IMF's Koshy Mathai on Sri Lankan economy

We firmly believe that Sri Lanka’s flexible exchange-rate regime is appropriate and that there should be no peg. Of course, a central bank can never be totally hands off – it’s sensible to intervene in order to avoid disorderly movements in the exchange rate that could harm the economy. But econo­mists generally would say that sustained intervention in one direction or the other to keep exchange rates either above or below the levels suggested by fundamentals should be avoided.

Soon after the end of the war, we saw a long period when the rupee was virtually fixed against the dollar. Since then, we’ve seen some flexibility in one direction, with the rupee appreciating. And given the amount of foreign currency flowing into the economy, there’s little wonder that we should have seen stable or appreciating exchange rates over this period.

Going forward though, rising imports and high oil prices could imply smaller balance-of-payments surpluses or even deficits; and in such a scenario, it would be important to illustrate to markets that the rupee is flexible in both directions. This would also encourage the development of forward markets in foreign exchange and discourage short-term, speculative capital inflows, which Sri Lanka doesn’t need.

As for where the rupee should be headed in the medium term, let me just say that I learned a long time ago not to try to predict currency movements! Economists have statistical models that try to explain the appropriate levels for exchange rates, but the results of those models are sometimes difficult to assess, particularly in a world of large capital flows. In the IMF programme here, in Sri Lanka, rather than looking at the price side of things – that is, the exchange rate – we have focused on the quantity side (i.e. the level of reserves at the Central Bank).
Reserves are certainly not a problem for Sri Lanka. In fact, the build-up of reserves over the past two years has been a resounding success, far in excess of what we initially expected – and that’s not just because of foreign borrowings. Nonetheless, reserves are not high compared to levels seen in many other EMEs, and there is probably some scope for at least modest further accumulation. So in the programme, the Central Bank commits to achieving such accumulation and the exchange rate is allowed to adjust however it needs to, in support of that reserves targe