COLOMBO (News 1st); The Central Bank of Sri Lanka issued a statement on Monday (6) detailing the current exchange rate agreement, including its background, positive impact so far and expected outcomes.
This note aims to explain to the general public the context of the current exchange rate regime, the positive impact it has already had and the expected results in the coming period.
The country is currently facing extremely difficult economic circumstances as it goes through the worst balance of payments crisis in its history. The Sri Lankan rupee has come under enormous depreciation pressure, amid the shortage of foreign exchange liquidity in the domestic foreign exchange market, warranting a measured adjustment in determining the exchange rate in early March 2022, relative to the level prevailing in the market amid concerns about the negative impact of any significant exchange rate depreciation on the company. However, the outcome of the exchange rate flexibility that was subsequently allowed following the initial measured adjustment fell short of expectations due to the significant overshoot of market forces, reflecting the significant liquidity pressures that have prevailed in the domestic foreign exchange market as well as the delay in market correction. This behavior of the exchange rate since allowing greater flexibility in March 2022 suggests the need for careful sequencing of measures when allowing exchange rate flexibility under balance of crisis conditions. payments.
Following the excessive depreciation, inflation accelerated significantly through import prices, while second-round effects of this excessive depreciation on other goods and services were also subsequently observed. In addition, due to the severe shortage of foreign currency in the national foreign exchange market, as well as the continued depreciation of the exchange rate, currency conversions by currency holders have been delayed due to the expectation of a further depreciation and the high premium offered on the gray market. , thus adding further pressure on the currency. Meanwhile, demand for currency on the gray market has flourished to partly finance the growing demand for imports outside the banking system, causing further pressure on the currency as well as increased stress in the banking system. This significant exchange rate volatility has caused interbank exchange rates as well as customer buying and selling rates to spike sharply, causing undue speculation in the currency.
In this context, limiting the extent of write-downs and excessive volatility became necessary. If left unresolved, such an unlimited depreciation of the exchange rate could have had an extremely detrimental impact on overall macroeconomic stability, given the severity of the balance of payments crisis that the country is currently experiencing. In addition, during discussions with heads of treasuries of licensed commercial banks, the need for market guidance from the Central Bank on the degree of volatility of exchange rate movements was emphasized, while banks trading companies have the prerogative to determine the interbank spot market exchange rate.
In consultation with market participants, the Central Bank has started providing daily guidance on the degree of volatility (with an authorized bilateral variation margin) to all licensed commercial banks from 13 May 2022 based on the rate of exchange determined on the interbank market the previous day. daytime. Although this arrangement is often misinterpreted as a “pegged exchange rate” regime, there are clear distinctions between the current transitional arrangement and the pegged exchange rate system. Under the pegged exchange rate regime, a fixed intermediate rate is usually dictated by a central bank, while the floating market-determined spot rate is considered the intermediate rate under the current arrangement. The implementation of this arrangement has so far brought greater stability in the determination of the exchange rate in the formal market and the gray market, while minimizing the excessive margins that prevailed in both markets, and the effects of the same should be reflected in exchange rates. used for transactions with customers. According to the feedback received from stakeholders, there is a broader consensus on the current exchange rate arrangement, which is market determined with less volatility and more predictability, compared to the previous arrangement, which experienced excessive exchange rate volatility driven more by speculation than market forces and economic fundamentals.
The government and the Central Bank have implemented several complementary measures, alongside the current exchange rate regime, to correct some of the imbalances observed in the external sector, thus resulting in the stability of the internal foreign exchange market. Restrictions on open accounts and consignment payment terms have helped reduce gray market activity, narrowing the gap between the official exchange rate and the gray market rate. As a result, the current exchange rate arrangement is seen as a more credible mechanism, compared to an arrangement where gray market activity could operate freely. As a result, inflows of workers’ remittances to the banking system have accelerated since the introduction of the new exchange rate regime, while conversions have improved. Import spending fell significantly in May 2022 compared to April 2022, according to provisional data from Sri Lanka Customs. Despite the reduction in import expenditure, all possible measures would be taken to ensure the availability of essential commodities with the expected inflows from multilateral and bilateral sources to the banking system in the coming period. Given the degree of exchange rate overshoot in March 2022, a further market-based correction is expected with non-emergency import spending decelerating alongside increasing inflows into the banking system in terms of remittances. workers’ funds and earnings from the export of goods and services, among others.
This improvement in domestic foreign exchange market dynamics is expected to consolidate with progress towards the conclusion of a staff-level agreement with the International Monetary Fund (IMF) on a financing agreement, as well as negotiations for bridge financing. other multilateral and bilateral partners. The Central Bank would like to reiterate that the current exchange rate arrangement would be reviewed from time to time and greater flexibility would be allowed where necessary once market confidence is restored, supported by the currency inflows envisaged in the country.