Guest Column

28th January 2001

Taking stock of floating rupee

The mudalali, actually isn't disturbed by it as much as my carpenter Banda, who has a family of seven to feed with his pension and irregular work. Herath whose family prepares short eats has raised his prices. Vijay is shrewder, he told me he won't increase the price of his milk toffee, as the students may not buy it. So he will reduce the size. He is actually badly hit, as the cost of his tractor that he uses for transporting the grass for his cattle will increase. In short even his grass is dearer. This is real economics but not the sort of thing the Editor expected of me when he invited me to write this column. In fact I would not give any marks to my students if they were to write this sort of thing in their answer scripts. Like my students, I too have to prove that I know the parlance of economists. Let me try.

First of all let me remind readers that the Rupee has been on a float for the last 23 years. The Rupee was floating from November 1977, when it was devalued from around Rs.5.95 to the US dollar to Rs 16 to the Dollar. It has been floating ever since to reach around Rs 72 at the end of 1999 and about Rs 82 to the dollar at the end of last year. Although the currency was afloat, there were interventions by the Central Bank, which did not allow the currency to float freely according to market forces. The Central Bank fixed the exchange rate each day according to the supply and demand for exchange of a basket of currencies. However there was the fiction that market forces determined the exchange value of the Rupee. Now that fiction has been jettisoned. The Central Bank allows market forces to actually determine the value of the Rupee. The Central Bank will not intervene in the market. The demand for foreign exchange will now determine the value of the Rupee in relation to other currencies. That is what floating the Rupee means.

In other words, the determination of the foreign currency value of the Rupee has shifted from one in which the Central Bank managed the currency fluctuations to one in which market forces would determine the value of the Rupee. In the parlance of economists and central bankers, it is a shift from a" dirty float" to a "clean float". The depleting foreign exchange reserves and the continuing strain on the balance of payments would have compelled the Central Bank to put the Rupee on a clean float. In this context the Central Bank may not have had any choice but float the Rupee cleanly. It is probably a precursor to seeking assistance from the IMF. The IMF may have insisted on the free float as a condition to providing balance of payments support.

The Rupee is likely to fluctuate considerably owing to "market forces." These "market forces" would include speculation by buyers and sellers of currency. The gyrations and swings in the value of the Rupee are unpredictable. They can be quite large and disconcerting in view of the economic fundamentals being very weak. Unfortunately the speculative forces are likely to be mostly in one direction, in expectation of a further depreciation of the currency. The wide swings in the currency was evident on Thursday, when the Rupee swung between a peak Rs 98.50 to the US Dollar to a low Rs 92 and then settled at Rs 94 to the US Dollar. This sort of behaviour is likely for sometime.

The Rupee is likely to depreciate further in the coming months. Expectations of further depreciation of the currency could lead to some capital flight, in as far as this is permitted and possible. Exporters are likely to keep their proceeds abroad. Imports can even rise in the expectation of higher import costs later. All these can result in the destabilising of the economy. A chaotic scenario indeed.

A legitimate question to ask is when will the Rupee attain some sort of stability. I think it will only happen when the IMF steps in with a facility to support the balance of payments. Till then the Rupee will be unstable and continue to depreciate.

The fundamental issue is whether the free float of the currency and the likely continuing depreciation of the Rupee would correct the balance of payments problem we are facing today. The IMF and World Bank would argue that it would, provided the depreciation of the currency is also backed up by other policies.

I am of the view that our import -export structure makes it very unlikely that we could correct the current balance of payments problem through a depreciation. At least not in the short run. The nature and character of our imports and to an extent our exports make it unrealistic to expect an improvement in our balance of payments in the short run. Let me explain this briefly, albeit inadequately. The underlying reason for the balance of payments difficulties was the high import bill for crude oil and the armaments imports. These imports created a severe strain on the trade balance and increased the balance of payments deficit significantly. This despite an export growth of about 17 per cent last year. We have been having trade deficits every year since 1978 and a deficit in the current account of the balance of payments in most years. The capital inflows have offset this deficit in several years. This inflow of capital has also dried up. Therein lies part of the problem.

The depreciation of the currency or devaluation will not solve this problem to any appreciable extent. The increase in the price of imports as a consequence of the free float is expected to reduce imports. Export earnings are expected to rise through increased export volumes. The reasoning is that by making our exports cheaper in foreign currency terms we would be more competitive and could increase the volume of exports.

These gains are expected in both the short- run as well as in the long- run. In my view these expectations are not likely to materialise in the short-run owing to the structure of our imports and exports. The nature of our main consumer imports does not give much hope for an adjustment of the balance of payments through a reduction in imports. It is unlikely that rice, wheat flour or sugar imports would be drastically curtailed owing to higher prices, as they are essential consumer items. In any case, the total expenditure on consumer imports is small compared to the imports of intermediate and capital goods. Consumer imports amount to only about 20 per cent of our imports. Therefore the reduction in these imports are not likely to have much of an impact on the balance of trade. The bulk of our imports are raw materials or intermediate goods. These account for over one half of our imports. Most significant among these are the crude oil imports, raw materials such as chemicals for our manufactures and imports of textiles for the garment industry. Textile imports constitute over 20 per cent of total imports.

The other important intermediate import, crude oil, is a key item in the trade balance.

In 1999 when crude oil prices were relatively low, petroleum imports absorbed about 7 per cent of our import bill. Last year the oil import bill increased sharply owing to the quantum of oil imports increasing as well as a doubling of crude oil prices. Imports of crude oil imports alone are likely to have absorbed more than 15 per cent of our import bill last year. This year too it is likely to be high, though perhaps less than that of last year, if prices do not shoot up again and rainfall in the catchment areas is adequate. The depreciation of the currency is, however, not likely to lead to a severe curtailment of crude oil imports.

Similarly, other intermediate or raw material imports too cannot be curtailed, as they are vital for our manufactures and agriculture. Therefore the depreciation of the currency is not likely to reduce intermediate imports. In fact if they are reduced it could be to the detriment of the economy.

An important determinant of our balance of payments is the expenditure on armaments. If these imports were to be at the same high level as last year, it would indeed be a serious strain on the balance of payments. However, this is again an item of import expenditure independent of the devaluation of the currency. Armaments imports will not be reduced owing to the depreciation of the currency!

The bottom line with respect to a relief on the balance of payments from reduced imports is that it would be very marginal. The large depreciation of the currency and sharp increases in rupee prices of imports, are not likely to reduce the import bill significantly owing to the heavy imports of crude oil, armaments and raw materials.

The prospects of increased earnings from exports are better. This is especially so with respect to our manufactured exports. Last year's export recovery in manufactured exports was partly owing to the depreciation of the currency making our exports more competitive. The depreciation of the currency is likely to reduce the price of our exports in dollars. This would give exporters a competitive edge that could increase export volumes. However, there must be an increase in export volumes sufficient to compensate for the reduced dollar prices. The reduced export prices in dollar terms must induce a more than commensurate increase in export volumes, for export earnings to increase and improve the trade balance.

To gain from a depreciation in the currency, we must also be in a position to increase the supply of the exports to compensate for reduced dollar prices. We may be able to increase our exports of manufactured goods but not our agricultural exports. Even in the case of manufactured goods, the gains could be limited owing to the high import content of our industrial exports. The devaluation will also increase the costs of production of most exports through higher input costs and possibly increases in wages necessitated by the higher living costs. Exports with a larger domestic value addition could become more competitive if wages do not rise much. But these exports are relatively low.

The balance of payments could gain by increased tourist earnings. Yet even here other factors, notably the security situation has an important bearing. No doubt with the large depreciation of the rupee, Sri Lanka is likely to emerge as an attractive location price -wise. Yet, whether we would in fact gain from this would depend on other conditions in the country. Although the floating of the rupee and its consequent depreciation may bring some relief to the trade balance through increased exports, it is unlikely to be of a magnitude that would correct our immediate balance of payments problem. It is optimistic to expect a large increase in exports or a significant curtailment of imports through a devaluation. The depreciation of the currency is likely to assist export industry and export agriculture much more in the long run.

The danger in floating the currency is that its depreciation could set off a spiralling inflation, which itself could wipe out any advantages that the depreciation may have in the short run. Unfortunately, the free float has been resorted to at a time when the fundamentals of the economy are weak. It would have been different had we floated the currency at a time of greater economic stability when are reserves were high. Then the adjustment in the exchange rate would have been gradual and over a longer length of time. It is important to ensure that the float will not destabilise the economy and retard economic growth.

There is no doubt that much of the balance of payments crisis was caused by factors that are generally described "as reasons beyond our control". The import costs of the war and the escalating prices of crude oil at a time when higher imports were necessitated by the drought are the best examples. These factors are understood.

The incapacity of the government to respond to this crisis and take timely corrective measures, as well as poor governance, have sapped it of international credibility. That is in my view the root cause of the delay in international assistance. Even now we would have to put our house in order to get the needed support. The massive devaluation of the Rupee is a huge cost to the community. Its vibrations are even felt in my village.

The writer is the former chairman of NDB and the Bank of Ceylon.

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