Despite pressures on the Sri Lankan rupee, the Central Bank has continued to maintain the exchange rate at a fairly stable level of around Rs. 110 to a US dollar. However, there has been a depreciation of the rupee in relation to several other significant international currencies, such as the Euro and British pound.
The Central Bank has also continued to keep policy interest rate unchanged at 7 percent. These are a continuation of the policies discussed in last week's column. The Central Bank in recent statements has reiterated its intent to keep the exchange rate around its present level with respect to the US dollar despite IMF advice to the contrary.
The Central Bank is of the view that its policies serve the long-term interests of the economy.
The question that arises is whether these two policies are sustainable at a time when the trade deficit is continuing to grow. Besides, international developments on the horizon, such as recessionary conditions, lower demand for tea in the Middle East and the possibility of remittances from workers in the Middle East decreasing may aggravate the balance of payments position.
The trade gap is continuing to widen to reach massive proportions with import growth far exceeding the impressive growth in exports. Consequently remittances that have offset as much as 80 percent of last year's trade deficit would offset perhaps only about 60 percent of the trade deficit this year.
Central Bank standpoint
The Central Bank has reiterated its position strongly as one of not listening to the advice of the International Monetary Fund (IMF), but pursing its own policies in the best interests of the economy. It has said in no uncertain terms that Sri Lanka will follow its own course based on a longer-term path than on the advice of the IMF. Central Bank Governor Nivard Cabraal has said the Bank will not take all economic advice that is given by the IMF as its advice comes without responsibility.
The thrust of the Central Bank argument has been that the country has a large foreign exchange reserve and that the Sri Lankan economy is doing well with an expected economic growth of 8.5 percent for the year. Exports are also growing at an impressive rate and tourist earnings are increasing. The Bank's contention is that interest rates must be kept low to encourage investment.
There is also the confidence that the current situation is temporary and that there would be increasing inflows of capital that will change the balance of payments situation. The latter is expected mainly from investments in the hospitality trade. Meanwhile, the sale of US dollars by the Central Bank is depleting the reserves, even though they are still at a high level of about US $ 8 billion.
The IMF position
The IMF policy stance is that the Central Bank should not defend the value of the rupee by continuing to sell its dollars and that the interest rate should reflect monetary conditions in the country. The IMF statement after the recent consultations says: "The uncertain global environment underscores the importance of continuing to build foreign exchange reserves. While headline reserves are at a comfortable level, buoyed by the Central Bank's purchase of the proceeds from the recent 10-year Eurobond, non borrowed reserves-- that is, excluding Eurobonds, IMF disbursements, and foreign holdings of Treasuries -- have steadily declined, reflecting foreign exchange sales by the Central Bank. This policy does not seem to be in line with the current fundamentals of the economy.
 In responding to market pressures, the Central Bank should henceforth limit its intervention and allow more exchange rate flexibility. Flexibility in the exchange rate, which has appreciated substantially in real terms over the past two years, is also an essential component in ensuring Sri Lanka's export competitiveness." The Central Bank's policies are not only at variance from that of the IMF, but are also counter to conventional understanding of economists.
Important issues
There are several important issues that are brought out by the brief and concise IMF statement. The contention that the country could sell dollars as it has a large foreign exchange reserve could be misleading. As the IMF has pointed out these are mostly borrowed rather than earned funds. The Central Bank's reserves have been mainly from the recent 10-year Eurobond, IMF disbursements and foreign holdings of Treasuries. It points out that non borrowed reserves are low. In fact the net foreign exchange reserves, leaving aside the borrowed funds, could be as low as in 2009 when the IMF stepped in to save the country from a balance of payments crisis. The selling of dollars makes this situation much worse.
Exchange rate
The exchange rate is being defended on the grounds that eventually the country would have a balance of payments surplus despite the growing trade deficit to huge proportions.
The Central Bank argues: "Even though the deficit in the trade account has expanded inflows into the services account as well as continued higher worker remittances have helped contain the deficit in the current account and maintain stability on the external front. Meanwhile, foreign exchange inflows to the capital and financial account are also continuing in view of projects being implemented in diverse sectors of the economy. Further, the Central Bank has also absorbed the proceeds of the sovereign bond issued recently, leading to the gross official reserves recording historically high levels."
This is particularly significant in the context of the widening trade deficit, the recessionary global conditions and the adverse impact of the turmoil in the Middle East on the country's tea exports and inward remittances. Besides, these funds are contingent liabilities.
Apart from the issue of the foreign exchange reserve, the exchange rate stability could affect the country's exports and imports. A depreciation of the rupee would enhance the competitiveness of the country's exports, while checking imports through increased import prices. The IMF position is that "flexibility in the exchange rate, which has appreciated substantially in real terms over the past two years, is also an essential component in ensuring Sri Lanka's export competitiveness."
Flexibility in the current context means a depreciation of the currency. This would become even more important if other competing exporters depreciate their currencies. Then imports would be more attractive and exports less competitive. The argument of adequate reserves does not hold water with respect to the trade balance that is affected by the exchange rate.
Concluding observations
The rationale of the Central Bank for maintaining a stable exchange rate with respect to the dollar is that the current strain on the balance of payments is a transient one and that with expected capital inflows it would be possible to restore stability under market conditions.
The argument of the Central Bank is that this widening trade deficit is not of much concern as capital inflows and service earnings would ensure that there would not be a serious strain on the balance of payments. The Central Bank is of the view that foreign exchange inflows to the capital and financial account would increase due to projects being implemented with foreign capital.
Even though in recent years the deficit in the trade account has expanded, inflows into the services account as well as continued higher worker remittances have helped contain the deficit in the current account. Whether the outturn in the balance of payments would be favourable this year remains to be seen.
Several reasons have emerged as to why this may not be so this year. An overvalued exchange rate could affect the trade balance further, while the interventions in the foreign exchange market to stabilise the rupee could reduce the reserves that are mainly borrowed funds. Many believe that current Central Bank policies are not sustainable.
Meanwhile commercial banks have steadily increased their deposit interest rates. This may well be due to the view that the current policy of keeping the exchange rate and interest rates stable is not viable in the long-run and perhaps their current funds are inadequate to meet demand.
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