Sri Lanka broke a pegged exchange rate in 2022 in an attempt to ‘float’ the currency without hiking rates and taking monetary board recommendations in to account, Central Bank Governor Nandalal Weerasinghe said.
Sri Lanka’s soft-pegged central bank ran out of reserves in August 2021 (net foreign assets became negative) according to its own data. The agency continued to sell borrowed dollars and inject new money to maintain artificially low interest rates with new money preventing rates from going to protect the exchange rate.
Around March 2022 the peg was broken which was followed by a steep collapse from 200 to 360 to the US dollar.
“On the 08th of March the previous administration of the central bank let the currency float without any safeguards,” Governor Weerasinghe told a public forum in Colombo.
“Even the monetary board recommendation to gradually allow and take certain measures, without taking initiative to re-structure debt, without taking initiatives to tighten monetary policy, letting the currency float.”
Analysts have said a float involves stopping all interventions in forex markets so that reserve money is isolated from the balance of payments and surrender requirement also worsened the fall.
Sri Lanka forced commercial banks to sell dollars to itself in a surrender requirement, which is a tactic used by pegged exchange rate central banks to prevent appreciation of a currency (a strong side convertibility undertaking) and push the currency down.
Governor Weerasinghe hiked rates to 15.5 percent and allowed market rates to go up, slowing private credit and is now defending a peg around 360 with some success.
Dollars are bought and sold on both sides of the peg.
Meanwhile the Treasury has raised taxes to reduce domestic borrowings and energy utilities have hiked tariffs to reduce their borrowings.
The central bank also maintained liquidity short in the interbank market further discouraging credit.
Pegged exchange rate were generally not allowed to be broken without parliament approval until about 1980s when so-called basket, band, crawl (BBC) policy was peddled to the third world. In the UK, Bank of England originally had to have parliamentary sanction to break the peg and float through a Bank (covertibility) Restrictions Act.
Sri Lanka’s monetary law also originally had similar provisions. However from about 1980s when so-called basket, band, crawl (BBC) policy was peddled to the third world nations without a strong doctrinal foundation in sound money or knowledge about external anchoring critics, the rupee was depreciated to compensate for mis-targeted interest rates critics say.
Later, the obligation to preserve the ‘external value’ of the currency was removed, though other sections of the Monetary Law on the peg remained.
A pegged exchange rate collapses due a policy rate maintained with liquidity injections to create bank rupee reserves which are then loaned to real borrowers to spend and import.
Liquidity injection hit the balance of payments as imports via the credit system reserves have to be sold to stop the peg from breaking, creating a so-called balance of payments deficit roughly equal to the volume of printed money.
If there is strong credit demand, continued domestic credit disbursements lead to more reserve sales and liquidity shortages in the banking system, which needs a rate hike to slowdown credit.
Government credit is usually inflexible, and state enterprise credit comes from losses coming from price controls or ‘administered prices’ both of which will create balance of payments deficits if liquidity is injected to maintain the policy rate.
In Sri Lanka price controls on electricity are imposed by the Public Utilities Commission and fuel by the Treasury.
Currency boards (true hard pegs) do not have an active fixed policy rate, interventions are unsterilized and can maintain pegs indefinitely, by immediate curtailment of credit through floating domestic interest rates.
Countries like Dubai, Qatar and Oman, though not true had pegs, also do not have an active policy rate and can maintain pegs for many decades, giving long term stability and a foundation for economic growth and employment above the domestic population.
When Sri Lanka had a currency board, the country import large number of workers from India.