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Sri Lanka's money markets tighten, pressure mounts on the exchange rate

June 1, 2006 (LBO) - After almost two years of excess liquidity, Sri Lanka's inter-bank money markets are tightening up, as reserve money growth is arrested.
This usually happens when net foreign assets fall due to an outflow of foreign exchange reserves, though a fall in domestic assets could also drive down reserve money.
But central bank credit to government, in the form of treasury bills, which is the key component of domestic assets, has been rising throughout the month of May.
This indicates that a decline in net foreign assets is the reason reserve money is not growing.
In April, reserve money rose to 224 billion rupees as the Central Bank pumped in an unprecedented amount of cash to cater to the seasonal demand by purchasing treasury bills.

Central Bank T- bills Reserve Money
20-Apr 45,272 224,500
27-Apr 29,937 212,950
4-May 27,937 210,480
10-May 31,425 213,800
18-May 34,616 215,270
25-May 37,563 215,448
(Source: Central Bank)
This was absorbed by selling down the treasury bill stock to 27 billion rupees by end April.
Since then Central Bank has been buying bills and injecting money, to maintain reserve money and keep the markets liquid.
In May, Sri Lanka's interbank bank markets tightened with excess liquidity disappearing, as the reserve outflow took hold.
Over a two week period, excess liquidity of about 3-billion rupees, turned into a short position as market players started to borrow cash on a net basis from the Central Bank through the reverse repo mechanism.
Economists say, keeping the market tight, allowing rates to go up, and squeezing the system is the correct response to counter an emerging problem with the exchange rate.
If the outflow continues, analysts say further monetary tightening may be necessary.
In 2004, the central bank worsened an exchange rate crisis by buying large quantities of treasury bills to finance subsidies, and flushing the markets with cash, a situation which was only corrected with the arrival of tsunami aid flows.
In April alone, consumer inflation rocketed up by 5.4 percent, on the back of a 2.7 percent jump in March, driving 12 month inflation to 13.2 percent in May.
According to the latest data released by the Central Bank, Sri Lanka has registered a surplus on the balance of payments of 147 million dollars up to March, which climbed to 197 million dollars by end April.
This was despite the trade deficit ballooning above one billion dollars in the first four months of the year.
In April, exports surged, bucking a three-month trend of falling exports, raising hopes that exchange rate pressure may ease.
The central bank is still forecasting a surplus in the balance of payments of more than 400 million dollars for the year.

Analysts have warned that Sri Lanka's high inflation in the last two years and the appreciation of the rupee due to tsunami aid flows would eventually hurt exports, leading to a pressure on the exchange rate.

Critics say two years of fiscal indiscipline, loose monetary policy resulting in largely negative rates which feed import demand, subsidies dished out for imports like petroleum and fertilizer has created ideal conditions for an exchange rate problem, while the worsening security outlook also adds fuel to the fire.