Sri Lanka Central Bank Mops Up Liquidity in a Record Operation

28th October 2009, www.lankabusinessonline.com

Sri Lanka's central bank is engaged in a record mop up of excess liquidity in the banking sector generated foreign from dollar borrowings, surpassing a previous high in 2007.

Sri Lanka raised 500 million US dollars through a sovereign bond earlier this month.

Inflows from an October 2007 sovereign bond pushed excess liquidity to 33.9 billion rupees on November 01, according to Central Bank data.

But excess liquidity in the inter-bank market has been high after a balance of payments crises ended in March with a float of the rupee and a deal with the International Monetary Fund in July raised confidence in government credit worthiness.

Foreign investors have pumped hundreds of millions of dollars into high yielding government bonds, after the rupee was re-pegged at 114.90 levels to the US dollar after the float broke an expansionary sterilized intervention cycle.

On Monday and Tuesday the Central Bank mopped up 44 billion rupees of liquidity from the inter bank money markets, by selling its own securities.

The monetary authority paid 8.47 percent to mop up 34.1 billion rupees overnight, 8.99 percent to mop up 8.5 billion rupees for 14 days and 9.03 percent to mop up 1.5 billion rupees for 30 days.

Another 885 million rupees was parked via a standing facility at 8.0 percent.

The central bank has run out of Treasury bills, after it sold down its Treasury bill stock as and withdrew money printed during the balance of payments crisis in a contractionary sterilization cycle after the float of the currency.

Unlike sterilizing excess liquidity through interest bearing Treasuries where the cost is borne by the Treasury, issuing its own securities is a costly exercise for a central bank as the corresponding dollar foreign assets in its reserves yields low rates.

The problem comes up when a pegged exchange rate central bank maintains foreign reserves far above its domestic money issue.

The Central Bank is expected to use a swap transaction to reduce the negative carry.

Critics have pointed out that the problem underscores an inherent flaw in pegged exchange central banks which were largely designed by the US Federal Reserve to promote the dollar as a 'reserve currency', and get cheap finance for the US government and its economy.

Though pegged central banks are designed to give the illusion that 'monetary independence' is possible in reality any loosening results in a balance of payments crisis while tightening through liquidity mop ups and a build up of foreign reserves 'crowds out' the domestic economy.

Central Banks that have accumulated large foreign reserves and maintained pegs have had to permanently maintain interest rates above that of the reserve currency, unlike currency boards, where rates are neutral.