Sri Lanka flexible exchange rate can cut carry trade risk: IMF

Feb 04, 2011 (LBO) – A flexible exchange rate that moves in both directions can ward off speculative capital flows by signaling the risk of capital losses, while also improving competitiveness, an International Monetary Fund official said. Policy rates in Sri Lanka are now on a 7.0 to 8.5 percent band compared to almost zero to 0.25 percent in the United States.

Sri Lanka had a tight peg at 108.0 to the US dollar in late 2008 when speculative capital into Treasury bill markets went out triggering a balance of payments crisis.

Sri Lanka lost more than two thirds of her foreign reserves before the currency was floated and the peg broken days before the IMF came in with a 2.5 billion US dollar bailout.

Deadly Pegs

“The general understanding among economists now is that pegged exchange rates can introduce some risks,” Mathai said.

Balance of payments crises are a disease affecting so called ‘soft-pegged’ exchange rate central banks.

Under a soft-peg, a central bank tries to control both the interest rate and exchange rate, through inherently contradictory and unsustainable policies creating an unstable peg.

Sri Lanka created an unstable peg with the US dollar in 1950, shifting from a stable peg wit