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Sri Lanka warned on exchange rate intervention by IMF
11 Jun, 2011 13:55:07
June 11, 2011 (LBO) - Sri Lanka's central bank should refrain from sustained interventions in foreign exchange markets, to avoid a drift towards another foreign exchange crisis, the International Monetary Fund has said.
An IMF team who were in Colombo said exports were stronger than expected, remittances were flowing in, but imports could pick up later in the year. The IMF came into the country in 2009 when the country was hit by a balance of payments crisis.

"The principle role of our program has been to build reserves," IMF chief Brian Aitken said.

"Not just the stock of reserves but also to create an environment in which the economy generates its own reserves both preventing a crisis which it had a while ago and also putting the economy on a sustainable external basis.

"And that involves allowing the exchange rate to be flexible as needed for the economy to be competitive to generate its own reserves."

A balance of payments crisis is an economic disease associated with so-called soft pegs, where a central bank maintains a peg (defending a particular exchange rate level by selling dollars) while at the same time targets an interest rate by printing fresh money).

The process is known as sterilized intervention.

Inherent Instability

Soft-pegs were created as part of the failed Bretton Woods system, which collapsed in 1971. The IMF was created by the US architects of the failed dollar linked system to help countries that got into trouble with soft pegs.

Sri Lanka joined the IMF a day after the creation of a soft peg in the country. Before 1951 Sri Lanka had a 'hard peg' effectively linked to Sterling where interventions in the forex markets were not sterilized with an offsetting transaction in the money markets.

In a hard peg or currency board, only the exchange rate is targeted and not the interest rate, therefore monetary policy and exchange rate policy are complementary and balance of payments crises, or forex shortages and capital controls are absent.

In the past two months, the Central Bank has sold 257 million US dollars in forex markets, though it bought dollars and maintained the March foreign reserve target under the IMF program.

IMF had earlier also wanted the rupee to be flexible 'in both directions' after seeing a steady trend of appreciation.

"So in this case what we are saying is that that once again as we have always done, we are encouraging the central bank to retain the flexibility of the exchange rate going forward and to make sure that the economy remains competitive," Aitken said.

"And that means not using the reserves to defend a particular level (of the exchange rate)."

Recent forex sales however have not been sterilized in the money markets by injecting fresh liquidity, which give more ammunition for credit growth and imports, triggering a balance of payments crisis.

In contrast, recent dollar sales have mopped up excess rupee reserves which are deposited by banks overnight at the central bank. In effect recent dollar sales have been non-sterilized, currency-board-like transactions.

Excess Liquidity

There is about 60 billion rupees of excess liquidity left with banks. When banks loan them out the Central Bank could lose several hundred million dollars more in reserves, even if a part of the excess liquidity spills over to expand the money-in-circulation component of the defined monetary base (reserve money).

Analysts say the Central Bank may also be preparing the ground for the effects of a billion dollar sovereign bond due to be sold later in the year.

Though officials have said a large part of the bond will go for debt repayments, in the past the Treasury has used proceeds of dollar bonds to repay overdrafts at state banks which results in a new flood of liquidity and a loosening of the monetary system.

Sri Lanka however does not have a currency board law, and there is no assurance that interventions will continue to be non-sterilized and interest rates will move up slightly to slow credit growth and economic activity to match the net balance of payments.

Sri Lanka now has about 7.0 billion US dollars in foreign reserves including about 1.5 billion dollars borrowed from the IMF which has to be paid back. This is around twice the local rupee money supply (monetary base).

However high the level of foreign reserves, a central bank that targets the exchange rate and prints money continuously to maintain a policy rate can run them down in a few months, until confidence is lost and IMF is brought back again.

A monetary authority that does not sterilize dollar sales in money markets however can get by with foreign reserves that just about equal the domestic currency money supply (the monetary base).

Hong Kong survived the East Asian crisis with a similar arrangement. Sri Lanka had such as system until from the 19th century to 1951, when East Asian firms raised money in Colombo's stock market.

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1. Siripala Jun 11
Remember end of 2008 foreign investors cash out $600 million in govt. securities and the defence of the rupee against depreciation cost the CB 50% of its foreign reserves. What if there is a double dip in the West?.