How low can the rupee go

The Central Bank of Sri Lanka is reducing inflation, in some cases absolute prices, restoring confidence, and alleviating the pains of monetary policy, all by allowing the rupee to rise. Unlike prior bouts of recovery in an IMF program, as the monetary authority continued to increase reserves, CBSL Governor Nandalal Weerasinghe stated that there was no predetermined level at which the currency appreciation would halt. The intervention to reduce undue volatility would not defy the market. Under a flexible exchange rate, the value of the rupee might go up as well as down, according to the CBSL, however, the rupee has appreciated from around Rs. 360 to the US dollar in March to about Rs. 290 to the US dollar in the past week.

The rupee has been strengthening as a result of the Central Bank’s deflationary liquidity measures. When liquidity is pumped to keep policy rates low, the currencies of reserve-collecting Central Banks fall, spurring credit growth without deposits. Private credit is currently in the negative. In order to increase reserves and lessen the overly erratic movements of the rupee, CBSL purchased dollars. According to the Governor, $ 662 million were purchased from the market in May 2023 alone. He stated that total net acquisitions to date totalled $ 1,671 million.

Soon, certain exchange controls, namely the capital flow restrictions and prevailing import restrictions, would be eliminated. Yet Sri Lanka’s gross foreign reserves which were expected to be $ 3.1 billion in May have fallen short. A budget support loan from the Asian Development Bank was in the Treasury account, but when the Treasury needed money, the Governor stated that the money would be sold to the CBSL for rupees.

According to official data, Sri Lanka’s foreign reserves increased by $ 722 million from $ 2,761 million in April to $ 3,483 million in May 2023 as deflationary policies and bad credit slowed over-expected outflows. As the Central Bank sold reserves and printed money to keep interest rates low, known as the sale of sterilised reserves, which included dollars borrowed from India, Sri Lanka lost virtually all of its reserves in more than two years. 

After running out of borrowed Asian Clearing Union dollars from India, Sri Lanka’s Central Bank increased interest rates in April 2022 to curb credit growth and also ceased creating money. The Central Bank’s monetary reserves as well as any remaining balances on the Treasury account from loans or grants are combined to form gross official reserves. After breaking up borrowed reserves to lower rates, the Central Bank’s net foreign reserves are still negative. The Central Bank’s net reserves were negative by $ 3.7 billion by April. 

The US Federal Reserve pioneered borrowing dollars through swaps and busting them up while creating money and upending the Bretton Woods system in the early 1970s. The Asian Development Bank provided a tranche of $ 350 million to Sri Lanka, and the IMF provided the Treasury with $ 331 million for budget support. 

The Government has the option to sell the loans to the CBSL in order to make money to spend. Not all of the inflows leave the nation, though, because credit is scarce, especially while the Central Bank is on a net basis carrying out deflationary open market activities. Therefore, while the rupee appreciation prevails, and is likely to cause fluctuations in the export and import market, the reason it is temporary and to be short-lived at this rate, should be understood.