External value of the rupee: Market driven or Central Bank driven?

No unanimity on exchange rate movement

A front page headline news item in this paper on last Saturday had reported on an apparent division of opinion between the two top policy makers of the country, namely the Treasury Secretary Dr. P.B. Jayasundera and the Central Bank Governor Ajith Nivard Cabraal, on the depreciation of the Sri Lanka rupee (available at http://www.ft.lk/2011/11/26/devaluation-divide/).

The purported division has arisen after President Mahinda Rajapaksa, in an unprecedented fiscal policy move, surprised the markets by announcing in the Budget 2012 that the Sri Lanka rupee which had been pegged to the US dollar at a fixed rate of around Rs. 110 per dollar for some time would be depreciated by 3% with immediate effect to maintain Sri Lanka’s competitiveness in the international markets.

The news item under reference has been based on two statements made by these two top policy makers to Reuters. Dr. Jayasundera is reported to have said that that the rupee depreciation which has been a long overdue should be market driven, that is, the rate should be determined by the demand for and the supply of rupees in the foreign exchange markets.

In an apparent response to this statement, Governor Cabraal is said to have quipped that the rupee would be defended by the Central Bank at the newly-determined rate after the 3% depreciation implying that its value should be Central Bank driven.

A price cannot be fixed by a government

Both these two top policy makers have in fact tried to clarify the Government’s position with regard to the external value of the rupee. Dr. Jayasundera’s statement indicates that the current depreciation of 3% is not the end of the story and if it is needed, there would be further depreciation of the rupee in the future.

But Governor Cabraal has maintained that what was announced by the President is a one-off adjustment to the rate and the Central Bank’s mandate has been to maintain the rate at that level. He has also warned that, according to Reuters, if the foreign exchange position improves in the future, there could be an appreciation of the rate.

However, such an appreciation based on the level of foreign exchange resources would amount to a negation of the relief given by the President to the country’s exporters, since the domestic cost conditions faced by them would not have declined to match the fall in rupee earnings that come with such an appreciation of the rupee.

In a seminar on the Budget 2012, organised by Daily FT with the Colombo University’s MBA alumni association, Dr. Jayasundera is reported to have said that Budget 2012 has delivered three Cs, namely, clarity, consistency and continuity which are more than sufficient for the private sector to undertake new investments (available at http://www.ft.lk/2011/11/25/%E2%80%98clarity-consistency-and-continuity%E2%80%99/#more-57941).

But the reported division of opinion on one important price in the economy leading to confusion among the investors manifests a state which is far from these cherished ideals.

Background to the issue

Sri Lankan authorities have been stubborn in the past when it came to the adjustment of the external value of the rupee. When the annual average inflation rate in the country during the period from 2005 to 2008 stood at 14%, much above the average inflation rate experienced by its trading partners, the non-depreciation of the rate as required resulted in an appreciation of the rupee in real terms by about 20%.

To this extent, Sri Lanka’s exporters lost their competitive edge in the global markets forcing them to clamour for a depreciation of the exchange rate. But this demand was resisted by the country’s authorities who took the position that exporters should sort their problem not by asking for depreciation of the rupee but by taking measures to improve productivity.

Perhaps, the authorities would have been guided by the fear that such a depreciation of the rupee would be viewed as a loss of dignity and prestige of the country, it would increase the cost of living of the people and it would impose an additional burden on the budget by increasing government’s external debt service payments.

In fact, when the country started to get a massive inflow of foreign resources by way of borrowed funds after it was successful in negotiating a stand-by arrangement with the IMF in early 2009, the exchange rate was allowed to appreciate in the market by authorities. This measure contributed to further worsen the relative competitiveness of Sri Lanka’s exports.

A weakening of the hard resolve of authorities

The hard resolve of the authorities to maintain an appreciated currency would have weakened due to two adverse developments in the recent past. One is the projected ballooning of the trade deficit in the country in 2011 to an unprecedented level of some $ 9 billion, up from $ 5 billion in 2010.

Normally, a trade deficit has to be financed by the inflow of foreign exchange through the sale of services and remittances sent by Sri Lanka’s migrant workers abroad; economists call this the operation of the current account of the balance of payments of the country. The end result was that the trade deficit was so high that even the booming remittances at $ 5 billion could not meet the gap.

With no prospects for exports to grow faster than the imports in the next few years and the very high foreign debt repayments scheduled for the same period, it in fact portended an emerging balance of payments crisis which cannot be solved unless borrowing more from the international markets. This was not a healthy situation at all.

The second development was the fast depreciation of the Indian rupee by about 19% in the international markets in the last four weeks or so. Indian rupee fell from 44 rupees per US dollar to some 52.25 rupees per US dollar.

India being the largest single country trading partner of Sri Lanka with a total trade of some $ 3 billion in 2010 and a trade deficit of $ 2 billion accounting for about 40% of the country’s trade deficit in that year, this fast depreciation could not have been ignored by Sri Lanka’s authorities any more. Had an adjustment not being made to the exchange rate, the situation would have deteriorated in 2012 to a critical level when Sri Lanka would have been flooded by imports from India.

So, an adjustment in the exchange rate was necessary even at a meagre level of 3%.

Market driven? Use Walrasian auctioneer

But the question now is whether the rate should be defended at the current level as declared by Governor Cabraal or if it be allowed to be determined by the market as opined by Dr. Jayasundera.

The exchange rate is a price like the prices of any other commodities traded in a market. When that market price becomes a price that satisfies both the demanders and the suppliers of the commodity in question, the price becomes stable and all pressures for it to rise or fall in the market are removed.

Markets which acts independently and impartially have an ingenious way of arriving at that price by the activation of what Adam Smith called the operation of ‘an invisible hand’. It was in fact the 19th century French economist Leon Walras who explained the actual way the markets found the price that satisfies both the demanders and suppliers.

He did so by creating an invisible auctioneer in the market who would match both the demand orders and supply orders and eventually arrive at the stable price in the market. The auctioneer would do so by following a trial and error method known as ‘tatônnement’ or ‘groping’ process.

He will get an order from a demander and match it with an available supply order. If the two orders match with respect to both the price and quantity, then, the price is fixed. If the demander’s quantity is higher than the supplier’s quantity, then the price is raised; if it is the opposite situation, then, the price is lowered. In this manner, by matching all the orders, the final stable price at which there is no pressure for the prices to rise or fall further is arrived at.

Since the exchange rate is the price of one’s currency in terms of other currencies, the home country currency is supplied by the people of that country demanding the currencies of other countries to buy goods from those countries, pay for service supplied by those countries, give gifts to people in those countries and lend money or repay loans borrowed from those countries.

The home country’s currency is demanded by people in other countries to buy goods from the home country, avail the services of the home country, give free gifts to home country people and lend money to or make investments in the home country. If one uses a Walrasian auctioneer, the stable exchange rate has to be found by matching all these supply and demand orders.

Appreciated currency is forcing a country’s will on foreigners

When an authority announces that this is the value of our currency and you have to buy it at that price, the demanders, in this case the foreigners, have to make an assessment whether the currency is worth at that price. Since they demand the currency of that authority to do the transactions listed above, they would immediately compare the announced value of that currency with other currencies and buy that currency only if it is worth in relative terms too.

This can be elaborated with an example. Suppose that there is a potato seller at Delkanda Pola, announcing the price of his potatoes at Rs. 1,000 a kilo. A prospective buyer of potatoes will compare that price with those available in nearby markets and buy potatoes at that price only if other prices too are at similar levels when the additional costs involved in those markets like travel costs and the time costs too are added to those prices.

If a kilo of similar potatoes is just Rs. 100 at the nearby Nugegoda market and the cost of travel to Nugegoda is only Rs. 10, he would be rational enough to buy his potatoes from Nugegoda. With no buyers for his potatoes at his announced price, the potato seller at the Delkanda Pola has to eventually come down to a price that matches with the price at Nugegoda market.

When a country announces that its currency is worth so much, it actually makes that announcement to prospective suppliers and prospective demanders. If the rate is an appreciated rate, then, it says that its currency is pretty much stronger than the rate which market may have set for it and forces the demanders to buy it at that rate.

But a stronger currency means that the people of that country can buy more foreign currencies by giving a lesser amount of the home country currency and buy more goods from abroad. It is a sure way to give an incentive to importers to import more. If this has happened when the domestic inflation is higher than the trading partners, then, there is no demand for the home currency compared to its supply.

Suppose a kilo of tea in the home country is Rs. 1,000 and the rupee dollar rate is 100 rupees per dollar. Then, a kilo of tea in dollar terms is $ 10. By keeping that appreciated exchange rate, the home authority is forcing foreigners to buy home country tea at the price of $ 10 a kilo just like the potato seller in Delkanda Pola tries to sell his potatoes at Rs. 1,000 a kilo when at Nugegoda Market potatoes are available for Rs. 100 a kilo. A foreign buyer will compare the price of tea in neighbouring India and if it is just $ 5 a kilo, then, he would shift his demand for tea from the home country to India.

The exchange rate in the home country cannot therefore sustain and it has to fall to Rs. 200 per dollar if the home country is to compete successfully with Indian tea. When the President said that the purpose of allowing the rupee to depreciate by 3% is to maintain Sri Lanka’s competitiveness, he actually meant this universal truth.

The use of reserves to defend a currency

So, if a central bank is to succeed in driving the exchange rate, it has to find this stable rate by following the Walrasian tatônnement process. But what is usually done is to fix the rate at a level which it thinks is the desirable rate and meet the deficit out of its own holdings of foreign reserves.

The Central Bank may justify the use of its reserves on the ground that reserves are there for use to defend the country’s exchange rate when it is under pressure for depreciation and by doing it, the bank is simply stabilising the exchange rate which is an important price in the system.

This argument is flawed because no authority can stabilise a price by temporarily releasing its buffer stocks when the demand for that commodity is much more than the availability of such buffer stocks. Sooner or later, it will drive itself to the wall and at that level, without adequate buffer stocks, it may have to allow the prices to go up freely in the market.

When applied to the exchange rate, when the foreign reserves are depleted to a very critical level, it will have to allow a free fall of its currency, surely a dreaded situation by any standard. Since the central banks are supposed to make appropriate risk management of the economy, such a situation may be viewed as a negligence of the cherished mission of a central bank.

John Exter: foreign reserves are to meet foreseeable deficits in BOP

But why should a central bank have a foreign reserve? Some may argue that foreign reserves are there to defend the external value of a currency. The argument could also be extended to say that if reserves are not used for defending a currency when there is a grave need for it, then, there is no purpose of having a reserve.

This argument goes well with the Sinhala proverb that ‘if the sword is not used during a war, should it be used for cutting a jack fruit?’ But the authorities on central banking have a different opinion on the build up of foreign reserves by a central bank.

The wisdom of the founding father of the Central Bank of Sri Lanka, John Exter, has been pronounced boldly in the Exter Report in this regard.

Justifying that the Central Bank should have an international reserve, Exter says that “the Monetary Board is enjoined to endeavour to maintain an international reserve adequate to meet any foreseeable deficits in international balance of payments” (page 28).

Clearly, reserves are there for meeting future emergencies and not for defending an exchange rate which is under continuous threat for depreciation.

(W.A. Wijewardena can be reached at [email protected].)