|I recall how Governor Jayawardena responded to a call from anxious President Chandrika who wanted to know why he was delaying the announcement of the floating of the rupee. I was present in his room at that time. He said confidently, ‘Madam, I don’t want to put the vehicle onto the road until I’m convinced that the brakes are in proper order’. In other words, if the things would go wrong, he had to apply the brakes and stop the disorderly depreciation of the rupee. Also, he told President Chandrika that if the vehicle went down a cliff, he now had a tree nearby in the name of IMF to stop it by crashing to that tree. That was a risk mitigation mechanism
Claiming the controlled dollar-rupee rate as a success story
Sri Lanka rupee has collapsed in the foreign exchange market in the first week of March. Before that, the Central Bank has published data every day in its website that the buying and selling rates of the dollars by commercial banks as Rs. 197 and Rs. 203, respectively, though dollars were not available at those rates in the banking system. If anybody wanted dollars in a hurry, he had to look for them in the parallel black market at which dollars were bought and sold freely at rates ranging between Rs. 250-260. This illusive rate published by the Central Bank in its website has been described by the Bank’s Director of Economic Research as a success story of maintaining the stability of the rupee for 11 long months (available at: https://youtu.be/LpRQs4AGpBA).
Prior to his explanation, the Bank’s Governor Ajith Nivard Cabraal in the same very short video clip has described it as fulfilling the Bank’s mission of maintaining the economic and price stability and financial system stability.
True meaning of ‘economic and price stability’: No excess demand or excess supply
I have clarified in a previous article that what is meant by economic and price stability is not just maintaining inflation rate mechanically at a low level but maintaining the macroeconomic stability in all the sectors in the economy, namely, the fiscal sector, domestic monetary sector, and the external sector, so that there is no excess demand or excess supply in the goods market. If there is excess demand or excess supply in the market arising from an imbalance in any of the sub-sectors in the economy, the Bank has not attained its objective of economic and price stability (available at: https://www.ft.lk/columns/central-banke28099s-mandate-is-to-attain-both-e28098economice28099-and-e28098pricee280/4-51258).
Since all these three sectors have been in imbalance – budget running at an average deficit of about 11% of GDP, money supply expanding at 40%, and external sector having an overall deficit of $ 8.2 billion in the 25-month period from December 2019 – there had been continued excess demand in the economy causing the inflation to rise at about 17% and exchange rate to depreciate massively in the market. Hence, the claim concerning the attainment of this objective by the Central Bank has been far from the reality. Surely, when there is a massive black market outside the formal system and when there are queues for essential goods, no central bank can claim that it has attained its objectives. Does this mean that the top leadership of the Central Bank, including those sitting on the Monetary Board, should go back to school and re-educate itself of the first principles of central banking?
A.S. Jayawardena the former Central Bank Governor who did not want to put the vehicle onto the road without checking on the brakes
The failed homegrown strategy
The present collapse of the rupee has not been totally unexpected. For many months, independent analysts had warned the Government and the Central Bank about its insane attempt at fixing the rupee-dollar rate at 200 at mid-level without a supportive foreign exchange reserve.
But the Bank had adamantly maintained and misled the President too that it has enough resources at hand to keep the rate at that level and there is no necessity for Sri Lanka to seek IMF support or work on restructuring the country’s foreign debt. Governor W.D. Lakshman ascribed this to following an alternative policy measure which only he knew of; Governor Cabraal said that it was a homegrown policy, and gave the market of the main ingredient of that policy in his Six-Month Road Map announced on 1 October 2021.
That main ingredient was to seek temporary funding from friendly neighbours and central banks. The risk of that homegrown policy was that if they did not materialise in sufficient amounts, the rupee should collapse in the market without support. This is what happened to the rupee in the first week of March 2022. The Central Bank has now stopped publishing that fictitious rate of 197-203 in its website. Instead, the rates published now are 250 and 260. But the commercial banking sources indicate that the actual over the counter rates have moved up to 265 and 275 per dollar.
Meanwhile, on the first day of floating, the rates in the parallel black market had converged with these two rates. However, since then, the black-market rates have jumped up over the formal sector’s rate since there was not enough foreign exchange with banks. That is because the Central Bank had let the rupee have a freefall without other supportive policies like increasing interest rates and seeking a funding line from IMF. Hence, the black market is still very active and the existence of such a parallel market is the worst enemy of a central bank because it thwarts the efficacy of its policy actions.
Is floating a taboo word?
What has happened is the floating of the rupee because the rates are now determined by the market in response to the demand for and the supply of foreign exchange. Floating is not a simple task, and much work must be done to make it a success as a macroeconomic tool. But the short video clip which the Bank has released to the market shows that the Bank has been unaware of what had been happening in the marketplace. That is why both the Governor and the Economic Research Director say that they have made the rupee-dollar rate more flexible and not floating, probably floating may be a taboo word.
This is simply reverting to the period from 1977 to 2001 during which the country was having a flexible exchange rate system. But the rupee was fully floated in January 2001 when the late A.S. Jayawardena was the Governor. He meticulously planned it for a few weeks prior to final floating. Hence, looking at how he did it may be a useful re-education program for all of us.
The floating saga in 2001
Prior to 2001, the Central Bank has been announcing daily its buying and selling rates of dollars as per the provisions of the Monetary Law Act. Commercial banks had to keep their rates around the rates announced by the Central Bank. However, due to a chronic balance of payments problem, the Central Bank had to supply foreign exchange regularly to the market to keep the exchange rate at levels it had been announcing to the market. If the Bank could not supply foreign exchange to the market at the given rates, the result was either the rate had to move up or allow the development of a black market dealing in foreign currencies. Since the Bank did not want a black market to develop because it is the worst enemy of a central bank, it allowed the rates to go up by widening the margin between its buying and selling rates from time to time.
Accordingly, the margin was widened from 2% to 5% in June 2000, to 6% in November and to 10% in January 2001. But each time when the margin was widened, the operating rates of commercial banks moved up to the selling rate of the Central Bank indicating that the rupee is under increased pressure for depreciation. The result was what is now known as being hit by a double whammy: the Bank was losing reserves and at the same time, the rupee was depreciating. The same double whammies had been attacking the Central Bank in the current period too: it was losing reserves and the rupee was under pressure for continued depreciation. But today’s Bank had been hiding this latter factor from itself by posting a non-existent exchange rate in the market to its website. The result was the development of a vibrant black market in foreign currencies.
A.S. Jayawardena: Falling reserves and black markets are the worst enemies of a central bank
But reserves fell at a rate and Governor Jayawardena did not like it. In 1998, the reserve level was $ 2 billion; it fell to $ 1.6 billion in 1999 and further to $ 1 billion in 2000. At the same time, rupee was also depreciating from Rs. 68 a dollar in 1998 to Rs. 72 in 1999 and further to Rs. 80 in 2000. So, you cannot hold onto both the reserves and the dollar. If you hold onto the dollar, you will lose reserves driving the country to an irrecoverable risky situation. If you lose reserves, you will lose everything, sovereignty, freedom, economy and so on.
Above all, without reserves, you will not be able to continue with the import program that will create shortage of both inputs for industries and essential consumer goods for consumers. It will lead to other unintended consequences, namely, queues, black markets and smuggling of the goods into the country. They were all the worst enemies of a central bank. Governor Jayawardena did not want to place the Central Bank in this risky situation.
He had discussions with the IMF, got into a program with the Fund, and made preparatory work for floating the rupee for the first time since 1977. He also convinced President Chandrika Bandaranaike Kumaratunga who was the Minister of Finance as well of the need for floating the rupee. The most important act he accomplished in this exercise was getting the support of Dr. P.B. Jayasundara who was the Secretary to Ministry of Finance cum official member of the Monetary Board. Governor Jayawardena knew that without their support, the whole exercise would fail.
Don’t put a vehicle to a road if brakes are not in order
After completing this initial work, he got the Monetary Board to increase the Bank rate, the equivalent of today’s Standing Lending Facility Rate of the Central Bank, from 16% to 25%. The reason was to eliminate the speculative elements in the market by making speculation more costly. If they kept money outside, the local cost of financing the activities was raised to a higher level. I recall how Governor Jayawardena responded to a call from anxious President Chandrika who wanted to know why he was delaying the announcement of the floating of the rupee. I was present in his room at that time. He said confidently, ‘Madam, I don’t want to put the vehicle onto the road until I’m convinced that the brakes are in proper order’. In other words, if the things would go wrong, he had to apply the brakes and stop the disorderly depreciation of the rupee. Also, he told President Chandrika that if the vehicle went down a cliff, he now had a tree nearby in the name of IMF to stop it by crashing to that tree. That was a risk mitigation mechanism.
IMF supporting the floating
On 23 January 2001, Governor Jayawardena went for the floating of the rupee. He did so by making the announcement at 7 a.m. that the Central Bank will stop from that day onward the announcement of the Bank’s buying and selling rates of US dollars. Instead, the Bank would report on its website the weighted average of the buying and selling rates of dollars by commercial banks as an indicative rate. Outside the Central Bank, only Chandrika and PB knew of this. Even the Deputy Minister of Finance – Prof. G.L. Peiris – was briefed of the change just 10 minutes before 7 a.m. only as a courtesy.
The secrecy in the entire work was necessary because if others knew of this change, they could have made money out of the floating. So, it was done with the minimum number of people knowing about it and after the markets were open, the rate increased to Rs. 98 per dollar. But IMF issued a statement saying that it would welcome the decision to float the currency and it would stand by Sri Lanka in this exercise. It eliminated the speculative elements from the market. The rate began to appreciate and settled at Rs. 88 by 12 February 2001. Reserves started building and at end-2001, they were at $ 1.3 billion, at end-2002, $ 1.7 billion and at end-2003, $ 2.3 billion.
|For rescuing Sri Lanka from the present acute foreign exchange crisis, there is no alternative other than getting a longer-term loan from IMF. Without that, the Central Bank has allowed the kite to float freely in the sky without
The legal hurdle
But the Bank ran into a legal hurdle too. In terms of the Monetary Law Act that had been enacted in 1949, the Bank should announce its buying and selling rates daily. But the Act was silent about whether the Band could refrain itself from making that announcement. Hence, when it stopped making this announcement, there was the risk of someone taking the Bank to courts. Governor Jayawardena assessed this risk and decided to fight it at courts if someone decided to challenge the Bank’s action. He felt that the Bank had a strong case on two counts.
First, the markets have changed in their structure since the enactment of MLA in 1949 from a fixed exchange rate system to a floating exchange rate system. Second, the courts may appreciate the necessity for ignoring archaic laws if they stood in the way for progress in the current period. Hence, the announcement was made as previously decided.
But an opposition Parliamentarian took the Bank to courts and the case got dragged on. Then, the very same Parliamentarian became a part of the government that seized power at the general elections held subsequently and he chose to go into a settlement with the Bank. However, as a permanent measure, MLA was amended in 2002 suitably under that new government removing the legal impediment.
A lot more to be done
Today, rates are rising in the market day after day. Hence, the Central Bank should immediately apprise the Government of the need for negotiating a financial facility with IMF, that cannot wait until Finance Minister Basil Rajapaksa goes to Washington DC for Spring Meetings of IMF and the World Bank, increase interest rates to eliminate both the black market and speculative elements, and return to the tax system that had prevailed prior to 2019.
The address to the nation by President Gotabaya Rajapaksa last week was vague about the Government’s seeking a funding facility from IMF immediately. He said that the Government was willing to work with IMF referring to the Fund’s role as the provider of technical support to member countries. This was wrongly read by local media as his going to IMF for a loan facility. That confusion will make the foreign investors more confused. It could not make a significant turnaround in the falling prices of ISBs out there in the market. It at all helped the prices to mark a marginal improvement only. In the meantime, Finance Minister Basil Rajapaksa who made a begging visit to India was successful in getting $ 1 billion from the State Bank of India guaranteed by the central government.
Though this loan is useful, it will not help Sri Lanka to solve its acute foreign exchange problem on a permanent basis since, as reported, it is for import of essentials from India and repayable in three years. For practical purposes, it is a three-year trade credit and cannot be counted for calculating Sri Lanka’s foreign reserves.
Hence for rescuing Sri Lanka from the present acute foreign exchange crisis, there is no alternative other than getting a longer-term loan from IMF. Without that, the Central Bank has allowed the kite to float freely in the sky without direction. Even at the time this article is going to press, the over-the-counter rupee-dollar rate has moved up to Rs. 285 and settled at that level. Hence, the expected reversal of the fall of the rupee does not seem to be taking place further adding to uncertainty in the market. That is a risk which should be avoided at any cost.
(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at email@example.com.)