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"Definitely we need a correction on interest rates," Treasury secretary P B Jayasundera was quoted as saying by Reuters, a news agency.
"We need monetary growth of less than 16 percent, but it is around 19 percent. That excess 3 percent must be wiped out in the first half of 2012."
Sri Lanka has a Bretton Woods style 'soft-pegged' crisis-prone exchange rate regime which was abandoned by most countries in 1971-73, when most advance nations shifted to floating rates.
In the 1970s, Sri Lanka closed her entire economy, created crony-capitalist import substitution business class and drove unemployment above 20 percent.
Soft-pegs get in to trouble because the central bank tries to target both the exchange rate and interest rate at the same time.
Jayasundera however blamed 'cheap' imports and a trade deficit for the problem.
Sri Lanka has a large trade deficit because the Treasury is a net borrower abroad, the island gets billions of dollars of remittances from exported labour.
Tourism receipts and foreign direct investments also increase domestic spending power over and above incomes from goods exports.
The trade account is just a part of the overall balance of payments but because the island's capital account is not free, incomes over and above exports either triggers imports or be 'sterilized' by the Central Bank and captured as foreign reserves.
While it is easy 'sterilize' excess rupee liquidity and lock up reserves in a contractionary fashion it is not possible to do so when credit growth grows up.
When a soft-pegged central bank defends a currency it also has to keep injecting rupee liquidity to prevent rates from shooting up in an 'expansionary' fashion.
Continuous reserve losses are caused by the excess demand generated from the expansionary sterilization. To break the cycle of sterilized intervention the dollar peg has be made 'flexible' or the rupee floated.
Sri Lanka has had balance of payments trouble from within two years after the abolition of a hard peg or currency board shortly after the end of British rule. Under a hard peg only the exchange rate is targeted, and capital flows are free.
The inability to allow capital flows (or imports) and control both the exchange rate and interest rates is known as the 'impossible trinity' of monetary policy objectives.
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