Devaluation of the exchange rate and the rate of interest

By Asia Wealth Management/Research Team

A great deal of discussion is currently being focused on the so called ‘unexpected’ decision of fiscal authority to devalue the Sri Lankan rupee.

The fact that rupee was devalued under the aegis of the President alienating the role of CB sparked much debate on the credibility of CB with regard to its faculty to maintain stability of monetary sphere.

It’s learnt that President’s move to devalue the rupee with immediate effect had not only surprised the market but also, the Central Bank.

It is important in this regard to clearly state the position held by CB to justify its exchange rate and interest rate policy, which came under assault few days ago by the hands of fiscal authority.

CB claimed that with corporate and banks set to raise capital abroad, about a billion dollars in equity and debt would flow in towards the end of this year.

This expectation was the only justification of maintaining exchange rate and interest rates below the free market equilibrium range, by sustaining a fragile mix of rising CB assets and shrinking dollar reserves.

In an article titled ‘Expectation of Foreign Inflows and Future of Monetary Policy’, we pointed out that this expectation of CB of arriving at a surplus inflow by year end does not fall in line with regional trend in portfolio flows.

The benchmark share indexes of regional markets have shed base points significantly during the past two months and currencies of frontier as well as emerging economies of the region such as India, South Korea, Philippines, Maldives, Thailand, Hong Kong were depreciated against the USD from 10 to 30 per cent. This indicated the contrary to what CB was suggesting; the trend in portfolio flows showed a very significant net outflow from the region while CB was expecting surplus inflows during the year end rendering their expectation very irrational.

Therefore, we maintained that the monetary stance of CB cannot and will not remain unchanged and it’s pity that this change occurred not under the purview of CB but by the President during his budget speech.

Commissioning of the devaluation by the fiscal authority could very well suggest that surplus inflows Central Bank expected during the year end did not materialise and moreover, CB reinvestments of country’s foreign reserves could possibly be making mark-to-market losses owing to the collapse of Treasury bond prices in European economies such as Greece, Portugal, Italy and Spain. CB could have opted investing the foreign reserves in government paper of these economies owing to comparatively higher yields offered and the sense of security attached to them being members of Euro Zone.

This is to say that foreign reserve position of Sri Lanka has deteriorated during the past few months significantly and the move to devalue the currency was a step taken towards its re-strengthening.

However, in our assessment of 2012 fiscal proposals we held that the rate of devaluation of the rupee will not prove to be sufficient to curtail the domestic demand for imports and hence, market interest rates will not witness any downward pressure owing to this move.

The drain of foreign reserves will therefore, continue as intensely as before exerting upward pressure on interest rates. The interest rates will now tend to rise more rapidly for since more rupees will now be dragged out of the system owing to the devalued rupee and the domestic demand for imports being unaffected by the rupee devaluation.

Rupee liquidity in the market will now tend to dry out more rapidly than the period prior to devaluation as the devalued rate of exchange will require importers to pay more rupees for a dollar worth of imports in an economic setting where the demand for imports is unaffected by the devaluation of the currency. This means that more rupees are now being dragged out of the system than the period prior to devaluation exerting upward pressure on the market interest rates, data on which is readily available. Further, in the absence of sterilisation measures by CB the rates will push further up and safeguard the foreign reserves.

However, in an attempt to control the interest rates, if CB sterilises the market by raising rupee liquidity levels independent of the growth in aggregate savings, foreign reserves will continue to flow out of the government coffers.

There are economic forces so powerful they constantly break through all barriers erected for their suppression.

In a quite similar phase, it appears that Sri Lanka’s Central Bank is somewhat now unanimously ended up being merely a constituent of economic entities governed by the interplay of market forces, rather than being able to determine an equilibrium range at its own will which free interplay of market forces does not permit.

It seems that all attempts on Central Bank’s part to insulate itself from country’s foreign exchange market to counteract the effects of a changing monetary base are proving to be futile.