Sri Lanka to allow more flexibility in rupee
COLOMBO: Sri Lanka’s central bank said it was shifting the focus of its foreign exchange policy to allow the market to determine the currency’s rate, removing a point of friction with international lenders and relieving pressure on its fast dwindling reserves.
The bank has so far been defending a certain price level by selling dollars and has spent more than $2.7 billion, or a third of its reserves, since July, attracting criticism from the International Monetary Fund (IMF), which had urged Colombo to allow more flexibility in the exchange rate.
“We used to support intervention on a rupee price, and now we are going to be intervening based on a quantity,” Governor Ajith Nivard Cabraal said, adding that the bank will intervene only to meet any shortage in the currency market for the country’s oil bills.
The central bank will also provide dollars for oil payments outside the market for the next three months to prevent the country’s fuel imports from distorting the rate, he added.
The bank’s marked policy change comes after it decided to let the rupee fall this week and raised the benchmark interest rate by 50 basis points for the first time in five years on Friday.
It stopped intervention in the foreign exchange market earlier in the day, allowing the currency to weaken to a nearly three-year low of 116.20 at one point.
It has since recovered to 115 per dollar, still down 0.6 percent on the day.
The Sri Lankan central bank’s foreign exchange policy was a bone of contention with the IMF, which has withheld the eighth tranche of a $2.6 billion loan since September due to the bank’s failure to adopt a flexible exchange rate.
Its insistence on holding the rupee steady, despite a jump in imports, has left the rupee overvalued, analysts say.
The government has favored correction in the currency. President Mahinda Rajapaksa used his power as finance minister to devalue the currency by 3 percent on Nov. 20 while Treasury Secretary P.B. Jayasundera also called for a market-driven policy.
For traders in the market, it may be a case of too little, too late.
“The central bank could have done this in June when we had a lot of reserves,” a currency dealer said. “Now the depreciation pressure on the rupee is huge and the market has no idea of where it will end up.”
Most of the currency dealers Reuters spoke to said they expect the rupee to stabilize between 116-118, but could even weaken to 125-130 if there is some unexpected dollar demand.
“There will be huge volatility until the market sees the ceiling,” Danushka Samarasinghe, head of research at TKS Securities, told Reuters. “It will increase the import bills and inflation. Consumer spending may slow down and the economic growth may slowdown due to this.”
Sri Lanka’ central bank has projected an 8 percent economic growth this year, slowing from an estimated 8.3 percent in 2011 and the governor said last month it expects $ 25 billion of inflows in 2012.
The Sri Lankan benchmark stock index ended down 2.3 percent on Thursday, partly weighed by concerns of rupee weakness and by Friday’s rate increase, traders said.
The central bank will also take the pressure from oil imports out of the market for the next three months by providing dollars outside the market, the central bank chief said.
“We are going to fund the bulk of the oil bills for the next three months off the market, and let the market adjust itself, so the overall tension will be less and the market can decide the level on its own,” Cabraal said.
He said the government would use an external funding mechanism, by taking expected inflows to pay for the oil bills directly via state banks without running them through the foreign exchange market.
“The market still will be slightly short. But we don’t want to support the imports of anything but oil,” he said adding that expected the amount to be removed from the forex market would be $850 million over the next three months.
“After three months, there will be certainty and the rupee also would have stabilized,” he said.