The Central Bank has been asked by the International Monetary Fund (IMF) to phase out restrictions imposed on foreign exchange trading by commercial banks. The multilateral lending agency has also exhorted the bank to focus on inflation controls rather than attempting to control the exchange rate, while warning that it was less optimistic than the Central Bank on the balance of payments front.

Releasing a staff report on Sri Lanka yesterday, the IMF highlighted some of the issues it had discussed with the authorities during the last review mission.

`Discussions focused on the challenge of developing a more liquid foreign exchange market, to help consolidate the shift to a flexible exchange rate regime. (IMF) Staff noted that progressively rolling back restrictions on banks` net open and forward positions would help deepen the market and provide opportunities to hedge risks. As well, limited intervention could be considered to counter excessive volatility, provided that it is not one-sided and not inconsistent with meeting the target on official reserves,` the IMF staff report said.

As previously reported in these pages, currency dealers said these restrictions caused sharper movements in the exchange rate, although authorities insisted speculation was the main reason for the rupee`s sharp fall after the currency was floated in February and interest rates were raised. Authorities believe Rs. 125/US$ to be more a realistic exchange rate, but the market believes this was unlikely anytime soon.

`The authorities (Central Bank) had already relaxed the forward restriction for exporters, and noted that open limits were not precluding banks from financing external trade. They felt that these measures had been useful in curbing volatility that had the potential to unhinge expectations and weaken support for the new regime, and explained that further relaxation of the restrictions would be undertaken gradually,` the IMF staff report said.

`(IMF) Staff also noted the potential benefit of increasingly emphasizing inflation control and macroeconomic stability rather than the exchange rate in communicating policy intentions,` the report said.

Authorities have been trying to control inflation, interest rates and the exchange rate all at the same time which is impossible to sustain without inflicting some pain on the economy. Economists refer to this as the `Impossible Trinity`. From June 2011, authorities were controlling these variables leading to balance of payments problem, resulting in more painful adjustments from early February 2012.

`The CBSL has largely ceased foreign exchange market intervention, allowing the rupee to move flexibly. However, volumes in the foreign exchange market have thinned with the slowing of external trade, enhanced supervision of foreign exchange trading, and the tightening of restrictions on banks` net open positions and forward transactions which the authorities had introduced to curb speculative positions they believed had generated heightened volatility. The market has become more settled recently,` the IMF said.

`With the external current account deficit narrowing, IMF staff project the balance of payments to move to a small surplus in 2012, with net international reserves rising slightly. The authorities and staff agreed on the need to raise reserves to provide an additional buffer against external shocks, although the authorities were hopeful for a larger balance of payments surplus this year, supported by higher foreign direct investment inflows and current account adjustment. Staff were more cautious, given the uncertain global environment, and the finding that while the real effective exchange rate has depreciated recently, standard methodologies suggest a mild overvaluation remains,` the IMF said adding that `the macroeconomic balance and external sustainability approaches indicate overvaluation in the 6 9 percent range, though there is uncertainty over such estimates.`

The report highlighted three key risks facing the economy.

`Global slowdown. A sharper-than-anticipated slowdown in global demand, particularly in Europe and the United States accounting for about 60 percent of Sri Lanka`s exports is a downside risk to growth and the external current account. Lower oil prices would provide some offset, while also benefitting the state-owned energy companies, however increased risk aversion could undermine capital inflows.

`Inflation. Though growth is slowing, there is not much slack in the economy, and there is a risk of second-round effects from pass through of depreciation and energy price increases.

`Revenue. Weak imports associated with the external adjustment and slowing domestic demand pose challenges for achieving the budget`s revenue targets. Meeting the deficit target through expenditure restraint could further dampen growth,` the IMF report said.

`Sri Lanka`s economy is transitioning through a major macroeconomic policy adjustment in the context of a weakening global environment. Although an earlier adjustment would have reduced the loss of reserves, the authorities deserve to be commended for taking bold and decisive policy measures in recent months to arrest the reserve loss. The main challenges now are to build on these policy achievements while coping with an increasingly uncertain global outlook,` it said.