Exchange rate in turbulent times
View(s):The most attentive local business news in the past week was, perhaps, the exchange rate; it depreciated sharply reaching Rs. 170 per US$. As some media called it, Sri Lanka reached that high rate “for the first time in history”. It looks like a statement a mom made about her 10-year old child: “My child is now 10 years old for the first time after his birth!”
The Sri Lankan rupee exchange rate which was Rs. 16 per US$ in 1977 has been continuously and constantly on a downward path depreciating over the past 41 years.
Therefore, every year it recorded the “highest,” breaking its own historical record.
However, the year 2018 is a special one: It is depreciating almost every day hitting its previous day records. Why? I thought of taking this issue today because I have seen many misconceptions out there. Depending on the angle that you look at it, you may also realize that someone would say “the glass is half-empty,” while another will say “the glass is half-full.”
International turbulence
These are turbulent times in the international economy. The fast depreciation of the Sri Lanka rupee is basically a response to external factors. Apparently, a weaker rupee is more vulnerable to external shocks than a stronger currency.
I have heard many saying that, rupee was getting weaker since the time Sri Lanka became an “open economy”. Give me a break! Sri Lanka is not an “open economy” and, I will talk about it some other day.
Because the current problem is global, the exchange rate problem has hit many countries that experienced sharp depreciation of their currencies: While the Sri Lanka rupee depreciated so far this year (up to September 17) by 7 per cent against the US dollar, the Indian rupee depreciated by 10.9 per cent, Australian dollar by 8.2 per cent, Indonesian rupiah by 8.9 per cent and the Philippine peso by 7.7 per cent. In addition, Chinese renminbi, Taiwan dollar, Korean won, Singapore dollar, British pound, Malaysian ringgit and Euro, have all depreciated against US dollar at different rates.
Strengthening US dollar
The global storm that caused the international turbulence was partly emanating from the strengthening US dollar.
There are at least two sides of the US dollar problem: One of them is the continuous interest rate hike in the US. The Federal Fund Rate was near zero level during the time of a global financial crisis is now at 2 per cent; it is expected to rise up to 2.5 per cent by the end of the year and further in the subsequent years.
The increase in interest rates has a double impact on the US dollar; it makes borrowing costly so that credit-financed spending is expected to be under control. This will reduce pressure on import expenditure on the one hand.
The second implication of the interest rate hike is due to increased dollar inflows to the US from the rest of the world. Financial investments in stock markets and security markets in other countries will experience greater outflows.
Both channels will strengthen the US dollar. If you examine both the reduction in US imports and the increase in financial inflows, they both affect negatively to other countries resulting in a corresponding depreciation in their exchange rates.
Strengthening trade war
There is another issue that has caught world attention: the escalation of a trade war between the US and China. These two are the world’s super powers today, according to the size of their economies. The two countries together possess about 40 per cent of the world GDP.
The US is a country that has been used to consume more than what it can afford to, by borrowing from the rest of the world; the interest rate hike is part of the answer to that problem as well. As a result, however, the US has a massive trade deficit exceeding $500 billion as of 2017. The problem with China is that 75 per cent of this trade deficit is with China!
File picture of a vegetable market. The writer argues that currency depreciation is inevitable due to external issues.
The US strategy to deal with this issue was to reduce trade deficit with China by imposing more tariffs. The US fired the first bullet, imposing higher tariffs on $50 billion worth imports from China.
Now would anyone expect China to remain silent being a super power? No, it also retaliated imposing higher tariff on the same amount of imports from the US.
China has a missile
Last Monday, the US announced the firing of its second bullet covering $200 worth imports from China with higher tariffs. Why would China remain silent?
The US has even threatened that, if China retaliates, the US is prepared to bring all imports from China under higher tariffs. More than 20 per cent of US imports come from China alone.
However, China has even stronger weapons to fight its trade war with the US. Perhaps, it is China as a single country that has lent to the US more than any other country. China holds more than US$ one trillion worth of US securities.
What would happen if China decides to send a “financial missile” by reducing US bonds? I can’t imagine the world financial chaos that this would cause first through the US interest rates that would translate into more exchange rate issues in the world.
So far the story
Without going that far, however, the current attempts made by the US to deal with its massive trade deficit together with interest rates hikes have already created external turbulence which has sweeping implications on the exchange rates all around the world.
The Sri Lankan exchange rate is also under pressure. Although the situation is fundamentally temporary, the forces underlying turbulence are not yet over. They have created much uncertainty in the world’s international economic order.
Immediate measures?
Many have asked me what would be the immediate policy measures that can be adopted to stop the exchange rate depreciation. I said that at the beginning that the Sri Lankan rupee had been weakening year by year for 41 years now. If it had not been weaker, we would have had more shock therapies in our hand at this moment. But we are left with almost no medicine at home now!
Imagine the usual strategy of releasing the Central Bank’s foreign reserves to meet the excess demand for US dollars and to hold the exchange rate. The negative repercussions of the use of our little amount of foreign reserves less than $8.5 billion are much greater than using it to hold the exchange rate. We should not forget that this is the year of foreign debt repayment!
Someone might also argue that imports can be controlled. Sri Lanka’s import controls are already severe; as the US Department of Commerce has classified it; that Sri Lanka has a “prohibitive” tariff regime. Besides, the negative implications of bringing even more import controls back to the scene will have even more severe negative implications on long-term economic growth.
Then, what?
The best immediate remedy is to let the exchange rate depreciate as it does now. The country can achieve the same result of import controls by allowing the exchange rate to depreciate; the import demand will respond to the higher domestic prices easing the pressure on the exchange rate.
While allowing that, there are two important things to do: The first is that refraining from adding more fuel to the fire with short-term policies. The second is that, at least it might be a good idea to commence our abandoned reform process to bring export growth back on track; then the country will be in a stronger position to face the challenges in the years to come.
(The writer is a Professor of Economics at the Colombo University. He can be reached at sirimal@econ.cmb.ac.lk).