Sri Lanka is effectively devaluing its currency as its foreign reserves dwindle, potentially accelerating the worst inflation surge in Asia as the nation struggles to service its debt and pay for imports.
The Central Bank of Sri Lanka said in a statement late Monday that “greater flexibility in the exchange rate will be allowed to the markets with immediate effect.” The central bank also said it’s “of the view” that transactions would be capped at 230 rupees per dollar, about 12% below the current market level of 201.49 rupees.
The decision comes as the government of Gotabaya Rajapaksa grapples with a spiraling economic crisis, as its foreign currency reserves shrink and after consumer prices accelerated 15% last month, the fastest on record.
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The island nation’s debt load, which the International Monetary Fund has said is “unsustainable,” is becoming increasingly difficult to manage as it also struggles to pay for imports of fuel and other necessities, leading to power cuts and other shortages.
“This was definitely needed to ease pressure in the system. We saw the impact on fuel,” said Kavinda Perera, head of research at Asia Securities in Colombo. He added that inflation would be stoked in the near-term.
Speculation began growing recently that the central bank wouldn’t be able to defend the currency as its reserves shrank. Economists at Standard Chartered Plc had seen the rupee tumbling to 230 per dollar by the end of June as the central bank ran low on dollars.
The local currency has traded in a relatively tight band of 201 to 203 per dollar since October, a range central bank Governor Ajith Nivard Cabraal last month called “fair” for all stakeholders.
But in unofficial trading the rupee was being quoted at a far weaker rate as exporters have been mandated by the central bank to convert 25% of their earnings while importers were forced to seek dollars from exporters in the so-called kerb market.
“There was no choice other than to allow the exchange rate to move. Most of the importers were importing between 230 to 240 already,” said Udeeshan Jonas, chief strategist at CAL Securities. “Monetary policy should be tightened further to prevent a very steep fall of the currency,” he said.
W A Wijewardena, a former deputy governor of the central bank, said the monetary authority would not be able to eliminate “parallel exchange rates” unless the rupee is allowed to float freely.
“The kerb rate will simply go up,” he said, adding that further monetary policy tightening was needed to support the currency.
Shortly before the currency announcement Monday, the central bank said foreign-exchange holdings dropped to $2.31 billion in February, the lowest since November 2021, from $2.36 billion a month earlier.
The government has so far relied on bilateral loans to bolster its finances, including from China and India, while shunning an IMF bailout.
A depleting foreign exchange pile heightens risks the country may have difficulties meeting its next overseas debt repayment in July.
Sri Lanka’s dollar bond that matures in April 2023 was up about 0.5 cents on the dollar at 43.3 cents as of 8:30 a.m. Hong Kong time on Tuesday, according to data compiled by Bloomberg. The price had fallen 4.6 cents on Monday, the biggest decline since April 2020, the data show.
The central bank last week raised borrowing costs for a second meeting, and urged the government to provide economic support by undertaking measures such as discouraging non-urgent imports and increasing fuel costs.
Sri Lanka’s dollar-denominated debt repayments due this year total more than $6 billion, including a sovereign bond of $1 billion maturing in July.
The central bank on Monday also said it will “continue to closely monitor the developments in the domestic foreign exchange market and make appropriate policy adjustments accordingly.”