Sri Lanka begging IMF to continue the war

The Sri Lanka rupee closed at 115.20/45 against the greenback, with the country’s reserves running low as talks with the International Monetary Fund for a bailout package, stretched to a second week.

The Sri Lanka rupee broke the Central Bank’s defended peg level of 114.25 last Thursday.The IMF team began talks with authorities on March 23, and was expected to wrap up talks in the same week to reach a ’staff level agreement’ and the first tranche was expected in the first or second week of April following board approval.

However the team is still in the country, and is expected to remain at least till the middle of the week. An IMF spokesperson last week declined to put a deadline for a successful conclusion of talks.

Analysts are now hoping that a deal would be approved at least by May.

Sri Lanka’s reserves are running low with the monetary authority spending 240 million US dollars to defend a peg in February and close to 200 million US dollars in March.

While gross reserves had fallen to 1,415 million by end January 2009, net reserves were about 1,151 million US dollars. With every passing month, Sri Lanka has been losing about 200 to 250 million US dollars in reserves.

The ‘balance of payments crisis’ is perpetuated by ’sterilization’ of such outflows by injecting money into domestic money markets, which is expansionary. To break the cycle, the currency has to be ‘floated.’

A float of the currency is usually a ‘prior action’ for an IMF bailout.

Allowing peg defence to continue with IMF money will create extra liabilities, which will then lead to a deeper contraction in the economy when reserves are collected to repay the global lender.

Meanwhile the central bank has also rapidly cut interest rates in the past two months, and short term bill yields have plummeted. Such actions are usually expected after a float.

Analysts warn that rate cuts before a float could also make the currency weaken more than it would have otherwise done.

The currency crisis is itself a result of trying to target interest rates (or domestic money supply) and the exchange rate at the same time, which is impossible without massive outflows of capital or exchange and trade controls to block flows.

The phenomenon is known as the ‘impossible trinity’ of monetary policy objectives.