IMF: ‘Y U NO Remove the Peg’

The IMF has just asked us to remove the currency peg. What is a peg? Well as the video above beautifully explains using the metaphor of yacht racing; a peg is a peg cause its a peg. Basically allowing us to fix the value of the rupee with any currency of our choosing.

We chose the dollar because it is so powerful in trade. Pegging to the dollar will stabilize the value of the dollar with respect to the rupee. This means more certainty when it comes to trade, as sudden fluctuations in rupee-dollar prices won’t happen. Things like oil will also stabilize and prices here will rise only if oil prices rise relative to the dollar.

So this is a good thing. Or is it? The IMF wants the peg to be removed because it feels that the Central Bank has basically lost all sense of decorum. Having a peg means that as the dollar value increases, in other words as the value of the rupee drops, the Central Bank buys rupees from the local economy and injects dollars into it.

This props up the value of the rupee. And its all good if it ends there. But it doesn’t.

By sucking in rupees from the system the CB is essentially reducing the amount of rupees in the economy, this would generally result in higher interest rates and a slowdown in growth, especially since Sri Lanka has been fueled by cheap credit. So the CB doesn’t want this either.

So how does both have the cake and eat it? Easy, it pumps new rupees back into the system. Where do these new rupees come from? Some of it is of course, printed. But a lot seem to have come from foreign inflows.

This continuous injection of new liquidity into the system is keeping interest rates artificially low. Current interest rates don’t reflect market conditions. People aren’t depositing money at anywhere near the amounts they seem to be borrowing. So the IMF fears inflationary pressure and wants the Central Bank to devalue the rupee, stop injecting liquidity into the system and basically let ‘market fundamentals start reflecting in the exchange rate’.

I think this makes sense to do, but the IMF has its own agenda. The Central Bank will probably pay lip service because of an upcoming IMF credit line tranche, and ease up a little. But its notoriously stubborn nature is likely to see it engaging in sterilized interventions until it hits upon a crisis, it being the last minute crisis averter that it is.

Where does this leave us? Well dollars might become a little more expensive, though i don’t think the government will increase fuel prices again. Interest rates might go up too. So if you’ve been eyeballing something on ebay, better buy it fast.

 

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2 comments
  1. b said:

    So the value of the dollar (relative to the rupee) is likely to spike in the short term, and it’ll get pegged again soon after, balancing it out?

    • Whacko said:

      IMO it looks like it. Assuming the CB listens to the IMF. It is anyway going to need some serious forex reserves to keep doing this

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