The FX saga

The topsy turvy story of the economy continues, this time in better spirits. While news of expensive Independence Day celebrations and delayed democratic elections due to alleged lack of funding, March has ushering in a Spring; to the Lankan crisis. For three days in a row, the Sri Lankan rupee rose against the US dollar. The rupee traded at Rs. 334 per dollar on Friday, up from a bottom of Rs. 360 previously.

The Governor of the Central Bank of Sri Lanka has announced that from this week, the guidance peg for the currency exchange will be discontinued allowing the Rupee to trade more freely.

The reason this rapid appreciation was seen is due to a myriad of reasons. The CBSL lowering the surrender requirement for export proceeds from 25% to 15% was a significant motivator. Dollars held overseas for ease of exchange when transacting in FX were brought back, flooding the market and easing pressures on dollar requirements, which had previously maintained the exchange rate at Rs. 360.

FX conversion by exporters in expectation of further LKR appreciation; a drop in importer demand − due to a drop in real sector economic activity and import restrictions − and a reduction in the current account deficit.

The decline in the current account deficit is due to multiple reasons as well. While one was the dwindling trade balance, another factor is a rise in tourism and remittances. In January 2023, the former increased by 7%, while the latter grew by 69% year on year. More exchange easing pressure can be anticipated, although not guaranteed, in light of increased FX inflows from tourism and even the bailout package. 

In terms of the indicator of this change, the average daily volume in the interbank FX market is now $ 42 million, up from $ 8-10 million in the early days of the crisis in May-June 2022. This figure was around $ 60 million in February 2018. The Central Bank has been a net buyer in the foreign exchange market over the last three months, increasing from $ 6 million last year to around $ 211 million in January.

The CBSL also, continuing its laisser-faire currency stance, increased the daily trading range to plus or minus Rs. 5 of the middle spot exchange rate on 27 February. Previously, this was traded within a tighter bound of Rs. 2 rupees and 60 cents. However, last week, CBSL Governor Dr. Nandalal Weerasinghe most recently ordered banks to use Rs. 353.65 as the middle spot exchange rate for USD/LKR interbank transactions, with a wider variation margin of Rs. 7 and 50 cents followed by Rs. 10 on either side.

Due to the Sri Lankan Rupee›s growth against the US Dollar, the price of gold in Sri Lanka has dropped dramatically to Rs. 20,480 per gram. The Central Bank›s figures for the Troy ounce of the precious metal showed a price drop of more than Rs. 20,000. Moreover, as a result of these currency signaling Foreign Funds which stood at $ 1.7 billion in September of last year, had risen to $ 2.1 billion by February.

The number of tourist arrivals in the first two months rose by 261% compared to September last year as well. Tourist visits in the first two months alone, totalled over 200,000 in 2023.

However, currency, which is usually a zero-sum game considering exchanges, has seen the dollar rise nearly 5% from its recent lows and is nearing a seven-week high against a basket of other major currencies. This is on the belief that the Federal Reserve will need to raise rates more than many investors had previously forecast to cool inflation.

A stronger dollar tends to restrict global financial conditions while decreasing desire for risk and weakening global commerce, according to a November study from the Bank for International Settlements. It also makes it more difficult for nations that borrowed in US dollars to service their debt, an issue that emerging market economies are often keenly aware of.