ECONOMYNEXT – Sri Lanka’s real effective exchange rate (REER) index has dropped below 100 amid a collapse of a soft-peg with the US dollar, forcing the central bank to spend 1.2 billion US dollars to prop up the currency while printing money.
A REER index calculated by the central bank dropped from 102.24 in September to 98.10 in October and 96.29 in November, as credibility of Sri Lanka’s dollar peg was lost making exporters hold dollars and borrow printed money and foreign holders of rupee bonds to flee.
The rupee fell from 161 to the US dollar in August to 179 to the US dollar by end November. Meanwhile other currencies such as the Indian rupee appreciated. The rupee has fallen from 151 from the beginning of 2018.
A real effective exchange rate index is calculated by measuring the changes against a basket (usually trade weighted) and adjusted for inflation.
Sri Lanka is targeting the exchange rate to maintain a REER peg of around 100.
Central Bank Governor Indrajit Coomaraswamy said earlier in January that the rupee had depreciated almost 20 percent in 2018 and it was a ‘disorderly depreciation,’ of the currency.
"The real effective exchange rate is well below 100, so it is undervalued," Coomaraswamy said.
"So now we have to intervene. The depreciation of the currency is no longer aligned with fundamentals in terms of current account flows. It is being driven by capital outflows from the government securities market."
Analysts had warned that a soft-pegged central bank which prints large volumes of money to offset interventions in forex markets through open market operations to target interest rates (sterilizing outflows), allowing banks to give loans (or buy securities) without raising deposits, cannot hope to target an exchange rate with any degree of success.
Analysts have said that targeting the REER index requires currency board like tools (hard peg), such as a floating policy rate to limit or eliminate outflow sterilization with new money and a variable target reduces the credibility further.
Only Singapore runs a successful variable exchange rate target with money supply fully covered by forex reserves at all times.
"Whether the exchange rate target is perfectly fixed (zero or currency board), or 4 percent, or 6 percent makes no difference," EN’s economic columnist Bellwether explained.
"Policy has to be currency board-like to accurately control the exchange rate either at zero or 4 percent. "Controlling the rate at 4 percent is even more difficult because there will be uncertainty and speculation (no credibility), unlike zero when people just forget about the exchange rate.
"It is a serious policy error to think that the REER can be targeted without floating the overnight rates."
In the last four months about 1.2 billion US dollars had been spent on defending the peg, and large volumes of money printed to stop reserve money supply from adjusting to the movements of the balance of payments by simultaneously targeting a policy rate.
Governor Coomaraswamy had said that the new money was not inject to monetize debt (print money for deficit financing). Finance Minister Mangala Samaraweera in fact had raised taxes and managed the deficit.
"I wish to emphasize that Open Market Operations are a strategy to manage market liquidity and align short term rates wth the policy rate and is a not a mechanism to print money by purchasing or holding treasury bills by the central bank as wrongly interpreted by some analysts," Governor Coomraswamy said.
"A clear distinction must be made between such OMOs widely practices by the central banks all around the world and monetizing the fiscal deficit through the central bank purchasing Treasury bills issued on behalf of the government. That is essentially high powered money."
Sri Lanka’s soft-peg makes the country to go for frequent bailouts to the International Monetary Fund, while blaming monetary instability on trade or the finance ministry.
Analysts have faulted the International Monetary Fund for building a program which required forex reserve collection, which requires the operation of a peg which sterilizes inflows (mops up inflows) keeping rates slightly higher than credit demand.
But there were no performance criteria in the form of ceilings on domestic assets to prevent open market operations from generating monetary instability either through injections of new money like in April or unsterilized excess liquidity, like in August/September.
Monetary instability which started with a liquidity spike in April with printed money ended with the exchange rate at 161 to the US dollar by August. An unsterilized spike in September has driven the rupee to 182. In contrast, an inflation target, which requires a floating exchange rate with no forex reserve target, was given.
However even the IMF does not advocate intervention in the forex market when there are capital outflows.
As late as June 2018, the IMF executive directors warned that "exchange rate flexibility should be the first line of defense against volatile global capital flows."
Sri Lanka runs a soft-peg with multiple convertibility undertakings which is called a ‘flexible exchange rate.’
These include an IMF performance criteria to collect reserves, which implies implicit strong side convertibility undertaking, an undertaking to keep the REER around 100 (which could be either strong side or weak side peg), and an undertaking to prevent a ‘disorderly adjustment’ of the exchange rate (weak side) which are in the spot market.
There are also explicit convertibility undertakings in the forward market through legacy and new rupee dollar swaps. (Colombo/Jan22/2018)