Sri Lanka swims against Asian currency depreciation tide

By Simon Montlake

Forbes.com: On my first trip back to Sri Lanka since February 2010, I noticed plenty of positive changes. New construction, cleaner streets and a lighter security presence (a bloody civil war ended in May 2009).

The IMF predicts Sri Lanka’s economy will expand this year by 7.5%, keeping pace with next-door giant India. Colombo-listed stocks are slightly up so far this year, which is much better than many emerging markets after two months of sell-offs.

One thing that was largely unchanged was the value of the Sri Lankan Rupee (LKR). A dollar is worth Rs. 110, compared to Rs. 113 on my last visit. Yet the economy is booming, exports are up, and the dollar has been in a global funk, at least before the recent volatility, so you might expect a more rapid appreciation. But lately the opposite has been happening: the rupee has been under pressure as the economy sucks in more imports, including oil and other essentials.

Sri Lanka’s Central Bank has responded by selling dollars in the market in order to keep a loose peg to the dollar at Rs. 110. So while other Asian exporters are accused of keeping their currency artificially weak (China, anyone?), Sri Lanka appears determined to maintain a strong currency, to the dismay of exporters who price their goods in dollars. It’s not clear why the Government is so set on keeping the rupee strong, though the Central Bank governor insists that his legal duty is to provide stability to the economy.

This currency defence has begun to irk the IMF, which put together a rescue package for Sri Lanka in 2009 after it ran down its foreign reserves towards the end of the war. Human-rights groups lobbied Western governments to block the bailout in protest at the conduct of Sri Lanka’s troops, and it took some persuasion to get approval for the $2.5 billion bailout. The package now seems to be under a different cloud, namely the IMF’s misgivings over Sri Lanka’s currency peg.

Unlike in 2009, Sri Lanka now has over $8 billion in foreign reserves to fight its corner, but is still counting on further loans from the IMF, so its voice must count for something. Discussions are currently stalled on the next loan tranche.

“Sri Lanka’s Central Bank intervenes on both sides of a peg of around 110 rupees to the dollar buying and selling small quantities in the forex markets. But net sales of foreign exchange began to gather pace from around the second quarter of 2011, amid stronger domestic credit growth.

Since then according to one estimate more than 600 million dollars in interventions have been made. Liquidity in money markets has run down amid dollar sales and shortages have been sterilised with fresh domestic asset purchases to keep interest rates from spiking – via Sri Lanka IMF talks continuing on stalled review – LANKA BUSINESS ONLINE.

As global investors flee to safety, Sri Lanka isn’t alone. Central banks in South Korea and Taiwan have begun selling dollars to stop a rout in their local currencies. The Australian dollar is down 10% against the greenback since July.

Worries about strong currencies have turned into fears of rapid depreciation. But selling dollars into a market that expects further devaluations can be a dangerous spiral, as Asian governments discovered during the 1997 financial crisis (one reason why they’ve built up such huge reserves). These are tense times for central bankers everywhere, including Sri Lanka.