Sri Lanka foreign reserves fell to 2.3 billion dollars from 3.4 billion dollars two months ago as the monetary authority first defended a peg at 108.00 and then at 110.00 US dollars.
Economic analysts have pointed out that currency defence and tens of billion of rupees of cash injections (printed money) into the banking system would create a macro-economic imbalance that could only be corrected by a depreciation of the currency.
In the past senior government officials and central bankers have misled the public who have little knowledge of monetary policy, saying oil imports caused currency depreciation.
But analysts now say the deception can no longer be maintained in the light of collapsing oil prices.
Analysts say the misconception also seemed to have motivated officials to use oil derivatives in an ill-fated bid to 'save' foreign exchange, which has now backfired on the country, putting the banking system also into trouble.
The central bank began its liquidity injection and peg defence cycle (known as sterilized intervention) in mid-September.
Sri Lankan officials and politicians also claim that oil prices cause inflation. Some believe that inflation is specifically caused by diesel.
Therefore diesel, which costs more to import, is sold at a lower price, while discouraging the use of cheaper petrol.
Right of reply: The Central Bank's chief economist, Nandalal Weerasinghe has denied that central bank officials have said that oil imports caused currency depreciation. The central bank has only said that oil imports affected the balance of payments, he said.
Editor's Note However, from time to time the central bank has made the following statements:
a) "On the external front, rapid increase in oil price will widen the trade balance leading to a worsening of the overall balance of payments (BOP), a loss of country’s foreign reserves and exerting pressure on the exchange rate."
(Economic impact of oil prices - Central Bank of Sri Lanka(CBSL). Sri Lanka Development Forum 2005, background paper. Page 114)
b) "The higher domestic inflation and the resultant market expectations of sharper depreciation of the rupee and higher import expenditure on crude oil and refined petroleum products exerted pressure on the exchange rate."
(Recent Economic Developments, 2007 page 47)
c) "We had some of the highest oil bills ever which puts pressure on the currency,'' Cabraal said. "We believe this will ease over the next couple of months and the rupee will be back to more normal levels like in 2004 and remain there.'' (Interview with Bloomberg news service published in Nov 23, 2006)