Feb 04, 2011 (LBO) - A flexible exchange rate that moves in both directions can ward off speculative capital flows by signaling the risk of capital losses, while also improving competitiveness, an International Monetary Fund official said.
Crawling Up
After being tightly pegged soon after a balance of payments crisis in 2009, the rupee was appreciated by the Central Bank in 2010, slowly crawling up.
"Over recent months we have seen some appreciation," IMF resident representative Koshy Mathai said.
"A little depreciation recently, but generally, over the last few months, some appreciation and we were glad to see the introduction of flexibility in one direction.
"That is a good thing, because it indicates to the market that exchange rates can move that there is a potential for getting capital losses if you want to do carry trades; things like that.
"But we would like to see movement in both directions."
Sri Lanka's rupee is tightly pegged to the US dollar with the help of substantially higher interest rates than the anchor currency allowing the central bank to appreciate the currency at will as long as it does not print large volumes of money.
Sri Lanka had a tight peg at 108.0 to the US dollar in late 2008 when speculative capital into Treasury bill markets went out triggering a balance of payments crisis.
Sri Lanka lost more than two thirds of reserve before the currency was floated and the peg broken days before the IMF came in with a 2.5 billion US dollar bailout.
Deadly Pegs
"The general understanding among economists now is that pegged exchange rates can introduce some risks," Mathai said.
Balance of payments crises are a disease affecting so called 'soft-pegged' exchange rate central banks.
Under a soft-peg, a central bank tries to control both the interest rate and exchange rate, through inherently contradictory and unsustainable policies creating an unstable peg.
Sri Lanka created an unstable peg with the US dollar in 1950, shifting from a stable peg with the Sterling and Indian rupee under British rule.
Under a sustainable peg also known as a hard peg or currency board, capital inflows will increase the domestic reserve money supply (the monetary base), push interest rates down, and ward off further capital inflows.
A soft-pegged central bank on the other hand will try to maintain its own interest rate, drawing in more speculative capital.
Carrying Cost
The pegged central bank will 'sterilize' the capital inflows (withdraw liquidity) with high interest rates encouraging more inflows and putting upward pressure on the domestic currency.
It will build up reserves until the cost of sterilization is so great that it makes losses as profits from its low yielding foreign reserves will be lower. A central bank (or currency board) that builds reserves only to back its monetary base incurs no cost as rupee notes bear no interest.
But if it builds up foreign reserves above the monetary base, the central bank's carrying cost turns negative raising the possibility of making losses. Last year Sri Lanka's cost of sterilization had risen to over 11 billion rupees.
An appreciating exchange rate on the other hand can ward off new speculative capital by making rupee assets 'more expensive' at least to some extent.
When capital flows out of Treasuries markets suddenly, a soft-pegged central bank will sterilize in the opposite direction printing money to maintain interest rates and expand its domestic assets, triggering a 'balance of payments crisis'.
If the exchange rate is allowed to move (float) there will be no need to print money to maintain the interest rates or domestic liquidity (a process known as sterilized intervention) worsening the balance of payments crisis.
In a floating regime capital flows do not 'pass through' the domestic monetary base and cannot affect interest rates. A float ends the reserve pass through and stops the expansion of the central bank's balance sheet allowing the crisis to pass.
A true floating exchange rate central bank, which only controls the interest rate is also inherently sustainable.
Crawling Up
Sri Lanka floated the rupee in April 2009 ending the crisis. When capital started to come in the central bank reversed the earlier cycle of expansionary sterilization returned to a peg, which is now essentially crawling up.
"And right now we have a regime that is a flexible exchange rate," Mathai said. "But for a long time after the crisis we saw the rupee dollar rate absolutely flat at a 114.8.
"We were never very excited at that. We thought it was better to show some volatility."
The Central Bank had told the IMF that it had to keep the exchange rate stable to prevent a "disorderly appreciation" hurting exporters. Mathai said the IMF agreed that it was a "correct" and "sensible" response.
"We would like to see that flexibility in both directions so that the market is fully aware that in fact it is a flexible exchange rate regime so that competitiveness can be maintained over the medium term so that the overall health of the economy can be maintained," he said.
According to the Central Bank's real effective exchange rate index the rupee is overvalued by about 20 percent.
But the index has been stable at about 120 to 125 percent for over two years with inflation being kept generally around global levels by the Central Bank. An appreciating exchange rate also dampens inflation coming from the anchor currency.
Mathai says the IMF is not advocating a specific exchange rate.
"There is a need to preserve the competitiveness of the exports; the government also probably sees an inflation risk on the other side, balancing the concerns is always a difficult thing," he said.
"I think to us, without taking a position on the level of the exchange rate, what we always thought was a more productive thing to do is to focus on the quantity side of things.
"To say we want to build up our stock of reserves, so that the central bank will have more flexibility to deal with future situations and let exchange rate adjust as it needs to adjust."
Both the finance ministry and central bank officials have said that over the next few years the rupee will be made to appreciate slowly.
There is also an expectation among market participants that investors who bought into Treasury bills will be given time to exit before a full float is allowed to take place as happened during the last balance of payments crisis.
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