Flexible exchange rates and impact on exporters

By Cheranka Mendis

Gathered to discuss the implications, opportunities and challenges of the sudden announcement and introduction of the Government’s new policies, the export community was advised by a panel of experts to watch ahead, be prepared and make their own judgments from the information provided.

With the country facing no immediate risks of getting into a ‘danger zone’ and successfully diverting from a road towards a crisis that would have left the economy scarred, the country must now work on building transparency and predictability.

With credibility being the best asset of a policymaker, steps must be taken to enhance such qualities to keep things moving in a positive direction.

Acknowledging the Government’s new policy direction as a timely  and one that should have ideally happened some time ago, the panellists – Commonwealth Secretariat Economic Affairs Division’s former Director Dr. Indrajit Coomaraswamy, CBSL former Assistant Governor Dr. Anila Dias Bandaranaike, CBSL former Deputy Governor Dr. W.A. Wijewardena and Hayleys PLC Economist and Sampath Bank Director Deshal de Mel – noted that caution must be exercised in analysing the data and making corrective measures about the future of the companies, organisations and the economy of the country.

They noted this at a forum organised by the Exporters Association of Sri Lanka (EASL).

What really happened?

Commonwealth Secretariat Economic Affairs Division’s former Director Dr. Indrajit Coomaraswamy noted that the reason for the new policy was the perfect storm generated in terms of external development and misaligned policies. While external developments such as changes in oil prices affected the market, the biggest problem was the misalignment of domestic policies.

“Real effective exchange rate was said to be 25% overvalued and people say the inflation has been low for the past few years in comparison to others.”

There was however a backlog of adjustments which led the country to lose competitiveness. “Exchange rate was out of alignment. When the exchange rate was overvalued 25% and you aggressively reduce interest rates and ease monetary policy it is inevitable that you have an expansion of credit and surge of imports,” Dr. Coomaraswamy noted.

Sri Lanka’s key policy rate, repo rate was reduced by 300 basis points approximately between 2009 and 2010. Moral suasion was used for banks to lend aggressively during which a credit growth of 30% took place.

“Rapid increase in credit and overvalued exchange rate inevitable led to deterioration in the trade balance,” he said. “The situation was compounded because the physical consolidation trajectory that was hoped for was not achieved.”

He asserted that the trajectory was heading towards crisis with the budget deficit for 2011 expected to end on high 7.8% and doubling trade deficit of Rs.10 billion. Policy interest rates were also increased by 50 basis points. “CBSL is still however following the market rather than shaping the market. Market related interest rates, TBill yields, deposit rates, lending rates have all gone up much more than the policy rates,” Coomaraswamy expressed.

“If you have this perfect storm of policies you will have deterioration in deficit, improvement in exports, remittances, tourism and FDI. He also assured that the international reserves of approximately 7.5 billion was not a good situation to be in of which three billion was in Eurobonds, 2.5 billion in Tbills in foreign hands and 1.8 billion in IMF lending.

Corrective action is now being taken. Banks asked to limit lending to 18% which could go up to 23% provided they raise the extra 5% abroad. However, for the banking sector to borrow abroad, the Government headroom for further commercial borrowing is limited.

“We have reached the saturation point now so banks have been asked to borrow and can do that with their strong bank sheets. CBSL has agreed to take 50% of the risk. However the guarantee is for 12 months, so if they borrow for three to four years, there is an issue. This must be done cautiously. But really you cannot borrow your way out of the situation,” Coomaraswamy said. “Change in prices in fuel and electivity has fed through to a whole lot of other price increases.”

Make some noise

Claiming that Sri Lanka has never had it so good, CBSL former Assistant Governor Dr. Anila Dias Bandaranaike expressed that while certain happenings such as the Government policy point of view has been really good, one must take responsibility to chose from the correct information available. Applying the rules of gravity, Bandaranaike noted that the coming change was very clear. “It was very clear that this was coming – what goes up must come down.”

She noted: “On the macro side, from a business perspective we really need to be aware of the big picture. We can no longer afford to just look at our own areas only. We cannot just look at the exchange rate only; we need to instead look at credit growth, import growth, reserve decline, key price increases such as the fuel prices, inflation and see what is happening on all fronts to round up on what will happen next.”

To give credit, the Government has done a great job on infrastructure but on the other hand a lot of confusion, miscommunication and contradictions along with inconsistency are created on what Government Spokespersons say and do.

“There is a contradiction between what is said and done; we as informed citizens must look at not what is said but at the facts.”

As an example, she noted that credit growth for 2011 which had a target of 18-19% in the CBSL Annual Report ultimately ended at 34%. “Nothing was done to rein that in. Policy rates went down steadily and credit was growing. Money supply target was 14.5% ended up at 19.1%. We need a policy consistent environment; we need to be sure as a business person that what is said is done.”

Monitor the movements and make noise when necessary since if everyone keeps mum “policymakers will go along a situation heading for disaster”.

Bandaranaike said: “The business community needs to get the information; if it is not available, something is wrong. You can know which parts of the economy are strong and which are weak by looking at the numbers. There must be noise. Right to information is something that needs to be pushed. Consistent information is needed to make informed decisions. As citizens of the country you are entitled to know these numbers to make business decisions.”

In Sri Lanka there is also very often an overreaction, she admitted. She noted that the Government should have gradually increased the cost of living and fuel price without a lump change.

“Even if you impose a 10-20% hike on every item that is consumed, you are still not in a situation of a year ago,” she said. “The world is volatile, deal with it, take it in stride, hedge your risks and diversify risks and deal with it. It won’t get easier. Demand and supply will be volatile. We need to hedge the risks and cope with it.”

More fuel increases?

“In the last three years we have been very happy as exporters as fuel prices were below international prices, which was a subsidy the Government gave. At the same time the exchange rate was overvalued which was from an exporter side, a tax. All of a sudden when the Government had gone to the final stages and not been able to give the subsidiary and when it was forced to adjust the exchange rate, they have done a partial adjustment,” CBSL former Deputy Governor Dr. W.A. Wijewardena said.

What exporters must do is adjust themselves in the future. With all the losses made by Government entities from CPC, CEB, SriLankan Airlines and Mihin Lanka, the Government is likely to adjust fuel prices again.

“Generally, if the net worth of a company income is negative, you need to liquidate the company. In the case of a Government institute, they do not do it because there is a ‘big brother’ who is there who has the capacity to run the organisation. The Government will eventually take over these companies without any fanfare or announcements by secretly issuing T-bonds.”

He noted that Mihin Lanka was taken over by the Government with Rs. 4 billion worth of T-bonds. Similarly, loss-making CPC and CEB were taken over with Rs. 25 billion T-bonds. Similar adjustments will come in the future as well.

“If we are unable to assess the business today and make our own adjustments, then the situation will not be good for us all. We must make informed decisions.”

What to expect

There will be a lot of volatility in the immediate short term, Economist at Hayleys PLC and Director at Sampath Bank Deshal de Mel, moderator of the forum, said. He expressed that it was essential for companies to invest in information that would focus on where the market is going both locally and internationally and to keep pressurising Government authorities to ensure information is given out in a timely and transparent manner. 

“Recently we have had a lot of policy changes but must keep in mind developments overseas as well,” he said. “In the latter part of 2011, there were sharp depreciations in currencies of almost all Asian economies, which reflected a huge increase in risk environment globally. We saw investors putting lot of effort into Japanese Yen and related assets and US Government Bonds. The appreciation was seen in all these economies, leading to deprecation in emerging economies and frontier markets.”

Exporters must stay aware of capital movements in Sri Lanka in the next six to 12 months, de Mel said. “We will see capital repayments of a number of previous bonds such as Sri Lanka Development Bonds, first sovereign bond before October, remittances and due bonds taken by the government going forward.”

This, he said, would have short-term implications for the exchange rate. “Judging by 2011 secular trends, 81% of the increase in imports in 2011 was driven by imports of intermediate and investment-related goods. These are largely inelastic in nature.”

The situation in Middle East is the biggest risk to the economy at the moment, which would affect Sri Lanka as well.

There will be a lot of opportunities with the new currency regime and with Sri Lanka Rupee following a more market determined rate, which means the previous disadvantage has been corrected to an extent. However, it must be remembered that this is not a new advantage received but a correction. “This gives exporters a more even playing field and better chance for tapping opportunities.”

However there are many more policy movements that need to be addressed. “With the depreciation of the currency, we are likely to see the exporters who engage in domestic value addition to a greater degree benefiting more than those who does not,” he said.

However, exporters who rely on a lot on energy-oriented manufacturing will have a tough time because of the adjustment of fuel prices. “Going forward there will be a number of strategic changes required from an exporter’s point of view. There will be a lot of tough decisions to be made. There will be certain industries where the entire product mix will have to change and some will no longer viable. It is now time to take a hard look and deal with it.”