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Sri Lanka tightens forex trading curbs amid IMF warnings

ECONOMYNEXT – The International Monetary Fund has warned that forex trading curbs which were tightened progressively by Sri Lanka’s central bank are counter-productive as the country attempts to move towards an inflation targeting framework.

Sri Lanka’s central bank typically keeps rates down as private and state credit demand go up giving various excuses not to raise policy rates and then print money to inject more rupee reserves into the banking system and boost credit to unsustainable levels.

"Continued efforts are needed to deepen the forex market to facilitate price discovery," an IMF staff report released in June said.

"The authorities could reduce constraints on market participants (allowing higher net open positions), develop derivative markets, and increase hedging opportunities to build capacity to manage foreign exchange risk.

"Although Sri Lanka has spot and forward markets, they are shallow (average daily interbank volumes are about $30 million)."

The IMF report noted that interbank market depth is reduced due to trading curbs or narrow ‘net open positions’ which limit the amount of dollars a bank can buy and keep to meet daily fluctuations in demand.

Commercial bank dollar holdings are outside domestic monetary base and do not affect local rupee liquidity, credit or interest rates and are monetary policy neutral. When dollars are sold to the central bank however rupees are created driving credit and imports, unless the liquidity is mopped up.

When a central bank sells dollars however domestic monetary base contracts and typically the agency will print money to offset the effect and maintain its policy rate (sterilized forex sale), worsening the problem and creating more credit and dollar demand.

"To deepen foreign exchange markets and reduce volatility, it is recommended that the CBSL undertake a review of foreign exchange laws and regulations and develop a timeline for rolling back restrictions on banks’ net open and forward positions in foreign exchange, as well as phasing out remaining capital account restrictions," the IMF report said.

"A number of official and customary practices foster the lack of depth. Transactions by intermediaries are monitored by the CBSL, which asks for detailed information when a trader’s net open position is not consistent with orders—creating moral suasion to limit trading.

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"Traders cannot smooth interventions by building short or long positions to anticipate large orders, which leads to higher market volatility and less depth."

Over the past month, the authorities have started to question trades within the ‘net open positions’ and are asking to see trade bills, market participants say taking pressure tactics to a new level.

At the moment however spot trading has been halted by moral suasion. In the forward market spot next (spot plus one day) has also been halted and lately even one week trades are questioned.

Authorities also forced exporters to convert dollars, resorting to tactics not seen for over 30-years.

Meanwhile in money markets overnight call rates are kept at 8.18 percent with moral suasion, discouraging bank who would not mind borrowing at higher rates real money already existing in the system to go the reverse repo window or auctions to get printed money from a last resort window.

The IMF said a transparent intervention rule could be developed, which will help eliminate "on-again, off-again’ approach to forex market interventions and help move towards inflation targeting.

But other analysts warn that the mindset of Sri Lanka central bank is towards pegging (smoothening out volatility) and providing large volumes of liquidity, buying dollar inflows to the state all of which undermines any ‘floating’ and tends depreciate the rupee uni-directionally.

Under the current IMF program, net international reserve targets have been set, which are also fundamentally inconsistent with both a floating rate and inflation targeting, EN’s policy columnist Bellwether says. (Colombo/June22/2016 – updated)

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