Exchange rate policy options for Sri Lanka in the context of financial integration

Global financial integration, which took a U turn following the Second World War and experienced a rapid growth since the 1970s has been one of the most important developments in international economic relations in the recent past. The integration of capital, goods, and labour markets across national borders brings about benefits as well challenges. The recent experience in the South East Asian countries vividly exemplifies the possible implications of financial globalisation. Foreign capital inflows into these countries not only supplemented domestic saving but also provided a ready market for finished products and diffused technological innovations that led to substantial improvement in well-being of nations. The financial crisis in 1997 /98 however devastated most of these economies that had some important ramifications on social and political fronts as well. Even though the debate has been far from conclusive as to the fundamental causes for the crisis, it aptly shows the challenges faced by the countries that have financially integrated. As impossible trinity shows financial integration, monetary policy, and exchange rate policy are interrelated issues. Accordingly, with increasing financial globalisation countries should opt for either exchange rate flexibility or fixity. Following the Asian financial crisis a new twist was added into these policy prescriptions due to the advancement of what is known as the hollowing out the middle hypothesis according to which financial globalisation had made the intermediate exchange rate incompatible and therefore countries should move to either fixed or flexible corners. This re-ignited the age-old debate on the choice of appropriate exchange rate policy. Sri Lanka since 1977 has been cautiously moving towards a market economy. Current account convertibility was achieved by the mid-1990s. Even though there are still some restrictions especially on hot money flows, capital account also has been progressively liberalised. The exchange rate policy by 2001 evolved to an officially declared free float. The transition to freely floating was done as a crisis preventive measure despite the fact that the exchange rate policy movement had been towards the flexible corner. In this situation the obvious concern over the appropriateness of a freely floating regime to Sri Lanka motivated this research. Thus the main objective of this thesis is to analyse the appropriate foreign exchange regime for Sri Lanka given the prevailing economic conditions and the overall economic objectives and strategies. Two analytical procedures were used in this thesis in analysing the appropriate exchange rate regime. First, the past performance of various exchange rate policies that have been followed was evaluated based on an analysis of real exchange rate misalignment. Second, recent experience with exchange rate regime choice of a large number of countries was evaluated. The lessons garnered from these analyses in combination with the existing economic conditions and broad economic objectives were used in drawing the final conclusions. Even though the lessons that can be drawn from the other country experience have been far less illuminating than expected, overall findings favour a more flexible exchange rate regime for Sri Lank