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

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 [email protected].)