Global Currency Crisis: Can Sri Lanka stabilise its own currency?
It is an apparent fact that currently most of the developed and developing nations have lost their own smooth-running economies and are heading towards a rapid economic turmoil. Such turmoil is reflected by their key macroeconomic variables such as economic growth rate, interest rate, and exchange rate and stock market indices. Economists and policy makers warn of a potential global economic crisis for the first time after the global financial crisis occurred in 2008. However, the predicted crisis seems to be mainly driven by a currency crisis which is already apparent in many countries. Furthermore, International Monetary Fund (IMF) highlighted that growing trade and geopolitical tensions along with rigid macroeconomic policies will considerably worsen the situation.
File picture of old currency notes which are not in use today
Geopolitical issues, global trade tension
The US, China and India have been the key forces in the global economy. However China’s rapid growth and efforts to form the world’s largest regional integration – so called ‘One Belt One Road’ (OBOR) – creates a geopolitical tension among other counterparts. The nationalist approach of US President Donald Trump is mainly to capture the geopolitical power over China and other key nations. Ultimately, the geopolitical tension turned into a US-led trade war driven by mainly three aspects.
Firstly, tit-for-tat tariffs between the US and China initiated this trade tension. Secondly, Trump expressed his intention to withdraw from NAFTA and initiate bilateral trade with Mexico and Canada. Thirdly, the US imposes higher tariffs on imports from the EU and other countries.
In fact, the trade war initially started last year with 10 per cent tariffs imposed on China and this tariff rate is expected to be increased up to 25 per cent by the end of this year. Beijing responded to US by imposing 10 per cent tariff on US$60 billion worth imports from the US. The US imposed tariffs not only on China, but also 15 per cent on Europe and 12 per cent on the rest of the world as well. The trade tension was further escalated due to the US’s intention of withdrawing from NAFTA and initiating bilateral agreements with Mexico and Canada. As the World Economic Outlook highlighted, the trade tension reduced world trade volume from 5.1 per cent in 2017 to 4.8 per cent by 2018 and it is expected to reduce further down to 4.5 per cent by 2019.
The slowdown in trade volume is expected to be adversely affected on global economic growth as well. In fact, the drop in global economic growth started with ‘China’s New Normal’ which has key features such as shifting economy from previously adopted high speed growth (around 10 per cent) to medium (around 7 per cent) but steady growth and focusing on an economy driven by innovation and productivity instead of input driven. The New Normal of China adversely affects the growth rate of many countries which supply inputs to China nominated as ‘Factory of the World’. The combined effect of these two recent incidences led IMF to cut down its global economic growth from 3.9 per cent to 3.7 per cent.
Stronger dollars, weaker currencies
The US dollar has been depreciating since 2003 and reached its worst position in 2007. In 2017 the US dollar was drastically depreciated which started since 2003. In fact, President Trump expected the dollar to depreciate further in order to promote its exports. However, sharp reduction in corporate tax in the US encouraged US firms who performed outside the US to relocate in the US. Therefore, there has been a growing demand for the US dollar with huge inflows of capital. In turn, the dollar started appreciating since early 2018. Moreover, the US’s decision to increase the interest rate also caused an inflow of capital toward the US, further strengthening the US dollar.
The combined effect of such policies helped to surge the economic growth of the US to 4 per cent while most other countries are losing their economic momentum. In fact, this economic gain also is one of the key reasons for an appreciating US dollar. Apart from that, the trade tension created by the US reasoned to change their previous expectation of having a depreciated dollar. The US’s decision to increase tariff adversely affected the currencies of most of the developing and emerging countries including Chinese renminbi and Korean won. In contrast, the US dollar started appreciating continuously.
This unexpected increasing trend of the dollar is expected to continue further. The appreciation of the US dollar dramatically depreciated other currencies in countries such as China, India, Pakistan, Indonesia, Russia, Sri Lanka and South Korea as well.
The depreciations of Yuan, Won, Ringgit and Singapore dollar are below the average of 10.5 per cent. The general trend in currency depreciation has accounted for severe internal and external macroeconomic imbalances of such countries that are currently struggling to get away from such severe depreciations.
Sri Lanka rupee
Unlike major currencies in developed countries, the Sri Lanka rupee is one of the isolated currencies in the world. Taking historical observations, the rupee depreciated from Rs. 4.76 to Rs.15.56 during the period of 1950-1977 under fixed exchange rate policy. As the Central Bank highlighted, Sri Lanka rupee depreciated approximately 19 per cent per year under managed floating exchange rate regime and therefore this depreciation accounted for 415 per cent of depreciation in total over 22 years.
Apart from that, Sri Lanka rupee has depreciated 941 per cent during the last 40 years, which is around 23 per cent per year on average. More specifically, the recent depreciation trend in rupee is widely being discussed and in fact, the rupee has depreciated by 11.8 per cent during the period of December 2017 to October 2018. As discussed previously, most of the developing and emerging markets are suffering from a currency crisis mainly due to global economic unrest which includes global trade tension and macroeconomic policies of the US. However, in addition to such global issues, Sri Lanka has several in-built factors which weaken the rupee.
Sri Lanka’s low export earning is one of the most apparent factors of such depreciation. It is a well-known fact that the exchange rate is determined by both supply of foreign exchange and demand for foreign exchange. Foreign exchange supply of Sri Lanka is mainly driven by export earnings, workers remittances and tourism receipts. Particularly, declining trend in export income as a percentage of GDP has been a severe issue in terms of external sector development of Sri Lanka. More specifically, export earnings as a percentage of GDP has dramatically declined from 32.3 per cent in 2005 to 21.4 per cent by 2016. This reduction in export earnings is mainly due to a drop in agricultural and industrial exports. In fact, competitiveness of Sri Lankan exports is considerably low due to low productivity in export-oriented industries compared to other Asian counterparts. Similarly, Sri Lanka is still unable to benefit from the global supply chain in order to optimise trade benefits. However, a country like Vietnam has extensively increased its export volume (93.3 per cent of GDP) by linking with global supply chains. The countries which have higher productivity also have higher competitiveness in terms of external trade. Hence, they are capable of gaining trade-based comparative advantages, while ensuring high volume of foreign investments, leading to create a BOP surplus. Ultimately, the surplus in BOP strengthens the currency against the dollar. Unfortunately, Sri Lanka has been experiencing unfavourable conditions in terms of both trade-based comparative advantages and inflow of foreign investments. Thus, Sri Lanka’s widening BOP deficit puts a downward pressure on the rupee.
While Sri Lanka has been facing a drastic decline in supply of foreign exchange, there is a growing demand for foreign exchange in order to settle the huge import bill and massive external debt. In fact, a stock of foreign reserve is the key victim of huge import bill and the current stock of reserve ($7.2 billion) is sufficient only to cover the import bill for four months. Apart from that, Sri Lanka’s external debt accounted for 60 per cent of GDP, which has increased equivalent to $3487.28 million in the second quarter of 2018 from $52090.15 million in the first quarter of 2018. In addition to the huge import bill, paying back of foreign debt also demands a large sum of foreign reserves, resulting in the rupee depreciating further. While huge external debt depreciates the rupee, the rupee depreciation also adversely affects foreign debt payments. By January 2018, Sri Lanka’s outstanding external debt was $308 million. Under this situation, if the price of the dollar increases by one rupee (from Rs. 171 to Rs. 172), Sri Lanka’s foreign debt will also increase by Rs. 308 million. Thus, this is an alarming situation and the impact would be more severe in coming years as foreign debt payments are expected to be maximised during the period of 2019-2022. Apart from that, the exchange rate will dramatically increase the prices of imported goods. Consequently, an inflationary pressure can be seen in the economy with hike of price indices. The Government and the Central Bank have imposed several controls over dollar transactions in order to stabilise the exchange rate. However, those efforts have become pointless and have also created short term economic unrest in the country.
Finally, it is highly essential to understand the root causes of rupee depreciation and find long term and steady solutions for such causes. In fact, it is repeatedly stated that Sri Lanka should address fundamental macroeconomic issues such as low productivity and competitiveness, lack of access to global supply chain, narrow export basket, nondiversified export market and low economic growth rather than defending a politically abused current model in order to stabilise the rupee and to sustain its long term stability.