Liquidity, Reserves, Grant Space

• CBSL’s ER Stance

As long as Government of Sri Lanka (GoSL) owned Central Bank of Sri Lanka (CBSL) has sufficient rupee liquidity and foreign exchange (forex) reserves, it can play around with the exchange rate (ER), a banker told this reporter.

CBSL’s gross official forex reserves as per available statistics were US$ ($) 8.1 billion as at end July 2011 (as opposed to a low of $ one billion about two years ago) while excess rupee liquidity as at Monday which was Rs. 31 billion, fell sharply by Rs. 7.9 billion (25.5%) to Rs. 23.1 billion by Wednesday, before recovering to Rs. 36.7 billion by the week-end (a Rs. 13.6 billion or 58.9% gain), probably due to inflows, thereby reversing the trend witnessed by the primary market in the first three days of last week which saw a fall in liquidity.
The source said that though CBSL through its agent, state owned Bank of Ceylon (BoC) was defending the ER at the Rs. 110.10 level per one unit of a $,  demand for the greenback by the primary market had slackened by Friday. There was virtually no need for BoC to sell $ at the Rs. 110.10 level in order to protect the ER, he said.
Howbeit market liquidity has been rapidly diminishing (it was at a high of Rs. 150 billion only a few months ago), in part due to CBSL administratively protecting the ER. Ideally rupee liquidity should diminish due to credit growth, a translation that investments are growing and not due to the protection of the ER.
CBSL, now appears to be selling $s to banks, an action that it usually takes to prevent the ER from falling due to demand for the greenback, while it gets rupees in  exchange from them (for the $s sold), thereby decreasing rupee liquidity from the primary market.
In July CBSL expended US$ 417 million of its foreign exchange reserves to prevent the rupee from falling. Last month’s figure is not yet known.
Asked whether reduced liquidity in turn would cause pressure on interest rates, the source said that CBSL’s current Treasury (T) Bill holdings are in the range of Rs. 2-3 billion. But just two years ago CBSL’s T bill holdings were in the range of Rs. 200 billion, he added.
As such it’s within CBSL’s capacity to increase rupee liquidity in the event it comes to a crunch, to control interest rates, he said. CBSL may increase rupee liquidity by procuring T bills and giving rupee in exchange to the Treasury, or, in the alternative by buying forex from the market/GoSL and releases rupees in lieu.
Howbeit in the present context what CBSL is doing is selling dollars and not buying the same from the primary market or GoSL, thereby diminishing rupee liquidity in the market.
The surfeit of rupees in CBSL’s holdings as a result of selling $s to the market may be ploughed back by investing in T Bills, while at the same time ensuring that by that exercise rates are stable and no new money is being released to the economy, thereby assuring the controlling of inflationary pressure in the economy (at least through its overnight market operations), he said.
“I don’t see any possible upward revision in CBSL’s repo and reverse repo rates, the source said. Those rates act as a catalyst as to which direction market interest rates would take.
Meanwhile CBSL’s T Bill holdings as at Thursday was Rs. 23,620 million; up Rs. 16.656 million (239%) week on week, an indication that Rs. 16,656 million worth of new money may have had been infused into the economy during the review period, barring the fact that the rupee surplus in CBSL’s account, as a result of selling $s to the market has not been utilized to invest in those T Bills.
Asked whether that won’t cause inflationary pressure on the economy, the source said that inflation has a lagged effect and will not be felt immediately. Anyway, it appears to be CBSL’s policy of keeping a tight leash on interest rates, he said.
CBSL which is known for its lopsided ER policy among others; on Monday deepened the ER corridor by 10 Sri Lanka cents (SLc) to Rs. 109/60/110/10 over the previous Friday’s (September 9) figure of Rs. 109/70/110/10. However, in the previous Monday (September 5) it maintained the ER at September 12 levels.  This ER corridor was maintained throughout last week.
“The $ is appreciating against all other major currencies due to the crisis in the Euro zone, but CBSL continues protecting it at the Rs. 110.10 level (against one unit of the $), this is not acceptable,” the source said.
He was also not amenable to the possibility that such a defense may be justifiable in the event such an action is backed by inflows.
The $ continued to strengthen against other major currencies throughout last week.
The source further said that previous Friday’s (September 9) artificial strengthening of the ER by 10 Sri Lanka cents to Rs. 110.10 was not warranted. A weak rupee makes imports more expensive while on the other hand it helps exporters to get more rupees for their $s. The ER continued to be protected at the Rs. 110/10 level throughout last week.
There is however a possibility that the Government might weaken the rupee after the end of next month’s local government elections, an action that may result in the prices of a number of basic food items going up as Sri Lanka is an import dependent economy in order to clinch the remaining US$ 900 million still outstanding from the IMF’s US$ 2.5 billion standby arrangement which may have had been kept on hold due to CBSL administering the ER, an action frowned at by the IMF (see also page22).