Rupee hits three-year low as CB allows more flexibility

Reuters: The rupee weakened 0.8 per cent on Thursday as the Central Bank said it would change the way it intervenes in the foreign exchange market after spending more than $ 2.7 billion to defend the currency since July.

In a marked policy shift, the Central Bank said it would allow the market to determine the currency’s rate rather than intervening to defend the rupee at a particular level. Instead, it will intervene only to ensure there are enough dollars in the market for Sri Lanka to meet oil import costs.

The rupee ended weaker at 115.25 a dollar, its lowest since 18 August, from Wednesday’s close of 114.30. It had touched 115.75 during the session, its lowest since 18 May 2009.



“The Central Bank stopped defending the rupee and it went up to 115.70/75 levels, but with banks selling dollars, it came down to 115.25 levels,” said a currency dealer who asked not to be named.

The Central Bank had weakened the rupee early in the day by 30 cents to 114.60 from Wednesday’s close of 114.30 and defended it at that level, selling around $ 17 million, before announcing its change of policy, dealers said.

The Central Bank has spent $ 1.25 billion in 52 sessions since a three percent devaluation on 21 November to curb a sharp rupee fall, despite the country facing a current account deficit and a balance-of-payments crisis. That policy had been criticised by the International Monetary Fund, among others. Thursday’s depreciation along with the Central Bank’s decision last week to raise benchmark interest rates by 50 basis points, its first hike in five years, pulled stocks down to a fresh one-and-a-half-year low.

The Central Bank said on Thursday it was shifting the focus of its foreign exchange policy to allow the market to determine the currency’s rate, removing a point of friction with international lenders and relieving pressure on its fast dwindling reserves.

The bank has so far been defending a certain price level by selling dollars and has spent more than $ 2.7 billion, or a third of its reserves, since July, attracting criticism from the International Monetary Fund (IMF), which had urged Colombo to allow more flexibility in the exchange rate.

“We used to support intervention on a rupee price, and now we are going to be intervening based on a quantity,” Governor Ajith Nivard Cabraal told Reuters, adding that the bank will intervene only to meet any shortage in the currency market for the country’s oil bills.

The Central Bank will also provide dollars for oil payments outside the market for the next three months to prevent the country’s fuel imports from distorting the rate, he added.

The bank’s marked policy change comes after it decided to let the rupee fall this week and raised the benchmark interest rate by 50 basis points for the first time in five years on Friday.

It stopped intervention in the foreign exchange market earlier in the day, allowing the currency to weaken to a nearly three-year low of 116.20 at one point.

It has since recovered to 115 per dollar, still down 0.6 per cent on the day.

The Central Bank’s foreign exchange policy has been a bone of contention with the IMF, which has withheld the eighth tranche of a $ 2.6 billion loan since September due to the bank’s failure to adopt a flexible exchange rate.

Its insistence on holding the rupee steady, despite a jump in imports, has left the rupee overvalued, analysts say.

The Government has favoured correction in the currency. President Mahinda Rajapaksa used his power as Finance Minister to devalue the currency by three per cent on 20 November, while Treasury Secretary P.B. Jayasundera also called for a market-driven policy.

For traders in the market, it may be a case of too little, too late.

“The Central Bank could have done this in June when we had a lot of reserves,” a currency dealer told Reuters on condition of anonymity. “Now the depreciation pressure on the rupee is huge and the market has no idea of where it will end up.”

Most of the currency dealers Reuters spoke to said they expect the rupee to stabilise between 116-118, but could even weaken to 125-130 if there is some unexpected dollar demand.

“There will be huge volatility until the market sees the ceiling,” Danushka Samarasinghe, Head of Research at TKS Securities, told Reuters. “It will increase the import bills and inflation. Consumer spending may slow down and economic growth may slow down due to this.”

The Central Bank has projected an eight per cent economic growth this year, slowing from an estimated 8.3 per cent in 2011 and the Governor said last month it expects $ 25 billion of inflows in 2012.

The benchmark stock index ended down 2.3 per cent on Thursday, partly weighed by concerns of rupee weakness and by Friday’s rate increase, traders said.

The Central Bank will also take the pressure from oil imports out of the market for the next three months by providing dollars outside the market, the central bank chief said.

“We are going to fund the bulk of the oil bills for the next three months off the market, and let the market adjust itself, so the overall tension will be less and the market can decide the level on its own,” Cabraal said.

He added that the Government would use an external funding mechanism, by taking expected inflows to pay for the oil bills directly via State banks without running them through the foreign exchange market.

“The market still will be slightly short. But we don’t want to support the imports of anything but oil,” he said, adding that expected the amount to be removed from the forex market would be $ 850 million over the next three months.

“After three months, there will be certainty and the rupee also would have stabilised,” he said.