"The free float is something that in the medium- to long-term (is in line) with the full liberalisation of the financial markets," said Nouzab Fareed, chief strategist at mercantile Merchant Bank.

Mr Fareed and others, however, question if the rupee can weather the pressure coming from the capital inflows and surging imports coupled with the limited foreign-exchange reserves.

Nadeem ul Haque, resident representative of the IMF in Colombo, said that the free float was welcome because it would speed up the liberalisation of the country's financial markets. "Doing it now would be a good move, and the float would benefit the long-term moves to (lift) restrictions on the market," he said.

Soon after the free float was announced on Jan. 23, M B Dissanayake, assistant to the central bank governor, said the country will manage to defend its reserves and avoid exchange-rate difficult;ties through a promised IMF loan package.

"There are a few shocks we'll have to face in (freeing the) markets," Mr Dissanayake said, adding that "with an IMF loan," due shortly, the central bank will contain the balance of payments problem and exchange-rate difficulties. Mr Haque said the IMF team in Colombo was primarily discussing with government officials the annual "Article IV" review of Sri Lanka. "Right now, we're having discussions on the annual Article IV consultations, but we stand ready to help," he said. "It is too early to discuss numbers (for the loan amount) or a specified time frame."

Soon after the free float, the rupee dived sharply by 3.3% and has tumbled an overall 12.8% by midday Jan. 25 to 96 rupees to the dollar. "The market is volatile and appears to be responding to the uncertainty caused by the weak fundamentals," said Dula Weerathunge, treasury had at Commercial Bank of Ceylon. Sri Lanka's total reserves were down to $2.23 billion at the end of October last year, compared to $2.58 billion at the end of December 1999. The overall balance of payments deficit is estimated over $500 million in 2000, up from $263 million the year before.

"There's bound to be a lot of pressure on the rupee in the short-term...the reserves aren't enough to defend the rupee, said Dushyant Wijayasingha, economist at Indosuez W I Carr Securities.

Mr Haque said the low reserves meant the timing was right for a free float. "With reserves falling low, one can't continue to erode them further by defending the rupee," he said.

However, given that Sri Lanka is a major importer, Commercial Bank's Mr weerathunge said the risk of the rupee tumbling well below 95 to the dollar was obvious. "The only short-term solution would be the IMF loan, otherwise it could be veery difficult to control the situation," he said.

Despite an expected slowdown in imports from last year's more than 20% growth, analysts say essential imports such as oil, weapons and consumables will continue to burden the trade deficit. Sri Lanka has spent more than $1 billion to fund an 18-year-old civil war with the Tamil tiger rebels and the cost has bloated the budget deficit above 9% of the gross domestic product in 2000, compared with 7.5% in 1999.

Traders and economists were divided over where the dollar would head by year end. A Dow Jones Newswires survey of treasury heads and economists put the rupee at an average of 91.50 rupees, by the first half, and at around 97 rupees by year end.

(The Asian Wall Street Journal)