This note is intended to explain to the public the background of the current exchange rate structure, the positive impact it has already had and the expected outcomes in the future.
The country is currently facing extremely challenging economic conditions and is experiencing the worst balance of payments crisis in its history. The exchange rates have been fluctuating since early March 2022, compared to the prevailing exchange rates in the market, amid concerns about the adverse effects of the large depreciation on society due to the sharp depreciation pressure on the exchange rate in the face of declining liquidity in the domestic foreign exchange market. Allowed for adjustment. However, after making a proper adjustment for the flexibility of the exchange rate, reflecting the liquidity pressures in the domestic foreign exchange market as well as the delay in correcting the market base, the expected effects may be due to the large devaluation of the exchange rate in the face of market forces at the outset. it was. Given the greater flexibility in March 2022, this behavior of the exchange rate reflects the need for careful action alignment in allowing the balance of payments to be flexible under crisis conditions.
After the sharp devaluation, inflation through import prices accelerated significantly, and the second round of similar devaluations on other goods and services was observed later. Further, foreign exchange holders have also made foreign exchange conversions in the face of the severe foreign exchange deficit in the domestic foreign exchange market and the persistent depreciation of the exchange rate, in the expectation that the exchange rate will depreciate further and the exchange rate will appreciate in the informal market. At the same time, it put further pressure on the exchange rate. Meanwhile, the high demand for foreign exchange in the informal market has been used to semi-finance the rising import demand outside the banking system, which has further exerted pressure on the exchange rate and increased the pressure on the banking system. This significant volatility in exchange rates led to an unexpected rise in interbank exchange rates as well as consumer buying and selling rates, which had an adverse effect on the exchange rate.
Against this background, it was necessary to limit the devaluation and high volatility of the exchange rate. If not, given the severity of the balance of payments crisis facing the country at the moment, such an unprecedented devaluation of the exchange rate could have a devastating effect on overall macroeconomic stability. Further, in discussions with the Treasury Heads of the Licensed Commercial Banks, it was emphasized that although the interbank market is where the exchange rate is determined by the commercial banks, there is a need for some guidance from the Central Bank to the market on fluctuations in the exchange rate.
From May 13, 2022, the Central Bank will provide daily guidance to all Licensed Commercial Banks on the level of fluctuations (with variance limits applicable to both sides) based on the exchange rate determined by the inter-bank market the day before, taking into account the views of market participants. Although this program is often misinterpreted as a 'fixed exchange rate' system, there are clear differences between the current tentative structure and the fixed exchange rate system. Under the Fixed Exchange Rate System, the central bank generally sets the fixed medium rate, while under the current system, the variable determined by the market is then treated as the middle rate. The implementation of this system has enabled us to achieve greater stability in determining the exchange rate of both the formal and informal markets so far and to minimize its high profits, and the results are expected to be reflected in the exchange rates used for consumer transactions. . Depending on the response from stakeholders, there is a better predictable and market-driven exchange rate consensus, with a lower variance compared to the previous system, which experienced more variations in the exchange rate, driven by speculation rather than market forces and economic principles. .
The Government and the Central Bank, in line with the current Exchange Rate Plan, have implemented a number of complementary measures to rectify some of the imbalances observed in the foreign sector, thereby stabilizing the domestic foreign exchange market. Restrictions on open account systems and post-sale payment methods have helped to limit the activity of the informal market, thereby narrowing the gap between the formal exchange rate and the informal market rate. Accordingly, the current exchange rate structure is considered to be a more reliable mechanism compared to an exchange system in which informal market activities can operate freely. As a result, remittance inflows into the banking system have accelerated since the introduction of the new exchange rate regime, which has increased the conversion into rupees. According to the provisional data of the Sri Lanka Customs, the import expenditure in May 2022 has decreased significantly compared to April 2022. Despite the low cost of imports, every possible step will be taken to ensure that essential commodities are available in the market with the expected inflows into the banking system from multilateral and bilateral sources in the future. A further market-based correction is expected in March 2022 as the exchange rate depreciates sharply, reducing costs on non-emergency imports and increasing inflows into the banking system from increased export earnings of goods and services for remittances.
These developments in the domestic foreign exchange market are expected to be further strengthened by the progress of reaching a staff-level agreement with the International Monetary Fund (IMF) on obtaining funding from other multilateral and bilateral partners. The Central Bank would like to reiterate that the current exchange rate structure will be reviewed from time to time and will allow the exchange rate to be further flexible if required once market confidence is restored with the expected foreign exchange inflows.
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