An Echelon Media Company
Thursday October 6th, 2022

Sri Lanka spends US$225.5mn to defend non-credible peg in July

ECONOMYNEXT – Sri Lanka has spent 225.5 million US dollars to defend a peg and give convertibility to newly printed rupees, official data shows, while 49.5 million dollars were bought amid a forced surrender rule, official data shows.

Sri Lanka’s central bank has decreed a 203 to the US dollar exchange rate to the US dollar without monetary policy to back it on September ‘revaluing’ from 226/233 levels day earlier.

The rupee had fallen to around 231 to the US dollar by the first week of September after the central bank denied convertibility to the rupees it is producing.

A sale of 200 million US dollars at 203 rupees to banks should create a 40 billion rupee liquidity shortage in the banking system and drive overnight rates up, curb domestic credit, reduce imports by curbing credit, to operate a stable exchange rate, avoid currency crises and external instability.

However in a soft-pegged exchange rate regime, the liquidity short is re-filled (sterilized) with newly printed money, preventing a correction in the external balance of payments, interest rates, savings or consumption.

The liquidity injection to sterilize interventions makes a peg ‘non-credible’.

Such unstable regimes, without credible monetary policy to back it, are now called a ‘flexible’ exchange rate and is also found in Latin America.

In Sri Lanka the ‘flexible’ exchange rate triggered capital flight from rupee bond markets and a series of credit downgrades.

Sri Lanka is injecting money to keep a policy rate of 6.0 percent in the overnight money market and is also injecting cash at various points along the yield curve through ceiling rates imposed on bond auctions.

The liquidity injected also drives credit, imports, discourages savings.

Sri Lanka has also imposed forced surrender rule for remittances and exports. In July the central bank bought 49.38 million US dollars reducing net interventions to 176.12 million US dollars.

A dollar purchase by the central bank also injects liquidity further weakening the currency peg, unless rupee securities held by the central bank are immediately sold down to mop up the liquidity and prevent it being used for domestic credit, investment or consumption.

Central bank dollar purchases at a time the exchange rate is weak, has been a recurring cascading policy error in past currency crises.

“A convertibility undertaking is a check against monetary excess and maintain the actual monetary anchor in operation,” explains EN’s economic columnist Bellwether.

“However if dollars are bought when the peg is weak, it adds liquidity and worsens monetary excess, and further weakens the currency by creating new money in excess of the anchor. Sterilizing a dollar sale also has the same effect.

In the past such so-called ‘strong side convertibility’ undertakings have been deployed to buy dollars coming to the Treasury from foreign loans.

However now the Treasury is now paying back foreign loans on a net basis, and the policy error is limited to forced surrenders.

With effect from September 01, the central bank imposed a 2.0 percent hike in statutory reserve ratio withdrawing around 130 billion rupees of liquidity. However it was also fully sterilized by overnight injections keeping the rate at 6.0 percent.

Overnight injections had since reduced with permanent money coming from failed bond and bill auctions.

Sri Lanka set up a non-credible peg in 1950 abolishing credible peg which had kept the country stable through two world wars and one great depression and has run into regular economic crises since then.

The peg has since broken from 4.77 to 203 to the US dollar officially, and to around 240 in parallel markets in the worst performance among South Asian currencies all of which are derived from the Indian rupee which was also at the same rate in 1950.

The most credible pegs in the region are being maintained by Bhutan and Nepal with the least activist, but are anchored to the Reserve Bank of India, which also has somewhat chaotic monetary policy.

On an absolute basis the Seychelloise rupee is the best at around 13.00 to the US dollar followed by the Maldives at 15 to the US. The Seychelles rupee broke in 2008. The Mauritian rupee, which tracks the euro is at 42. (Colombo/Sept15/2021)


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