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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » Sri Lanka warned to be careful about forex swaps by IMF

Sri Lanka warned to be careful about forex swaps by IMF

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Malika1990

Malika1990
Senior Vice President - Equity Analytics
Senior Vice President - Equity Analytics
June 18, 2012 (LBO) - Sri Lanka should be careful about the inflationary effects of liquidity created by large foreign exchange swaps with the Central Bank, an International Monetary Fund official said.

Sri Lanka's central bank has bought hundreds of millions of dollars from commercial banks that raised loans abroad for rupees through swaps to give then foreign exchange risk protection, creating large volumes of rupees.
Liquidity

Analysts have also blamed large volumes of liquidity from swaps - which for all intents and purposes have the same effect of money printed by purchasing Treasury bills - for recent weaknesses in rupee.

"In effect these are large capital inflows. In some sense this is a very positive signal," John Nelmes, the head of an IMF mission told reporters.

"International capital finding a home in Sri Lanka is a good thing. I would sit back and see it from a broader perspective.

"From the perspective of view of monetary policy that is focusing on maintaining inflation control as the primary objective or goal, there must be a number of indicators that one must look at when we gauge the tightness or ease of monetary policy.

"And one of them is the amount of liquidity that is circulating in the country.

"Ultimately it means when swaps are coming in are they being added to domestic liquidity? And is that consistent with overall macro-economic stability or not. So on a case by case basis I think it is important to gauge it from a broader perspective."

Analysts have warned that liquidity created by all central bank purchases for foreign exchange - including outright purchases - would flow out through the credit system, generating fresh credit and imports unless the purchases were immediately sterilized.
Inconsistent Policy

Viewed from the point of view authorities excess liquidity in the banking system provides ammunition for dealers to 'speculate' against the currency.

After generating large volumes of excess liquidity authorities have tended to blame dealers for 'speculation' instead of sterilizing the liquidity immediately with outright sales of the Central Bank's Treasury bill stock.

An unsterilized purchase would then require the dollar peg to be defended again with the same foreign exchange the central bank collected through the purchases.

If the peg was not defended through sales of foreign exchange, such pressure would then result in currency depreciation and immediate one-off inflation.

Any foreign reserves collected would then be limited to the increases in reserve money coming from a demand for a higher volume of notes-in-circulation to cover the inflated price structure in the country.

Under the last deal signed with the IMF the Central Bank was expect to have swaps outstanding of up to 780 million US dollars by June 2012.

There are fears that when swaps are unwound they could also have a negative impact on the monetary system, unless credit growth is substantially killed by then.

A large swap with the central bank that is unwound for rupees would trigger a liquidity shortage, which would need to be sterilized with liquidity injections, in the same manner as a sterilized sale of foreign exchange, unless a different mechanism was found to unwind them.

Broader Perspective

Meanwhile Nelmes said the monetary should "ensure that there is not an excess amount of liquidity in the system that would then generate instability in either the supply of credit to the country or in excess liquidity in the banking system."

"So in some sense the job of the central bank is to ensure that from the broader prospective - stepping back and looking at the macro-perspective - that liquidity conditions are consistent with maintaining stability and maintaining an overall economic scenario that is consistent with inflation control."

A central bank that is keeping monetary policy tight to contain inflation would automatically strengthen the exchange rate as well. Countries with strong exchange rates have very low inflation.

They can also avoid asset price bubbles and steep economic downturns.

Inflation indicates the domestic value of a currency and the exchange rate its external value which are two sides of the same coin.

Any sterilized foreign exchange sales nullifies the tightening effect of high policy interest rates creating a conflict with a central bank's own domestic monetary operations.

The IMF suspended its program in September 2011 amid heavy sterilized foreign exchange sales and resumed it after authorities raised fuel prices to contain ballooning state enterprise credit and raised interest rates and allowed the rupee peg to partially float.

Even a partial float reduces policy inconsistency. There have been warnings from February 2011 after an initial float of the currency weakened the rupee to 121 to the US dollar, that sterilized sales of forex for oil bills would make the rupee a crawling peg.

The rupee has since crawled to 131 to the US dollar.

Tight Policy

This year the IMF is forecasting inflation to rise to 9.5 percent, and the Central Bank itself has said it may touch 7.0 percent, a setback from the mid to lower single digits inflation it maintained for nearly four years until sterilized foreign exchange sales started.

"There is a need to focus on inflation pressures and a need to ensure that inflationary pressures remain well controlled," Nelmes said.

"And for that reason we see that tightening of monetary conditions that has been put in place is fully appropriate and that monetary policy should remain tight for the near term, until there is more evidence accumulating that inflation pressures are starting to ease."

Tighter monetary policy, despite a slowing of bank credit and what is generally called 'economic growth' would increase the well-being of the people with lower inflation and protect the real value of savings which is the capital that will be used for investment.

"I am very positive about Sri Lanka's prospects in the long run," Nelmes said.

"With continued macro-economic stability and continued focus on macro-economic stability along with continued infrastructure investment, the potential for Sri Lanka is very positive."

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