University of Colombo, Sri Lanka

Department of Economics
Master of Financial Economics – 2021
Semester II
MFE-04: - International Finance and Financial Institutions
Answer any five (05) questions only.
Time: Three (03) Hours

1. Looking at the status of the current Sri Lankan economy, it is evident that the
Economic policy makers and implementers have not paid adequate attention to the
risks that local economy is subjected to through exposure to both domestic and
global economic environments.
a) Identifying the risks that existed but not recognized, discuss the macro and micro
economic root causes for the current forex crisis
(10 marks)

b) Comprehensively explain your recommendations to overcome this crisis and bring

about sustainable balance of payment and reserve positions in the medium to long
term (10 marks)

2. In a country where economic policies are implemented based on rational evaluation,

consider the following circumstances.
• The country having a decent reserve position with an import cover of around 12
months and the country is enjoying BBB sovereign rating,
• an analysis indicates that the country’s major export business is losing
competitiveness to its regional peers due to domestic cost escalation.
• In the global markets, international Interest rates are quite accommodative
(lower single digit) as the western economies are focused on driving high level of
consumption to revive their economies.
• Country’s calculated approach to capital mobility (mostly opening domestic
capital markets to inward investments) has recorded positive impact on the
economy.
• In order to boost production yet prudent in economic management, the country
had been running a somewhat upper bound mid-single digit interest rate policy
regime (6-7% p.a.) during the last two years which have shown progress in

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 meeting expected credit growth. Simultaneously, inflation expectation in the
country is picking up steam and threatening to overheat the economy and the
ASPI has been north bound for some time.
• Oil imports is a substantial commodity of the import basket of the country for both
power generation and transportation, but the recent ADB funded domestic
Rooftop Solar drive along with tax reduction for Electric Vehicles is paying
dividends in reducing the fuel consumption. On top, the country is also blessed
with a good monsoon that enabled majority of hydropower reservoirs reaching
their capacity.
Taking the above into consideration,

a) describe the country’s current macroeconomic environment,

(6 marks)
b) the immediate threats lurking in the economy and what are the policy prescriptions
that should be implemented and
(7 marks)
c) why you think such policy prescriptions will be effective in addressing the current
threats. (7 marks)

3. Sri Lanka is going through a severe financial crisis. Consider the following hypothetical
scenario.
A) Impact in the financial sector

- Country rating is in default

- Most locals banks are perceived to have weak foreign currency credit rating
- Few local banks with strong parent support have stronger credit ratings
- Foreign banks have restrictions in transacting with weak banks and transact only with stronger
banks. This has created a two tier interbank market with liquidity limitations (constraints) leading
to two tier interest rate structure (i.e. some banks are able to generate funds at a lower interest
rate while others have to pay a higher cost).

B) Market information
- USD/LKR spot rate (buy:sell) is 355/360
- Interbank market LKR yield curve is: Overnight - 17%, 1 week 17.50%, 1 month - 18%, 3 months
- 20%, 6 months 20.75%, 1 year 22%

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- A,B,C and D (includes foreign and local banks) are strong banks and the applicable forward
rate for an fx SWAP is 5 cents per day when transacting amongst them (I.e. FORWARD rate is 5
cents more than the SPOT rate - forward premium).
- W,X,Y and Z are weak banks and the applicable forward rate for an fx SWAP is -5 cents per day
(I.e. FORWARD rate is 5 cents less than the SPOT rate - forward discount).
- D can borrow USD 1 Mn for 1 year from A,B and C while D also deals with W.

a) Explain how forward fx premiums are computed in the interbank market? (2 marks)

b) From given data, derive the USD interest rates applicable for the two groups of
banks? (6 marks)

c) If D is able to deal with A,B,C and W what do you call the special opportunity the
dealer at D has got? (2 marks)

d) Under normal market conditions, how would the market players react to such
opportunity as mentioned in C above and explain how the market correction would
happen? (2 marks)

e) What are the “Bank Market” avenues available to D to generate LKR funds. If D is
able to borrow USD 1Mn at 7.5% p.a. from international market (2.5% p.a. + 500bps)
compute D’s LKR interest rates if 365 day fx SWAPs are done with B and W
(6 marks)

f) What factors have enabled D to generate LKR funds at favorable rates as computed
above? (02 marks)

4.
a) What are the different accounts in the Balance of Payment? (04 marks)

b) Why do economists concern about Balance of Payment if it is in balance all the time?
Explain your answer. (04 marks)

c) Discuss the root causes of persistent current account deficit in Sri Lanka’s Balance of
Payment. (04 marks)

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 d) What are the immediate policy options that the policy makers can consider If there is
a deficit in the current account. (04 marks)

e) Discuss the long-term policy options for a persistent current account deficit.
(04 marks)

5.
a. Discuss the difference between fixed exchange rate regime and ‘managed’
floating exchange rate. (04 marks)

b. Discuss the asset market approach to exchange rate determination.

(04 marks)
c. What would be the effect of US interest rate increase on Sri Lanka’s exchange
rate against USD? (04 marks)

d. What is law of one-price? And how does it affect exchange rate movement.
(04 marks)
e. Discuss the impact of International Sovereign Bonds (ISBs) issuance on Sri
Lanka’s exchange rate against USD. (04 marks)

6.
a. What are the channels through which money supply affect exchange rate?
(04 marks)
b. “Foreign capital always flows to place where interest rate remains high” Do you
agree with this statement? Explain your answer. (04 marks)

c. What is meant by exchange rate overshooting? Explain your answer.

(04 marks)
d. Discuss the role of the foreign reserves under different exchange rate regimes.
(04 marks)

e. What policies you may propose in strengthening Sri Lanka rupee against USD in
the short-run? (04 marks)

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7. Write short notes on each of the followings
(04 marks each)
a. Fixed exchange rate regime and monetary policy
b. Current account deficit and floating exchange rate regime
c. Inflation, interest rate and Fisher effect
d. Real exchange rate and aggregate demand
e. Fixed exchange rate and foreign exchange intervention

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