16 and FIR during the pre-reform period was due to purely statistical reasons. First, our RER series might not have been a satisfactory indicator of real exchange rate behavior in an economy characterized by quantitative restrictions (QRs). In the presence of QRs, the distinction between traded and nontraded goods becomes blurred; commodities subject to QRs are usually priced not on the basis of the prices of competitive imports but on the basis of domestic demand and supply (as in the case of nontradables) (Corden, 1987). Second, the degree of year-to-year variability of both data series was rather small. Given this "insufficient" variability, our regLession exercise may have failed to distinguish the effect of the FIR on the RER from other random effects on the latter. As we expected, both net foreign capital inflow (NFC) and government expenditures (GEXP) seem to have exerted significant downward pressure on the real exchange rate. By contrast, the coefficient of BMP was not statistically different from zero. This result supports the view that the real exchange rate is determined by real variables, and that therefore the nominal exchange rate has little influence upon it (Brock and Tower, 1986).

To sum up, our regression exercise provided a useful framework for understanding the behavior of the real exchange rate in Sri Lanka following the 1977 reforms. While interest rate reform had a notably salutary effect on the real exchange rate, this effect was crowded out by the much stronger combined negative effect of massive capital inflows and uncontrolled public expenditures. Consequently, the significant improvement in the country's international competitiveness achieved through trade liberalization was short-lived (Table 3). Had it not been for the favorable impact of increased financial deepening, the squeeze on the profitability of tradable producticni during the ensuing period would have been much sharper.

# 4.3 Volume of Credit and Private Investment

The increase in financial intermediation after reform (section 4.1) was reflected in a massive increase in the volume of institutional lending. Total real credit recorded a three-fold increase from Rs. 15,361 million in 1977 to Rs. 47,798 million in 1985 (Table 11). There was also a major shift in the allocation of credit in favor of the private sector. That sector's share increased from 28 percent in 1977 to 60 percent in 1985, at the expense of the combined share of the government and public sector corporations. As noted above (section 3.2), financial reform did not include any measure to allow greater freedom for the portfolio decisions of government-owned nonbank financial institutions. Instead, these institutions continued to function as captive sources' of budgetarv finance. The increase in private sector credit therefore came predominantly from commercial banks. Refle:tinz the government's emphasis on guided credit to prioritv sectr-<. i-'Jit -xtended by the development finance institutions (PFIss di.l in(r-asz (TaIle 13), but their share of total i7stitutional .-redit allocated t- the private sector increased to only 7 per.ent by 1985. In that vear. ommercial banks accounted for 85