Sri Lanka rupee falls in bizarre trade

Sri Lanka rupee falls in bizarre trade:
Feb 25, 2009 (LBO) - The Sri Lanka rupee fell to a new low of 114.80 against the US dollar in value tomorrow trade with buying from a state bank, while spot dollars continued to be offered at 113.85 also by a state bank, dealers said.
Sri Lanka's foreign exchange markets have taken a bizarre turn in the past few weeks with the gap between spot trading (deals settled after two days) and tom (value tomorrow or settlement one day later) widening.

Bizarre Trades

On Wednesday a state bank that represents the monetary authority continued to defend a peg with the US dollar on the spot market (value two days later) at 113.85, while on tom market the rupee fell to a low of 114.80 with also a state bank on the buy side.

The local currency was quoted around 114.80.85 in tom trade later in the day, dealer said, down from 114.50/55 levels a day earlier.

In a freely operating market, the price of tom dollar would be lower than spot as an extra day's interest would be incorporated in a spot deal. But in Sri Lanka now a spot dollar is almost a rupee cheaper than a tom dollar.

Sri Lanka's central bank started to defend a dollar peg (target the exchange rate) and also inject liquidity into the domestic monetary system to target interest rates and sterilized liquidity losses from peg defence in mid-September.

Such sterilized intervention, rapidly dissolves into a currency crisis, as it is not possible to print money (control interest rates) and target the exchange rate at the same time, without having exchange controls.

Suicidal Trinity

This process is recognized as the 'impossible trinity' of monetary policy.

Since September the Central Bank has lost more than half its foreign reserves. In December official reserves were down to 1.7 billion US dollars.

This week the Central Bank's T-bill stock jumped to 184 billion rupees from 165 billion rupees a week earlier indicating further losses in foreign monetary reserves.

The overnight reserve shortage in the banking system climbed to 22 billion rupees Wednesday, indicating the volume of recent dollar peg defence.

The central bank has cut the reserve ratio effective from February 27 by 75 basis points releasing 9 billion rupees to the banking system.

Economic analysts say this brings the country nearer to a free float of the currency and a break of a 'soft' or non-credible peg with the US dollar.

Sri Lanka had a 'credible' or 'hard' peg with the Sterling pound until 1950 when the mechanism was abandoned in favour of a money printing central bank, paving the way for currency crises and depreciation.

The weakness of the currency also triggered foreign selling on a 4-year bond, dealers said.

An easing of the exchange rate would also help restore macro-economic equilibrium and improve the competitiveness of exporters that has been eroded in recent years by inflation triggered by heavy money printing by the central bank.