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.

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

There was no indication in the report when free floating would start, which would lead to the end of deliberate reserve collections, but for the duration of the IMF program, Sri Lanka has to collect reserves according to the targets, including to repay its own past loans to the central bank.

Industrialized countries, led by the US started to floated their currencies after the break up of the Bretton Woods program in 1971. Many of the countries are now folded into the Euro region.

Developing countries do not usually clean float ending currency troubles.

Former members of the British Empire, Canada, Australia or New Zealand no longer collect reserves as they do not intervene in forex markets and engage in offsetting money market transactions, allowing inflows of foreign exchange to match outflows at all times.

A fully floating exchange rate would allow the central bank to operate a true inflation targeting regime without creating currency crises, analysts say. New Zealand is credited with inventing inflation targeting.

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 if core inflation is targetted 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 members 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.

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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 (employment-inflation trade-off/Phillips Curve) 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 of the Sterling, the pre-eminent global currency of the period (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/Nov21-Updated/2023 – Story updated to make clear that there are no plans to free float in the near term, which would lead to the ending of deliberate reserve building.)