Financial Times

The writer says Sri Lanka has become a more ‘imported’ economy rather than an import-export economy where foreign earnings match the value of our imports. He says the best way to improve the situation is to raise the value of the local rupee and thus reduce the cost of living. In this article, he provides ways on how best this could be done.

We have been witnessing here an unfortunate phenomenon that depicts the gradual depreciation of the Sri Lankan rupee (LKR) against the US dollar (USD). What does this mean to the ordinary citizen? In order to clearly understand this situation, we need to explain the mechanics of exchange rates.

The nominal exchange rate, which we simply call the exchange rate(e) is the rupee price of a foreign currency. The exchange rate is the price of one country’s currency measured in terms of another country’s currency. There is a different bilateral exchange rate for each foreign currency.

For the purpose of understanding the mechanics of exchange rates, we will consider Sri Lanka as the home country and the USA as the foreign country. Thus, the exchange rate

‘e’ denotes LKR per USD. Obviously, the inverse of ‘e’ means the international value of the LKR measured as USD per LKR. Therefore,

e = LKR/USD
I/e = USD/LKR

To elaborate more on the point, the exchange rate between the LKR and the USD can be expressed in two ways, i.e.
(1) In terms of the number of LKR per USD and
(2) In terms of the number of USD per LKR

For example, the exchange rate between the two currencies in Sri Lanka as at 26th July, 2006 was
$1 = Rs 104.50 or equivalently
Rs 1 = $0.009569377

An increase in ’e’ factually denoted that the amount of LKR paid to purchase a USD has increased. This means that the USD has become more expensive or in other words, USD has appreciated. Of course the LKR falls in value, since the USD received from selling a LKR has fallen, which means the LKR has depreciated.

Hence, what is meant by the ‘appreciation of a currency’ is that its international value is rising whereas the ‘depreciation of a currency’ means that its international value is falling. The terms appreciation and depreciation refer to a flexible exchange rate system in which exchange rates are changing in response to the supply and demand in the foreign exchange markets.

Foreign Exchange Market
The law of demand and supply postulates that when all the other things remain constant (Ceteris Paribus – where the demand for a product /commodity is more than the supply of it), the price of that product/commodity will increase. Conversely, the above law also states that when the demand for a product/commodity is less that the supply of it, the price thereof will fall.

This truism will equally apply to the foreign exchange market as well. Therefore, it must be borne in mind that even the foreign exchange market too is governed by the law of demand and supply. Evidently, this means that if the supply of USD to the Sri Lankan market is relatively less than the demand for USD in the Sri Lankan market, the price of USD in terms of LKR will invariably rise. In such a scenario, Sri Lankans are called upon to pay more LKR to buy USD. This illustrates a situation where the international value of LKR has depreciated.

The converse of this situation is also true, where the supply of USD to the Sri Lankan market is relatively more than the demand for USD in the Sri Lankan market, then the price of USD in terms of LKR will inevitably fall. This situation manifests that the international value of LKR has appreciated wherein Sri Lankans are expected to pay less LKR to buy USD.

In the context of this scenario, Sri Lankans must endeavour to supply more USD to the market and demand less USD from the market, if the country is eventually going to benefit. (At this juncture, I want to highlight the methods through which a country could earn foreign exchange (supply of) and expend foreign exchange (demand for).

The Supply of Foreign Exchange:
FEs = X+CIp

This is the sum of two components:
(a) Receipts from exports (X), or in other words, export earnings that constitute

merchandise exports, services sold and income received on Sri Lankan assets abroad.

(b) Receipts from sales of Sri Lankan assets to foreigners, which are private capital inflows (CIp).

The Demand for Foreign Exchange:
Fed = Q+COp

This originates from two sources:
(a) Imports of goods and services (Q), or in other words, import expenditure that constitutes merchandise imports, services bought, income paid on foreign assets in Sri Lanka and foreign loan repayments.

(b) Purchase of foreign assets by Sri Lanka, which are private capital outflows (COp).

Traditionally, Sri Lanka had been considered as an import-export economy, but soon after the introduction of the so-called ‘open economics system’ (Open Sesame), the equilibrium (balance) between imports and exports became drastically eroded and disrupted which resulted in the imports expenditure rising by leaps and bounds over the export earnings. Currently too, this scenario persists, unhampered and unabated, with the adverse consequence of the Sri Lankan Rupee rapidly depreciating.

Remedial measures suggested
Against this gloomy backdrop, let us examine how we could beat this depreciating rupee scenario. Although there are several prudent strategies encompassing the short-term, the medium term and the long-term in order to arrest this unfortunate situation, my focus in this paper will only target the short-term strategies, because the implementation of the medium-term and the long-term strategies obviously will be dependent upon the efficient and effective operation of the short-term strategies. For the purpose of this exercise, the short-term may be regarded as period less than six (6) months.

Conserve foreign exchange
Stated in very simple terms, in order to conserve foreign exchange (USD) action must be initiated to reduce the demand for foreign exchange by way of restriction of imports. It is an open secret that unwanted, low quality, sub-standard imported products are proliferating in the Sri Lankan market. These products may be classified under the following headings.

(1) Used Motor Cars: Under the guise of the ‘reconditioned’ banner, several thousands of ramshackle motor cars have been imported into the country. Even a cursory glance at the imported used motor car yards existing at many a place around the country, will bear testimony to this fact. Immediate action should be initiated to prevent this wanton waste.

(2) Used Motor Cycles: It is a common knowledge that the life span of a motor is very short, relative to the life-span of motor car. Motor cycle yards existing throughout the country, will invariably narrate a pathetic story about the life-span of the motor cycles available therein. Looking at such yards, one wonders how careless and wanton the authorities have been, in permitting the imports of such motor cycles.

(3) Electrical Items: Sub-standard electrical items, appliances, gadgets etc., even without the country of origin have flooded the shops and pavements everywhere in the country. Why authorities have approved such imports to the country remains a question in the minds of many.

(4) Electronic Items: Sub-standard and low quality electronic items such as radios, cassette-players, TVs, tape recorders, computers and accessories etc., with no mention of the country of origin also have invaded the markets in Sri Lanka. Who seems to be responsible for such a massive drain of foreign exchange that went to purchase these items?

(5) Wrist-watches and Clocks: Low-quality quartz wrist-watches and clocks with no guarantee on efficacy and durability have been imported to Sri Lanka without any restrictions.

Heaps and piles of quartz-wrist-watches seen around the metropolitan areas in the island will prominently vouch for the veracity of this fact. One can imagine the quantum of foreign exchange saved if these items were not permitted to import at the very outset.

(6) Textiles and Ready-Made Garments: These items too have been imported to the island sans any restrictions, some of which are found to be sub-standard.

These low quality, sub-standard imported textiles and ready-made garments have become not only a drain on foreign exchange but also pose a threat to the local textile and garment industries.

(7) Toys and other Similar Items: Although toys and other playing items are necessary for children, they must be imported only from sources of reliable manufacture and also must never be allowed to be imported laissez-fare.

(8) Food and Edible Items: A cursory glance at some shop shelves and pavement will reveal the fact that there are many imported food and edible items which do not confirm to certain accepted standards. How these items came to be imported to the island remains a matter of utmost secrecy.

(9) Cosmetics and Perfumes: Notwithstanding the fact that these imported items are high-priced, they seem to proliferate in the market, going down even to the street-vendor’s mat.
When perusing the labels attached to the containers, even though one may discover that they claim to be well-known international brands, their true origin and authenticity seem to be dubious. Should the country utilize foreign exchange in order to import such questionable items?

(10) Hardware Items: Whether imported or locally made, hardware items such as mechanical tools, padlocks, hammers, spanners, measuring equipment, mason’s tools, etc, invariably should be strong enough to withstand hard pressure and strenuous work. It is found that some of the imported items of this nature do not meet the expected standards. Is not the import of these tools, a wasteful and unwanted drain on foreign exchange?

If diligent and meticulous action could be initiated to regulate and restrict the release of foreign exchange utilized to import the items enumerated above, Sri Lanka will be in sure position to conserve a considerable amount of foreign exchange particularly in the short-term. Stated in different terms, Sri Lanka will be able to substantially reduce the current demand for foreign exchange.

In essence, this means that when the demand for USD becomes less, relative to the supply of USD to the market, the international value (I/e) of LKR will rise (appreciate) thereby beating the depreciating LKR. Eventually, it will lead to a situation, wherein the essential imports to the country will also cost less in LKR terms.

Thus, the imported raw materials (inputs) that go into the manufacture of locally made products similarly will cost less in LKR terms. Hence the finished products too will cost less in the local market as well as in the international markets due to economics of scale, ultimately contributing to the overall increase in the aggregate demand.

This increase in the aggregate demand naturally will serve as an impetus to the enhanced domestic production.