Sri Lanka Rupee out of 'Exact Peg' at a Time When the US Dollar is Weakening Against Most Other Currencies : CB Governor

09th November 2009, www.lankabusinessonline.com

The Sri Lanka rupee strengthened Monday at a time when the US dollar is weakening against most other currencies, and an 'exact peg' with the greenback may no longer be maintained, the Central Bank said.

The rupee broke its customary 114.80 peg to the US dollar Monday when state banks started buying the greenback at 114.65.

"The rupee is responding to market pressures," Central Bank governor Nivard Cabraal said.

"When the dollar is weakening, we will probably see the rupee appreciating and if the dollar strengthens, you will see the rupee depreciating against it.

"So that kind of a fluctuation could occur."

Sri Lanka has been easily maintaining a peg from around April by keeping policy rates steeply above the US rate by steadily draining liquidity from markets at 8.0 percent compared to near zero levels in the US.

In the past few decades, despite having high policy rates compared to the US, the Central Bank has come under Treasury pressure to print quantities of money for state expenditure - a type of quantity easing - which de-stabilized the peg and brought high inflation.

But over the past year inflation has been in low single digits. The Central Bank is expecting inflation to end the year at 3.5 percent.

Cabraal said it was too early to say whether the monetary authority will use the exchange rate to counter dollar generated inflation in the way the Singapore Monetary Authority uses the exchange rate though the US dollar weakening was "concern" for inflation.

"Let's see how it works," Cabraal said.

"Because I think we are allowing market forces also to come back and move the prices as much as possible."

Sri Lanka has dual 'anchors' for inflation, in the form of an external anchor which is the peg, and a domestic inflation target of 'low single digits' for which policy rates are also used.

Singapore however does not formally control interest rates.

Sri Lanka's dual anchors as well as flaws in its monetary law which forces it to finance the government have been blamed by economists for the poor inflation record of the Central Bank in the past and general monetary and economic instability of the country.

A frequently adjusting peg, unless it has direct monetary policy benefits, can be a 'division' in trade with the rest of the world, bringing profits to banks but raising costs to importers and exporters.