Rupee’s sad destiny of one-way journey to

depreciation

When the Government took power in January 2015, the Central Bank’s
Monetary Board

as well as the Minister of Finance behaved as if there was no economic crisis

Sudden fall in the value of the rupee

Tuesday, 1 May 2018

The recent media reports have been abuzz with a sudden fall in the value of the
Sri Lanka rupee against the US dollar, the benchmark currency used by Sri Lanka
to quote the external value of its currency.

The Central Bank does not publish its own exchange rate now – a practice which it
started to follow since 2000 when it allowed the foreign exchange market to
decide on the exchange rate under what it called a ‘freely floating exchange rate
system’. Hence, the market guide today are two exchange rates, both applicable
to commercial banks.

The Central Bank publishes both these rates in its website subject to a time lag of
one day (available at: https://www.cbsl.gov.lk/rates-and-indicators/exchange-
rates).

Panic in the market

One is the indicative spot rate – a transaction in which the delivery of dollars
would be made within two working days – against the US dollar used by
commercial banks in transactions among themselves, known as the interbank
foreign exchange market. This rate which amounted to Rs. 155.75 per US dollar
two weeks ago fell to Rs. 157.65 per US dollar as at 27 April, indicating a
depreciation of the rupee by Rs. 1.90.

The other rate which is normally used by media and analysts to measure the fate
of the rupee refers to the buying and selling rates of dollars by commercial banks
when they receive or send money by telegraphic transfers. Two weeks ago on 16
April, the buying rate amounted to Rs. 153.76, while the selling rate to Rs. 157.53
yielding the middle rate of Rs. 155.64. On 27 April, they were Rs. 155.40 and Rs.
159.01, respectively, with the middle rate of Rs. 157.21. According to this
reference rate, the rupee has depreciated by Rs. 1.57 within a space of two
weeks. It is this depreciation which has caused panic among the media personnel
and the critics.

A fixed exchange system reinforced by import and exchange controls

This is not unusual and it is something that has been happening ever since Sri
Lanka started adopting a flexible exchange rate system in late 1977. Before that
Sri Lanka had a fixed exchange rate system in which the rupee-dollar rate was
changed by the government by deliberate policy decisions.

With a perennial deficit in the country’s foreign exchange receipts and payments,
there was no possibility to maintain this fixed rate system for long. Hence,
imports were restricted by implementing a draconian import and exchange
control system.

Cutting the coat according to the cloth

It was like cutting the coat according to the cloth, rather than enlarging the cloth
to stitch a coat that would fit the body size. It, therefore, imprisoned Sri Lankans
in an ever tightening coat. Thus, people did not pay in rupees but in time,
hardships and labour to buy dollars from banks. Hence, this system which
allocated the limited availability of dollars to citizens by rationing by quotas was
dismantled in 1977 and permitted people to acquire dollars by paying a higher
rupee price that was determined in the market.

Thus, the rupee-dollar rate which had been fixed at Rs. 4.76 per dollar in 1950
remained at that level till 1968 when it was devalued by the government by 20%.
Since then, there were several devaluations and one revaluation of the rupee-
dollar rate by the government. When the new exchange rate policy was
introduced, officially the exchange rate stood at Rs. 8.81 per US dollar.

But this official rate was misleading since almost all of the import transactions and
a fraction of export transactions were conducted by a special levy of 65% over the
official rate under a system called Foreign Exchange Entitlement Certificate or
FEEC system. Thus, the effective exchange rate was Rs. 14.54 per US dollar.
During the decade prior to this, an important source of revenue for the
government was the income from this FEEC levy.
A unified rupee in 1977

These systems with different exchange rates for different types of transactions
are known as multiple currency systems. In 1977, all these multiple exchange
rates were abolished and the rupee-dollar rate was unified at Rs. 15.56 per dollar
introducing an element of depreciation of about 7% over the effective rate. It is
from this rate that the rupee has started a one-way journey toward depreciation
and has ended up at about Rs. 157 per US dollar by the end of the last week.

It is a disappointing fate for the Sri Lanka rupee, but there is a cause for this one-
way journey.

Avoiding a deficit in the current account

If a country is interested in stabilising the value of its currency, there is only one
recipe for it. That is, it has to earn sufficient amount of foreign currency to meet
the demand for foreign currencies from its own citizens.

Foreign currencies are earned by countries by selling goods, known as exports,

selling services and selling factor services to foreigners. These are being topped
up by a non-selling foreign exchange flow, called inward transfers, which a
country gets by way of gifts. In banking parlance, they are known as remittances
by Sri Lankan workers abroad.

On the other side, Sri Lankans demand for foreign currencies to import goods, buy
services from outside and pay for factor services like paying interest on loans and
profits for investments. To these payments are added the gifts which Sri Lankans
extend to foreigners, known as outward transfers.

These transactions could be amalgamated into an account called the current

account of the balance of payments by recording the first category on the credit
side and the latter on the debit side. The essential requirement for a currency to
be stable is that this current account should be balanced or if it has deficits, those
deficits should be offset by similar surpluses in other years. If there are
continuous surpluses, the country earns more foreign currency than it needs.

Unless those surpluses are lent to other countries, the country may experience a
continuous appreciation of its currency. If there are continuous deficits, it has a
shortage of foreign currencies. These shortages have to be filled by borrowing
from other countries and it would help the country to temporarily stabilise its
currency. But it would add to its foreign debt driving it to a malady known as debt
trap. It makes the matters worse and the country is, therefore, destined to
experience a one-way journey toward depreciation of its currency.

Sri Lanka’s dismal track record in the current account

This latter situation is the one which Sri Lanka has experienced during the entirety
of the period since 1977. Its current account has been in deficit and, when
measured as a percent of the size of the economy or GDP, the deficit has been as
high as 16% in some years.

When it goes up, the country has been worried and when it goes down even by a
small magnitude, it has fallen to a state of complacency, ignoring the risk and
danger it is facing.

During the period from 2012 to 2017, the current account deficit has been on
average at 3% of GDP a year. Therefore, there has been pressure for Sri Lanka
rupee to depreciate. What the previous administration did was to borrow abroad
and use the proceeds to release the pressure in the market. It is like giving some
pain killer to a cancer patient to relieve of his pain. It is not a cure. Hence, the
wound begins to fester within the body without proper medication. One day
when the cancer becomes acute and it is too late to administer any medication,
the patient would succumb to his illness.

The inactivity of the new Government

This was known at the time when the new Government took power in January
2015. But the Central Bank’s Monetary Board as well as the Minister of Finance
behaved as if there was no economic crisis.

The Central Bank Annual Report for 2014, released in April 2015 under the
stewardship of the new Government, talked complacently about the stability of
the rupee during 2014. That was against the US dollar. It had been more
complacent when it had reported that the rupee has appreciated on average
against the currencies of its major trading partners during 2014.

To assess this average change in the value of rupee against its trading partner
currencies, the Central Bank calculates two effective exchange rate indices, one
for rupee’s nominal value and the other for its real value. The fact that both these
indices have appreciated in 2014 means that Sri Lanka has lost its competitiveness
against exports and gained a preferential advantage for its imports. This is an
ailment because it suppresses exports and encourages imports, the main cause
for the rupee to come under pressure for depreciation in the long run.

The Central Bank should have given a warning to the Government in this regard,
but it had chosen not to do so. Emboldened by this rosy picture painted by the
Central Bank, Finance Minister Ravi Karunanayake started making miraculous
promises to the country. He said that he would bring the exchange rate down
from Rs. 131 per dollar to Rs. 105 per dollar.

After he failed to deliver his promise, he made other promises like that he would
bring $ 3 billion to the country through a well-wishing Belgian investor. When that
was also not delivered, he started blaming the senior officers of the Central Bank
for causing the rupee to fall in the market. In that manner, the Government
continued to play cheap politics without taking effective measures to address the
issue.

Taking action too late

What are those effective measures? They would have been at least two-pronged.
In the short run, it would have temporarily stabilised the rupee by intervening in
the foreign exchange market. But, that would have led to the loss of the country’s
foreign exchange reserves. Hence, the more appropriate course would have been
to get IMF support to address the immediate issue and adopt a long-term policy
strategy to promote export of goods and services so that the country’s current
account would end up in a surplus.

Belatedly, it went for IMF support in June 2016 but implemented only partially
the needed reform programme to boost country’s export of goods and services.
The result has been a continuous depreciation of the rupee in the market.
Accordingly, from Rs. 131 at the beginning of 2015, it has now weakened to Rs.
159 per dollar. In the next few weeks, the Central Bank will intervene and stabilise
the rupee at the current level. But in the absence of a long term policy
programme, it would be just like watering a sinking well.

Increase in the cost of living

Normally, when the rupee falls, the whole country gets into a panic mode. That is
because it affects the cost of living of people directly. The consumption basket of
Sri Lankans contains a large component of imported goods and when the rupee
falls, the cost of those imported goods would increase. At the same time, the
depreciation affects the transport services and electricity generation which uses
imported fuel heavily.

Those institutions will begin to incur losses unless they are permitted to revise
their tariff upward. Either way, it affects the people. The losses of these
institutions, if not permitted to go for a price revision, have to be borne by people
as taxpayers. If they are allowed to revise their prices upward, it will increase the
cost of living of people directly. But simply to support people, a country cannot
allow its currency to be strengthened artificially.

Thailand’s sad experience

That is because sooner or later the currency would collapse. Along with that
collapse, the economy would also collapse. This happened to Thailand in the East
Asian financial crisis of 1997. For decades prior to 1997, Thai Baht had been kept
artificially stronger at Baht 25 per dollar by using the foreign reserves held by the
Bank of Thailand. But it could not rescue the Baht even after it had spent $ 25
billion from its reserves. It had to give up the battle and overnight, the Baht fell to
50 Baht per dollar sending shock waves throughout the economy. The next stage
was the collapse of the Thai economy which had to be rescued by adopting very
painful measures. Thus, unless the rupee is allowed to depreciate in the market,
Sri Lanka will also face a similar situation.

Change in the nominal debt stock

An often presented argument has been that when the rupee depreciates, Sri
Lanka has to spend more rupees to service its foreign debt. That is because the
Government has to spend more rupees to repay foreign debt and pay interest on
it. Very often critics point to the increase in the rupee value of the debt stock
which is denominated in foreign currency.

For instance, Sri Lanka Government’s foreign debt stock as at end of 2017
amounts to $ 31 billion and if the rupee depreciates by one rupee, it would
increase the rupee value of the foreign debt by about Rs. 31 billion. But this is
only an increase in the nominal value of the debt stock and it has no bearing on
the Government’s current operations since only a fraction of this is repaid in the
current period.

Government is a net beneficiary

But in the present circumstances, the Government has been a net beneficiary of
rupee depreciation.

According to Budget 2018, the Government has to spend on a net basis some $
1.7 billion to service its debt during the year. If the rupee depreciates by one
rupee, it would increase the Government’s debt servicing commitments by Rs. 1.7
billion and the Government will have to generate this amount to buy dollars from
the Central Bank. Hence, it is a material cost to the Government.

However, the Government gets foreign currency also during the year and it gets
one rupee more for that foreign currency at the new exchange rate. One such
source is the revenue from import duties which amounts to about $ 1 billion at
present per annum. In addition, it plans to generate some $ 2.4 billion as new
borrowings during the year. Altogether it would have an inflow of Rs. 3.4 billion
through these sources. Hence, the Government will end up as a net beneficiary of
Rs. 1.7 billion if the rupee depreciates just by one rupee.

Secret of managing exchange rate by Singapore

But this is not a reason to allow the rupee to depreciate in the market. Sri Lanka
should go for long-term measures to improve its current account in the balance of
payments until it becomes a surplus. Such a measure will help Sri Lanka to
stabilise the value of the rupee at the current level.

Then, what about allowing the rupee to appreciate as desired by the former
Minister Ravi Karunanayake?

But it would be disastrous unless the country is able to improve its productivity to
offset the loss of competitiveness. This was exactly what Singapore did over the
last 60 years or so. Comparatively, in 1950, Singapore dollar had been fixed at S$
3.06 against the US dollar when the Sri Lanka rupee had been fixed at Rs 4.76 per
dollar. But due to the continued surplus in the current account, Singapore dollar
continued to appreciate in the market reaching a level of S$ 1.30 per US dollar
today. But it did not affect its competitiveness since Singapore was successful in
improving its productivity to offset the loss in competitiveness. Hence, Sri Lanka
with its low productivity growth should not seek to appreciate its currency.

Thus, what Sri Lanka should do is to adopt a suitable policy package to convert its
current account to a surplus to relieve the pressure on the rupee to depreciate.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of

Sri Lanka, can be reached at waw1949@gmail.com.)

Posted by Thavam