LKR under pressure – How not to crack

The LKR weakness underscores the need to ensure that Sri Lanka keeps indicators like the budget deficit and current account deficit in check – Reuters

By the Economic Intelligence Unit, Ceylon Chamber of Commerce

The Sri Lankan currency (LKR) has weakened against the US Dollar in 2018 (9.4% as at 26 September 2018) with close to 4% of the depreciation being recorded in the last two weeks. Currencies like the Indian Rupee, Indonesian Rupiah and Philippines Peso have also seen steep depreciation so far in 2018. The weakness is in the backdrop of adverse global and local factors.

What are some of these factors?

1. Stronger US dollar – The US Dollar is the reserve currency of the world and domestic currencies are referenced against it. When the US Dollar strengthens, there is an opposite depreciatory pressure on local currency. In 2017, the US Dollar weakened about 10% against a basket of currencies. As a result, most currencies were either stable or appreciated against the US Dollar. The LKR only weakened 2%. However, this year it is quite the opposite with the strengthening of the US Dollar with money flowing back to markets like the US which are termed to be haven investments when there is a high level of uncertainty and risk in global markets. 

2. Impact of tight monetary policy in the US – The US Federal Reserve has increased interest rates eight times since December 2015, bringing to a gradual close a period of easy money flowing into emerging and frontier markets like Sri Lanka. Most of the other central banks globally have signalled a similar direction in terms of monetary policy. This has led to most emerging economies recording capital outflows from bond and equity markets. Sri Lanka has seen a foreign outflow of Rs. 64 billion from the local Treasury bill and bond market since the last week of April. In the first three weeks of September alone, there were outflows of Rs. 18 billion. 

3. Impact of trade war – The trade war between the US and China has increased trade and geo-political tensions with both countries engaging in imposing higher tariff on imported bilateral goods. This has derailed the positive trade growth momentum that was expected to continue into 2018 and benefit economies like Sri Lanka. As a result of this geo-political tension, global investor have tended to investment in less risk assets adding to the portfolio outflows from markets like Sri Lanka.

4. Higher oil prices and widening trade deficit – The rise in oil prices has exposed the sensitivity that net oil importing countries like Sri Lanka face. This coupled with higher imports in items like Gold and consumer goods has seen Sri Lanka’s imports widening by 12.7% in the first half of 2018.

5. Current account deficit countries most vulnerable – Countries with current account deficits like India and Sri Lanka are most vulnerable during times of global volatility. The exposure to capital inflows to balance the deficits is highlighted in period such as this. 

What the Central Bank of Sri Lanka has said and done

The Ceylon Chamber invited Central Bank of Sri Lanka (CBSL) Senior Deputy Governor Dr. Nandalal Weerasinghe to address the monthly Chamber Committee meeting in September. In his address he covered the following areas:

1. Don’t panic – While explaining the reasoning for the recent weakness in the currency, he urged the private sector to be more rationale in their thinking of the future movement of the currency and not take panic decisions. 

2. Measures to arrest LKR weakness – He explained the measures taken by the CBSL during the year to address the pressure on the currency. Some of these were the imposition of the 15% custom duty on global imports from 18 April 2018, imposition of a 100% margin deposit requirement against the Letters of Credit opened with commercial bank in importing motor vehicle from the 19 September 2018.

3. Expect limited intervention – Dr. Weerasinghe also explained that the CBSL will only conduct limited interventions to prevent sharp volatility of the Sri Lanka Rupee and will not intervene given the learnings from the past where reserves were unsuccessfully used to defend the currency which then eventually depreciated sharply (during 2011/12 and 2015). He explained that they would also look at strongly enforcing the exporter repatriation rules to help ease the pressure on the currency. 

4. Hedge currency exposure – Dr. Weerasinghe also advised the private sector to use the available forward market instruments to create hedges against possible exposure to currency risks. 

What next? 

The economy is in a difficult period given the external factors that are weighing in. A reversal of some of the factors mentioned above will ease some of the pressure. In the near-term a reversal looks unlikely. Here are a few steps that can be taken to ensure that a slide does not continue: 

1. Rebuild confidence in the economy – A key factor in mitigating a further weakness of the currency is for policymaker and Government to restore confidence in the economy and the future trajectory of the LKR. This can be ensured through credible policies that will ensure policy predictability and an improvement in overall economic sentiment. 

2. Keep indicators in check – The LKR weakness underscores the need to ensure that Sri Lanka keeps indicators like the budget deficit and current account deficit in check. The CBSL policy decision to not use gross official reserves excessively to temporarily defend the currency is a sound move given the need to have a strong enough buffer to meet the debt refinancing challenges the economy will face in the next few years. Indonesia has used up over $ 13 billion in foreign currency reserves in the first eight months of the 2018 but have seen the currency losing almost 10% highlighting that such measures may not always avert a currency slide. 

3. Avoid disruptive short-term measures – Policymakers should not look to curtail imports unless where deemed necessary. Short-term measures to curtail imports will distort business activity. Ad-hoc raising of para-tariffs will not be in line with proposed tariff liberalisation program that the Ministry of Finance has announced. Policymakers should look at curbing unnecessary government expenditure rather than imports which will have an impact on businesses and economic activity. 

Overall, the recent LKR weakness emphasises the need for the Government to improve the economy’s resilience to external shocks by pushing forward reforms that will benefit the economy through higher level of dollar income from exports, services and investment. The emerging global financial markets paradigm with higher interest rates globally will see future spells of currency pressure to which the Sri Lankan economy will need to be prepared for.