Exchange rate dilemma and the country’s economy: CB Governor
One of the hottest topics these days is the sudden rapid depreciation of the Sri Lanka rupee against the US dollar.
The people mistakenly assume the country’s economy is collapsing due to these developments. The reasons behind the pressure of the exchange rate are many and beyond the control of the Central Bank (CB) and the government, noted CB Governor, Indrajit Coomaraswamy.
Attending the LankaPay Technnovation awards held at the Shangri-La hotel in Colombo on Thursday Dr. Coomaraswamy explained the reasons for the root cause.
“There is a very unusual attitude to the exchange rate in Sri Lanka where nowhere in the world people would assume it to be the key determinant to the fall of the economy. People feel, if the exchange rate deteriorates the whole economy will collapse.”
Sri Lanka’s exchange rate has been an issue since April this year despite the fact that some progress was made to stabilize the economy. Inflation is within the target rate of 4-6 per cent, reserves have increased in terms of quantity and quality while Sri Lanka has been able to raise US$ 1.5 billion. Despite these indicators of stability in the economy, the exchange rate is under pressure, he added.
He pointed out that Sri Lanka is not the only country where the exchange rate has come under pressure. Argentinian exchange rate has depreciated by 50 per cent, Turkey by 40 per cent, India by 10 per cent, the Philippines and Australia by 8 per cent, and Sri Lanka’s currency has also depreciated by 8 per cent as of Thursday.
“It’s not something which is very much an outlier in terms of what has happened to the exchange rate, though domestically we feel that things have drastically gone wrong.”
Factors behind the pressure of the exchange rate are many. The normalisation of interest rates in the US is one reason. The US Federal Reserves have been accelerating at a pace at which it has been increasing the federal funds rate. That has led to a large scale movement of capital from emerging markets back to the US. The global financial crisis saw unconventional monetary policies by major central banks that flushed vast amounts of liquidity into the global system and money moved to the emerging markets seeking high yields. This trend has now been reversed where money is going in the other (US) direction.
Among other reasons is the elevation of the political tensions globally. The trade tensions are now a trade war because tariffs are being imposed by both the US and China. US pulling out of the Iran nuclear deal has created uncertainty both in the oil market as well as within the region. “So when there is an elevated tension in the global economy, you see money moving to safe areas which is the flight of capital to safe areas. That again has reinforced the movement of capital to the US after all that’s the global reserve currency,” he stated.
Higher oil prices is another factor, noted Dr. Coomaraswamy. When oil prices rise, the oil importing countries tend to panic when money is moving out of their economies because of the pressure on the current account of the balance of payments.
These exogenous factors which were meant as developments have largely put pressure on the exchange rates, stressed Dr. Coomaraswamy while elaborating that one must also concede that this is due to a legacy of largely inappropriate policies that allowed Sri Lanka’s exports to come down from 33 to 12.5 per cent of the GDP.
“Policies that meant at the same time where exports were declining, where we took on a lot of external commercial debt and much of it was invested and budgets with low rates have been returned. Para tariffs protected us from getting into global production sharing network. All these things together have meant that we have a large deficit in our current account to the balance of payments. A large trade deficit which to some extent is mitigated by remittances and services including tourism but still there is a deficit,” he stated.
When there are many developments going on while money is moving out of emerging markets, countries become vulnerable when there is a deficit in the current account and Sri Lanka has become vulnerable in that range. He emphasised, “We need to get out of this box of being a country that has a sustained deficit after which you have much greater resilience in terms of withstanding exogenous developments that are taking place in the US.”
The Central Bank and government together have taken certain measures. The sharp rise in the import of gold and the result of arbitraging opportunity arose when Sri Lanka reduced the duty on gold to zero at a time when India had a duty of 14 per cent. People were importing gold duty free to Sri Lanka and smuggling back to India.
There was a sharp increase in the gold import. As a result the duty was adjusted by the Finance Ministry and gold imports have now stabilized.
Equally there is a large increase in the import of motor vehicles. In the first seven months of this year, the trade deficit increased by about $1 million, almost 2/3rds due to motor vehicle imports, particularly in the import of small vehicles. The duty on small vehicles has now been increased in response and additionally on Wednesday there was a margins requirement on LC’s for motor vehicle imports.
“Essentially what we are trying to do is to increase curbs when the currency comes under pressure where the outflows are greater than the deficit. One way to reduce the pressure is to reduce the outflows. These measures have been taken intending to reduce the outflows in the form of non-essential imports. The basic policy is to manage the exchange rate flexibly, however we will not permit excessive volatility and we will intervene very aggressively if necessary to prevent volatility,” noted Dr. Coomaraswamy.