Excess rupee liquidity in the banking system rose to 10.8 billion rupees Tuesday from 7.5 billion rupees on Monday, indicating that the Central Bank was buying inflowing dollars and flooding the markets with rupees.
Any purchase by the Central Bank of dollars at a given exchange rate indicates that there is no 'shortage' of dollars but foreign exchange that could have hit the market have been pre-empted out, putting pressure on the peg.
Such purchases can weaken the rupee further unless they are sold back to the market the later in so-called 'unsterilized' sales to mop up the created rupees.
Analysts have urged the central bank not to make unsterilized purchases of dollars as reserves collected through such action will be 'redeemed' when the rupees are spent by the original owners of the dollars, or others who borrow the money from a bank.
Though Sri Lanka's private credit growth appears to have slowed in April, state borrowing and spending is up with the current account deficit of the budget more than doubling from a year earlier by March.
The Central Bank which was injecting rupees into the banking system at 9.5 percent until July 22, started withdraw excess liquidity at a lower rate of 9.14 percent on June 25 and 9.12 percent on June 26.
Overnight call rates which were around 10.40 to 10.75 fell to 10.00 to 10.55 after liquidity built up.
To stop money markets from sea-sawing between excess liquidity and liquidity shorts the monetary authority has to aggressively engage in open market operations at its given policy rate and sweep in all liquidity by selling down its Treasuries stock.
Even if foreign exchange purchase are not made (in a floating exchange regime for example), such actions result in a strengthening of the exchange rate.
A central bank under a target to collect foreign reserves cannot free float the exchange rate but it can still kill the liquidity created by forex purchases by outright sales of Treasury bills.
Analysts say allowing the excess liquidity to remain the banking system only sterilizing them overnight has an effect partially similar to relaxing the reserve ratio.