Curing the crash of the currency

Consensus on both short-term and medium- to long-term measures essential

The rapid depreciation of the Sri Lankan Rupee at present is due to two main factors. 

The first is the strengthening of the US dollar on account of the return of the US dollar funds invested in various other countries of the world back to the US due to the raising of interest rates by the US Federal Reserve Bank a couple of times and the lowering of the corporate tax by the Trump administration. 

The second is the continued decline of foreign exchange earnings by Sri Lanka (SL) from the export of goods ($ 11.4 billion,2017) and services and the rapid increase in US Dollar payments for imports of goods ($ 21 billion,2017) and services plus the part payments of the external debt of the country ($ 52 billion, 2017) mainly from borrowed funds; in other words it is the vulnerability of the Sri Lankan economy caused by very poor management on the part of governments especially sometime after the year 2000, made worse by corruption, waste and ostentation in fiscal operations.

Assumptions

Under normal circumstances the right thing to do appears to be to allow the currency to depreciate under a ‘floating’ currency system. The assumptions behind this approach are that, a) the increase in rupee prices of imports following the depreciation would lead to local substitution of such products and b) exports would become competitive as exporters would receive more rupees per US Dollar and therefore exports would expand.

The argument underlying both assumptions is that investment would take place for local substitution of the imported goods and services the prices of which have risen following the plunging depreciation of the rupee. This may not happen in Sri Lanka mainly due to the negative enabling environment especially for foreign direct investment (FDI) that has been prevailing in the country since 1956. 

Need for 

investment/FDI 

Why do we need FDI? Sri Lankans do not save enough to invest in economic development. It has been estimated that the country needs investment of about 35-40% of GDP ($ 87.2 billion, 2017) for the economy to grow at about 8% per year. Domestic savings have been an average of 26% of GDP during the last five years. 

Apart from the scarcity of capital, there is also a dearth of the necessary management expertise, technologies and global market access for products. This makes it necessary to attract FDI. But Sri Lanka has not been able to attract sufficient FDI unlike the most of the East Asian economies. As of 2016 the stocks of FDI inflows in billions of dollars to some of these economies particularly the ‘little tigers’ – South Korea 185.0, Hong Kong 1,690.8, Taiwan 75.0, Thailand 188.7, Malaysia 121.6, and Singapore 1,096.3, whereas in the case of Sri Lanka it was only 9.7, according to UNCTAD. This is the main reason for the economy of Sri Lanka to lag behind. 

The need for a small economy like Sri Lanka is for large-scale FDI that could produce (manufactured) goods and services mainly for export, as small-scale production for the small local market only cannot generate sufficient jobs and earnings for the country to prosper, the unit costs of such enterprises being low; the stock of $ 9.7 billion that has been attracted by Sri Lanka by 2016 has been mainly for construction described as non-tradable goods and services; it is chiefly for this reason that exports have not taken off (13% of GDP in 2017, whereas it was 33% of GDP in 2004).

Inability to attract 

investment/FDI

The main reasons for Sri Lanka’s inability to attract adequate FDI have been: 

i. The investment risk/political instability is the first. According to the OECD Country Risk Classification 2018 (previously and currently), Sri Lanka ranks 6 just behind war-torn Afghanistan ranking 7, Malaysia 2, Singapore 0, India 3; the Worldwide Governance indicators, World Bank 2017, appear to confirm this as Sri Lanka’s percentage rank for political stability and absence of violence/terrorism was 42.38, against Singapore’s 98.57, Japan’s 89.05 and Malaysia’s 52.38; Afghanistan’s was 0.48.

This investment risk may be due to the a) the absence of reconciliation between the majority and minority communities to solve the ethnic conflict, especially by creating a new constitution and other laws, b) the poor law and order situation due to the politicisation of the Judiciary, the low conviction rate of crimes committed, c) the frequent street demonstrations and strikes by workers’ unions and d) widespread corruption (Corruption Perception Index, 2017, score and rank, Sri Lanka 38 and 91, Malaysia 47 and 62 and Singapore 84 and 6, out of 180 countries, Transparency International).

ii. The low the efficiency/effectiveness of the State administrative apparatus especially due to the system of making appointments on the basis of political and other affiliations and not on merit after the 1972 Constitution which brought the management of the public service under the cabinet of ministers or the undereducated politicians. 

iii. The cumbersome regulations pertaining to approval, registration of businesses (Ease of Doing Business Index 2017, Sri Lanka 110, Singapore 2 and Malaysia 23 out of 189 countries, World Bank).

iv. The complex labour laws and regulations which make it difficult for companies to fire redundant workers, not just because of the compensation, but also because of the long administrative process involved, the labour tribunal system being ‘unworkable’. 

v. The poor physical and social infrastructure, particularly the inability of education and training systems, to create world-class soft and technical skills; the former especially by English proficiency and fluency, the latter by upgrading science, technology, engineering and mathematics; the business enterprises in the country claim that there are over 400,000 vacancies for skilled workers in their firms that cannot be filled.

vi. Weak macroeconomic management by most governments in SL; Government revenue has been low (13.8% of GDP, 2017), while expenditure has been very high (19.4 % of GDP, 2017) compelling the imposition of taxes even on essential imported items worsening the resultant inflation/price rises on account of the continuous depreciation of the rupee, leading to the lowering of the profitability of enterprises; these price rises have also had a stunning effect on the living standards of the casual wage earners and the poor (32% of the population, or those earning less than $ 2.50 per day in 2012/13; 85% of the rural population also poor, World Bank) in the country. The planned wage/salary increases and the various subsidies to win votes at the forthcoming elections would make matters still worse. Governments in Sri Lanka particularly in the last 13 years have been borrowing indiscriminately, (sometimes even to pay off the interest) from foreign sources building a massive external debt position mentioned earlier. Not much effort has been made by these governments to correct the position by reducing imports or expanding exports; instead the emphasis has been on protecting the domestic market-oriented firms and the loss-making State-Owned Enterprises.

vii. The adoption of socialist policies by previous governments, ignoring the fact that the engine of growth is the private sector (actually what is required is a mix of both referred to as ‘social market economic policies’).

Expansion of 

agricultural production

The next question is whether the rise in prices of imported items due to the depreciation would stimulate local agricultural production. Agricultural productivity in Sri Lanka has been quite low (agricultural value added per worker, 2017, $ 2,533 in Sri Lanka, 18,124 in Malaysia and 22,703 in Singapore, World Bank). 

The main reasons for low productivity are: a) ownership has been denied to farmers discouraging investment; most of the land, about 80%, in Sri Lanka is owned by the State, which has been leasing it out to farmers under the colonial Land Development Ordinance of 1935, b) about 45% of the lots are too small being less than 1/4 acre in extent (Agricultural Census, 2002, so that the percentage of the farmers in the labour force has been too high, being 26 in 2017); consequently unit costs of production have also been high, c) the farms are located far apart and dispersed making the use of machinery costly, d) the non-availability of adequate irrigation water especially in the dry zone where drought has made conditions worse, e) the absence of a value chain consisting of warehouses and transportation with facilities for storing/transporting particularly perishable items with a resulting perishability of 35-40% of most food items, and f) the absence of a mechanism of providing information on the demand and supply conditions of farm produce so that farmers could take correct decisions regarding production and sale of such items. 

Competitiveness of exports

The next argument for the depreciation of the rupee is that exports would be more competitive as exporters will receive more in terms of rupees for each US Dollar; this means that unit prices of exports would be lower and therefore profitability would rise (such unit prices do not include the duties and taxes paid on inputs imported for export processing as they are exempted in in this country). The competitiveness of an export product is not determined by its unit cost alone; ‘the true definition of competitiveness is the ability of a region to export more in value added terms than it imports’ (the Globalist). 

In value added terms the competitiveness of Sri Lanka’s exports is fairly low; according to the Global Competitiveness Index, 2016/17, Sri Lanka’s rank was 71 against Singapore’s 2, Malaysia’s 25, India’s 39 out of 138 countries. Value addition to a product is determined by what is referred to as product differentiation the definition of which is ‘making available to customers products with features they value that competitors do not offer’. 

Differentiation of products or services normally takes place due to the competition/rivalry among firms generated by low import tariffs/duties or the absence of protection of local enterprises by the state. In the case of Sri Lanka import tariffs are extremely high and therefore tend to protect local production rather than exports; in fact the World Bank says ‘the present import regime is one of the most complex and protectionist in the world’, ‘Sri Lanka: A Systematic Country Diagnostic,’ World Bank, 2016. 

It has to be stated therefore that Sri Lanka’s is not an open economy at present. Thus tariffs have to be reduced considerably, though in a controlled manner to give time for enterprises catering to the domestic market only to adjust. Unfortunately such a move, however, will not be feasible under the present circumstances when the high tariffs have to remain to reduce imports and to ensure a stable level of Government revenue. Therefore the alternative method of promoting competitiveness that has to be adopted is offering attractive fiscal incentives to exporters for value addition.

It would be clear that the above mentioned (longstanding) problems are not the type that could be resolved automatically by a depreciation of the currency; they need direct State intervention.

Increasing the interest rates

The option available to the Central Bank to solve the fast depreciation of the Sri Lankan Rupee is to push up the nominal interest rates; other countries which have been subjected to the same phenomenon have done so (although the literature on the subject does not indicate positive consequences). The practical alternative for Sri Lanka is to correct the above mentioned problems connected with export oriented investment (which in fact may be discouraged by increasing interest rates) and to improve the competitiveness of its goods and services. The problem with such a solution is that it consists of medium- to long-term measures. Short-term solutions have therefore to be found. 

Speedy short-term measures

One of the actions required is obviously to reduce the expenditure on major items of import such as petroleum products (16.3% of the cost of total imports in 2017) and oil driven motor vehicles (3.7% of the cost of imports in 2017); it may be possible to reduce both of these by restricting the latter drastically for a couple of years, as already decided by the Government.

In the medium-term the country has to replace the consumption of oil by developing alternate sources of energy such as solar and wind power for which it is necessary to prepare a fast-track plan of action that has to be closely monitored; the import of electrically-powered vehicles and establishment of the necessary charging points should be part of this plan. 

The import of building materials (7.6% of the total cost of imports, 2017) should also be restricted temporarily by stopping expensive construction activities that do not contribute to improvement of productivity significantly. Another item that should be restricted is the import of precious metals not meant for export production. These are actually long overdue actions. 

Another action that has been neglected in this manner is the reduction of Government expenditure (leading to price rises) especially by restructuring the heavy loss-making State-Owned Enterprises Perhaps on a Private-Public Partnership basis, while increasing the number of direct income taxpayers speedily to expand the collection of its revenue. In the meantime, the provision of redress to the poor who are severely affected by the present crisis and the drought should not be overlooked. 

Conclusion

The crisis in the depreciation of the rupee cannot be cured only by such short-term measures; the above mentioned problems connected with investment for export, the global competitiveness of the economy and its productivity especially of agriculture have also to be solved concurrently. The main difficulty of implementing such a strategy is the absence of a consensus on the subject. 

For instance, the political parties in the Opposition still cling on to the failed policies of protection of domestic market-oriented firms unlike the ‘little tigers’ of East Asia who have prospered using the global market approach. Most political parties also do not believe that a complete new constitution on the lines of those of the US and India is necessary to remove the negativity in the enabling environment for investment and economic growth. 

A consensus on at least these issues is absolutely necessary along with a passion to work for the welfare of the people on the part of the politicians and the officials to create a platform to obtain quick results. 

(The writer is a Development Economist.)