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ECONOMYNEXT – Sri Lanka intends to move towards a fully floating exchange rate and the central bank will no longer have to collect foreign reserves, Central Bank Governor Nandalal Weerasinghe was quoted as saying in a report.

Sri Lanka would like to see reserves around three months of imports, but not large volumes as recommended by the International Monetary Fund, Governor Weerasinghe was quoted as saying by Bloomberg Newswires in an interview.

Clean floating countries like Canada, Australia or New Zealand no longer collects reserves as they do not intervene in forex markets, allowing inflows of foreign exchange to match outflows at all times.

Sri Lanka intends to move towards a fully floating exchange rate, Governor Weerasighe was quoted as saying in the report.

There was no time limit given, but for the duration of the IMF program, reserves have to be collected, including to repay its own past loans to the central bank.

A fully floating exchange rate would allow the central bank to operate a true inflation targeting regime without creating currency crises.

Central banks with fully floating exchange rates do not provide reserves for private sector imports and therefore do not have to sterilize (or neutralize) foreign reserve sales with new injections of bank reserves making it impossible to either lose reserves or run balance of payments deficits.

Hard pegs operate on the same principle where interventions are unsterilized, also conserving foreign reserves by not injecting domestic currency reserves which would allow banks to give credit without deposits.

Both are stable single-anchor, self-correcting regimes where exchange and money policies do not conflict to create external instability.

However, floating exchange rates have tended to create banking crises (like the Housing Bubble), due to a positive inflation target, especially core inflation where a commodity bubble is initially ignored, and the ready availability of standing facilities, according to some classical economists.

Sri Lanka now has a ‘flexible exchange rate’ which critics say is the most dangerous ad hoc monetary regime cooked up by Western inflationists and peddled to countries with unstable central banks since the IMF’s ‘Second Amendment’ left countries without a credible monetary anchor.

Ad hoc inflationist regimes since 1978 which have failed in the past included targeting money supply while intervening in forex markets, steadily depreciating according to an econometric real effective exchange rate basket (basket band crawl policy).

To collect excessive foreign reserves, domestic investment has to be curtailed to capture inflows from the current or financial account, through a higher interest rate than required to run a clean float or a hard peg.

Collecting reserves is the same as repaying debt. Collecting large volumes of reserves in a short time could reduce the ‘relief’ Sri Lanka is supposed to get by debt restructuring, analysts have warned.


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But Sri Lanka’s central bank also has to collect reserves to end a negative net foreign assets position and fix its balance sheet for which a balance of payments surplus has to be operated with deflationary open market operations.

A clean float however may make it more difficult to link to global supply chains, as East Asia did with its largely fixed exchange rates, firms will be under more pressure to boost productivity, though poverty reduction may be faster, analysts say.

Western central banks started to have BOP troubles in peacetime after open market operations using government securities were formalized by the Federal Reserve on April 13, 1923 giving birth to a bureaucratic policy rate and the eventual torpedoing of the self-correcting gold standard.

The bureaucratic policy rate triggered the roaring 20s bubble, Great Depression and currency crises during peacetime, as well as the eventual collapse of of the Bretton Woods system, analysts have said.

It is not clear when the belief that reserves of a government central bank can be used for private imports mainstreamed, but the Anglo-American Bretton Woods system and the IMF itself set up on false doctrine permitting capital controls and lending of reserves to BOP deficit countries, German-speaking classical economists who helped maintain monetary stability, have pointed out.

READ MORESri Lanka use of reserves for imports is a deadly false choice: Bellwether

The Great Depression triggered Keynesianism and the belief, especially in the US after World War II ended, that printing money contributes to growth by denying monetary stability, resulting in an employment mandate and what later became potential output targeting (macro-economic policy).

The idea first brought by Scottish Mercantilist John Law, was defeated in his time leading to a long period of monetary stability (and also peace under Pax Britannica) of more than a century until the start of World War I and the setting up of the Fed.  (Colombo/Nov20/2023)

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