Sri Lanka has to increase foreign currency reserves through capital account and trade account adjustments because short term inflows could easily be withdrawn, IMF Resident Representative in Sri Lanka Dr. Koshy Mathai said.

He said the situation after the war ended was extremely favourable to Sri Lanka with capital inflows rolling in, especially in to long term government securities, enabling the Central Bank to boost the country’s reserve position.

The Central Bank said the reserves would exceed US$ 5 billion after the second tranche of US$ 2.6 billion standby facility amounting to almost US$ 330 million comes in this week.

A significant proportion of the reserves are made up of borrowed money—investments into government securities—and Dr. Dr. Mathai said there is a risk because investors could easily withdraw their investments.

According to the Central Bank, Gross official reserves recorded US$ 3.89 billion by end August 2009. This includes short-term net inflows to Government Treasury bills of US$ 212.7 million and Treasury bonds of US$ 797.5 million.

Dr. Mathai said there was a difference between these short-term borrowed funds and reserves built up through a boom in exports and remittances.

"We will not look at the headline reserves that are published in the newspapers but at the core of how the reserves are built. The IMF programme is structured to adjust the reserve targets upwards to account for these borrowed funds," he said.

He said it was important for Sri Lanka to build its reserves through a boom in exports and remittances.

"Even after making these adjustments Sri Lanka met the reserve targets," Dr. Mathai said, "This is because remittances fared well. However, we have seen that raising remittances is followed by increased imports spending."

Analysts have called the glut of foreign currency inflows hot capital, funds that can leave just as fast as they come in with destabilising effect but Dr. Mathai said the nature of inflows in to Sri Lanka was different.

"You cannot call it hot capital. The bulk of inflows have been into government securities with a longer maturity period, so they can be called luke-warm money," he said.

Dr. Mathai said that because Sri Lanka’s securities market was relatively illiquid which meant it was not easy for investors to exit.

Under the IMF programme Sri Lanka is committed to allow more flexibility in the exchange rate regime.

The rupee has been under pressure to appreciate with the increase in foreign currency inflows but Central Bank has prevented this from happening, keeping the exchange rate stable at around 114 plus by purchasing dollars from the domestic market.

An appreciating rupee could hurt exporters severely as rupee values of revenues decline.

"Predicting future exchange rate movements is difficult but the Central Bank has been sensible because there is a surge of foreign currency inflows and the rupee is under pressure to appreciate," Dr. Mathai said.

Dr. Mathai said the success of the recent US$ 500 million sovereign bond issue was a signal to foreign investors that Sri Lanka was back on the ‘scene’.

Sri Lanka’s five-year US$ 500 million Sovereign Bonds offered to international capital markets was priced at 7.4 percent and 13 times oversubscribed, last October.

Dr. Mathai said the 7.4 percent pricing was cheaper than domestic rates and the bond issues was important because it helped diversify Sri Lanka’s debt.

He said that the fact the issue was oversubscribed and had a long term maturity was an indication that Sri Lanka was back as a destination for investments.