Sri Lanka tightens capital account to maintain soft-peg
ECONOMYNEXT – Sri Lanka has slashed the volume of Treasury bill allowed to be held by foreign investor to 10 percent of total outstanding to 5 percent to maintain a soft-pegged exchange rate while the government is trying to make Colombo a financial centre.
Sri Lanka saw capital flight in 2018 after the credibility of peg targeting a real effective exchange rate index (REER) and other convertibility undertakings ,was lost, triggering capital flight and exporter holdbacks.
"The Monetary Board of Central Bank of Sri Lanka has decided to reduce the threshold of foreign investments in Treasury Bills and Treasury Bonds from 10 per cent to 5 per cent out of the total outstanding stock of Treasury Bills and Treasury Bonds with effect from 18.01.2019," the central bank said in a statement.
Critics says Sri Lanka has had to pay a heavy price so that central bank officials could print money to cut rates whenever they wish to (monetary policy independence) and also target the exchange rate without floating, a phenomenon identified as the impossible trinity of monetary policy objectives.
Sri Lanka progressively closed the capital account after setting up a soft-pegged exchange rate regime in 1951 to join the Bretton-Woods system of failed pegs.
Under soft-pegged exchange rate regime, which requires capital controls to maintain the exchange rate whenever the central bank prints money to cut rates or are unwilling to let market interest rates to be maintained domestic credit picks up or the capital account turns negative.
In addition to undermining the current administration’s financial centre strategy by rolling back already relaxed capital account restrictions, the central bank also made the finance ministry impose taxes on imports, torpedoing its free trade agenda.
Analysts and economists have called for the soft-peg to be abandoned and the central bank to follow prudent monetary policy consistent with its exchange rate and foreign reserve collection objectives.
Permanent currency depreciation is also blamed for high nominal interest rates. Depreciation destroys domestic savings and even if foreign capital flows in, depreciation makes lenders demand high rates.
By September 2018, there were 4,777.9 billion rupees of bills and bonds outstanding. A 5 percent ceiling is about 239 billion rupees.
Last week foreign investors resumed purchasing bonds, and their holdings were at 150 billion rupees, up from 145 billion a week earlier.