The Nexus Of Foreign Reserves, Exchange Rate And Inflation: Recent Empirical Evidence From Sri Lanka

The conventional mandates of the central banks on meeting stability objectives and maintaining a growth-maximizing inflation rate have come under some criticism since the global financial crises. Maintaining adequate foreign reserves is seen as a viable solution to foreign exchange liquidity needs during crisis periods. Since the end of 2011, many Asian economies, including China and Japan, led from the forefront in central bank-led reserves build-up. However, reserves build-up remains challenging and sensitive for small open economies. Such policies help create ‘risk-neutral’ buffers for monetary and fiscal authorities to absorb transitory current account shocks and foreign exchange stress to smoothen the balance of payments. This study is motivated by the importance of identifying the inflation–foreign reserves nexus that may affect inflation in a manner counterproductive to the central bank mandate of maintaining price stability. It probes the debate of the sustainability of reserves build-up in the long and the short term. The outcome of the study poses several vital questions for fiscal and monetary policymakers concerning their respective mandates. The reserves–inflation nexus and its magnitude is determined using monthly data spanning two decades, through engaging an autoregressive distributed lag (ARDL) model and relevant bounds-testing techniques proposed by Pesaran et al. The vector autoregression (VAR), error correction and Johansen cointegration methods supplement the robustness checks. Exchange rate is introduced to enrich the discussion on the reserves–inflation nexus and shows a cointegration relationship in the long run. The study provides an insight into the influence of exchange rate on reserves and inflation. The variance decomposition shows the presence of a lukewarm response from foreign reserves and exchange rate on inflation. Policymakers concerned with inflationary expectations in the medium-to-long term need to consider these signals, as reserves build-up is one of the important policy-driven objectives for a number of economies. JEL: C50, C32, E31, E52, E58, F30, F31, F39