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 May 13 on the basis of the exchange rate. determined on the interbank market the previous day. day, said a press release.
“Implementation of this arrangement has so far brought greater exchange rate stability in both the formal market and the gray market, while minimizing the excessive markups that prevailed in both markets,” the statement said.
Excerpts from the press release:
“The country is currently facing extremely difficult economic circumstances as it experiences 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 the determination of the exchange rate in early March 2022, against the prevailing level 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 prevailed in the domestic foreign exchange market as well as the delay in market correction.
“This behavior of the exchange rate since it allowed greater flexibility in March 2022 suggests the need for careful sequencing of measures when allowing exchange rate flexibility under libra crisis conditions. payments.
“Following 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.
“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 further depreciation. and the high premium offered in the gray market, thus adding further pressure on the currency.
“Grey market demand for foreign currency has flourished to partly fund growing import demand outside the banking system, causing further pressure on the currency and heightened stress in the banking system. This significant volatility in exchange rates caused interbank exchange rates and customer buying and selling rates to spike sharply, causing undue speculation in the currency.
“In this context, limiting the extent of depreciation 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.
“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 commercial banks 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 May 13 on the basis of the rate of exchange rate determined on the interbank market on the previous day.
“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, with the floating market-determined spot rate being 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 markups that prevailed in both markets, and the effects the same should be reflected in the exchange rate used for transactions with customers.
“Based on feedback received from stakeholders, there is a broader consensus on the current exchange rate arrangement, which is market driven with less volatility and more predictability, compared to the prior arrangement, which has 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.
“The current exchange rate agreement is seen as a more credible mechanism, compared to an agreement 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 declined significantly in May compared to April 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 to the banking system in terms of remittances from workers and earnings from the export of goods and services, among others.
“This improved momentum in the domestic foreign exchange market 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 agreements partners.
“The Central Bank reiterates that the current exchange rate arrangement will be reviewed from time to time and greater flexibility will be allowed if necessary once market confidence is restored, supported by the envisaged foreign exchange inflows into the country. .