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Rupee down 3%, reserves fall 17%

Rupee down 3%, reserves fall 17%
Foreign fund exits continued from the Treasury (T) Bond and T-Bill market for the fifth consecutive week to Wednesday, taking such exits to Rs 37,156.89 million in the review period, equivalent to 11.7% of the current foreign investments in T-Bond and T-Bill outstanding from Rs 279,566 million, which has fallen from a higher figure of Rs 316,722.89 as at 12 October 2016.

The reasons for such exits are three-fold. Those are the belief that the Federal Reserve System will raise its key policy rate (the Federal Funds rate) at next month's meeting of its Federal open market committee which decides on such rates due to the recovery of the world's largest economy; President- elect Donald Trump will increase inflationary pressure on the world's largest economy by tax cuts, increased State spending and adopting protectionist policies by capping cheap imports from source countries such as China and finally, Finance Minister Ravi Karunanayake's last week (10 November) Budget 2017 which increased the withholding tax rate on treasury investment by 40% ( four percentage points) to 14%.

Such exits also cause rupee depreciating pressure, upward pressure on interest rates and bleeding of the island's foreign reserves because Central Bank of Sri Lanka (CBSL) in such situations steps into protect the rupee from further depreciating pressure. In market trades, conducted under CBSL's over-arching moral suasion umbrella, the exchange rate (ER), since 31 October, 2016 to Thursday has had depreciated by between 15 to 25 cents, having had closed 31 October, 2016 at Rs 148/30/50 in two way quotes to the US dollar in one week's forwards, while on Thursday, 17 November, 2016 it had closed at Rs 148/55/65in two way quotes in 'spot next' trading.

The market allegedly is not allowed to deal in one week's forwards to find price discovery of the US dollar. The last time one week's forwards were allowed to come into play in the review period was on Tuesday, 15 November, where it closed at Rs 148/40/70 to the dollar in two way quotes. However, in normal markets, divorced from moral suasion and similar controls by the regulator, those markets deal in 'spot' in foreign exchange trading, where trades are settled after two market days from the date of transaction, whereas in the case of 'spot next' it's three.

As Sri Lanka is an import dependent economy, a weak rupee causes prices to go up and also increases the Government of Sri Lanka's (GoSL's) foreign debt servicing costs, as, generally, the required dollars for this purpose are bought from CBSL's foreign reserves.

But such an action also causes upward pressure on rates. Though the average weighted prime lending rate (AWPLR) of banks in the period 30 September, 2016 to 11 November, 2016 has had declined by 17 basis points (bps) to 11.95%, the weighted average yield (WAY) of the benchmark one year T-Bill in the review period increased by three bps to 10.14%.
However, CBSL's foreign reserves, in the one month period from end September, 2016 to end October, 2016 has declined by US$ 390.29 million to $ 6,065.43 million due to CBSL's rupee protection in the market.

In related developments, the ER in market trades, which closed last year at Rs 144.22 to the dollar in interbank 'spot' trading, has, in the calendar year to Thursday, depreciated sharply by between Rs 4/33 and Rs 4/43, having had closed Thursday at Rs 148/55/65 to the dollar in two way quotes in interbank 'spot next' trading. Similarly, the AWPLR of banks in the calendar year to 11 November, 2016 has increased by 4.42 percentage points (58.7%) to 11.95% andthe WAY of the benchmark one year T-Bill by 2.84 percentagepoints (38.9%) to 10.14%. Meanwhile, the country's foreign reserves in the calendar year to end October 2016 have had fallen by $ 1,238.21 million (16.95%) to $ 6,065.43 million.