last four days have money markets been consistent with a float.
This week the central bank rejected a 17.5 billion rupee bill auction which may end up as a permanent liquidity injection.
Due to the large liquidity shortfall that developed this week coinciding with the reversal of a 2013 swap with a state bank, a much bigger permanent shortfall had developed in the banking system. Any defense of the currency by the central bank then expands the shortfall.
It is not clear whether coupled with term auctions earlier this week, the money markets will again become flushed with excess liquidity overnight by the end of the week, putting further pressure on the rupee and undermining any float.
On Thursday the overnight shortfall fell to 18.25 billion rupees from 22.86 billion rupees a day earlier.
However some term reverse repo deals through which money was printed this week will expire next week. Analysts say it is important to keep the markets short by 20 billion rupees or more overnight.
Sri Lanka has a policy rate far in excess of the US Fed, which analysts say would allow the country to maintain a very strong peg with the US dollar, if the tendency to pump tens of billions of rupees through ‘quantity easing’ style exercises suddenly to give shocks to the system can be stopped. (Colombo/Sept21/2018 – updated with end of day data/recast)