Sri Lanka rupee steady amid interventions

ECONOMYNEXT – Sri Lanka’s rupee was quoted at 157.60/70 to the US dollar in the spot forex markets, with the state banks which usually act for the central bank selling dollars, dealers said.

The interventions so far seem to be unsterilized, which is consistent with maintaining a peg.

However not intervening after printing money is also consistent with a floating rate.

The rupee closed wide around 157.75/85 Friday.

Dealers say selected small banks are given dollars via state banks at around 157.60 rupees but the rest of the market can buy from each other at 157.70 levels.

There is no active spot market at the moment, with the central bank engaging in heavy moral suasion against forex dealers in recent days.

However the central bank should instead engage in moral suasion against banks which are borrowing from its overnight reverse repo operations, EN’s economics columnist Bellwether says.

"Forex dealers are helpless because excess imports and pressure on the peg comes from loans made with liquidity injected from domestic operations.

"No dealer, or investor can mount a speculative attack on a central bank with dollars. It is only with a central bank’s own money that a peg can be pressured."

If there is deterioration in the budget or state energy agencies, a generally higher rate of interest is required to keep generating deposits to fund credit.





Pressure on Sri Lanka’s non-credible peg comes either from money printed outright through Treasury bill acquisitions of the central bank, term pumping through reverse repo auctions or overnight through the standing liquidity facility (overnight window).

The least harmful for the credit system and the rupee is if money created through the overnight window temporarily and banks are forced to fund all credit with real deposits at least the following day.

The rupee came under pressure in 2018, amid excessive money printing to enforce overnight rates below the reverse repo ceiling rate in April, with a rate cut coming on top of a seasonal demand for extra cash.

The central bank first terminated repo deals to release liquidity in late March and then it cut rates on April 04 a s overnight rates, which were near the floor policy rate of 7.25 percent up to mid-March suddenly shot up.

Up to March excess liquidity in the banking came from dollar purchases as the central bank operated a pegged exchange rate involving sterilizing dollar purchases and domestic assets reduced and foreign assets rose.

However in April rates were cut and excess liquidity was maintained below the ceiling policy rate with a series of term repo auctions eventually putting the rupee under pressure, and undermining the credibility of the peg. Rupees were also injected by Treasury bill purchases.

The liquidity conditions in April 2018 was in sharp contrast to April 2017, money markets were short with banks forced to borrow overnight at the reverse repo window at 8.75 percent.

The central bank can withdraw the liquidity by selling down its Treasury bills, which spiked from 13 to 73 billion rupees in April. The central bank has since cut the holding to 50 billion rupees.

The central bank can also withdraw liquidity by selling dollars (unsterilized interventions), which will also strengthen the rupee.

At the moment the market still has excess liquidity. Last Friday the central bank mopped up 9 billion rupees and other banks 11.37 billion rupees from the reverse repo window.

Net excess liquidity has come down from 30 billion rupees on April 25 to about 4.1 billion rupees on Friday.

As long as dollar sales are unsterilized (disappearing liquidity is not replaced through outright bill purchases or term reverse repo pumping) dollar sales will tend to take away pressure from the peg as excess rupees are mopped up..

However if liquidity is injected to replace the dollar sales (sterilized forex sales) especially through term pumping, to keep rates down pressure on the rupee can increase.

In early 2015, the central bank triggered a balance of payments crisis with almost identical moves.

The monetary authority first terminated repo deals, then enforced a rate cut from April 2015 by purchasing Treasury bills outright to inject liquidity and also through term pumping. In April there was a rate cut despite pressure on credit markets with a deteriorating budget.

It was only in the first quarter of 2016 that then Governor Arjuna Mahendran ordered term pumping to end, letting rates to float up to the reverse repo ceiling.

At the moment the credibility of the peg, is only partly undermined with exporters holding dollars back.

If the central bank resumes term pumping, there will be renewed pressure on the rupee.

The credibility of the peg will be fully undermined with if foreign bond holders start selling out.

Forcing banks to borrow only overnight at 8.50 percent will create some pressure but will help correct the imbalance.  (Colombo/May08/2018)

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