Capital flight due to uncertainty puts pressure on rupee

By Natasha Gunaratne

It was 1977 when former Minister of Finance Ronnie De Mel expressed his intention to make the Sri Lanka rupee the strongest currency in the world during his budget speech to Parliament.

War ruined Lanka’s hopes of being another Singapore If not for the ethnic conflict that has ravaged the country, Sri Lanka would have been another Singapore, says Ronnie De Mel, Economic Advisor to the President and former Minister of Finance. Elaborating on comments he made in a 1977 budget speech about the strength of the Sri Lanka rupee, he said at that time, the country had seen a growth rate of 8.3%, the 'highest in the whole of Asia and probably the highest in the world.' At that point n time, he said there was no China and India so there was justification for his hope. "Unfortunately, my hope was never fulfilled." De Mel said that since 1983, Sri Lanka's economy has been moving backwards and attributes the decline to the ethnic conflict that has ravaged the nation. He recalled that in 1978, Lee Kwan Yew, the former Prime Minister of Singapore was invited by then President J.R. Jayawardene to come to Sri Lanka to offer some advice as to whether the country was going down the right economic path. "Before us, Lee Kwan Yew was the only person to liberalize an economy with the exception of Chile was done under a military regime," De Mel said. "There was opposition from various people in Sri Lanka who were advocates of a closed economy. All newspaper groups opposed me. All were against it and there was some confusion and a fair amount of doubt even within the Cabinet." After a week long visit by Yew along with six members of his Cabinet, final discussions were held at the President's house in Nuwara Eliya where Yew expressed great enthusiasm. "I popped a question and asked him if we went on like this without any break, how long will it take for Sri Lanka to get to Singapore's level?" The answer was 10 years but Yew told former President Jayawardene that it is imperative that the ethnic conflict be settled. De Mel said that after 1983, the problems that arose have severely prevented Sri Lanka from 'being one of the Tigers of Asia .' The problems never ceased even though there have been periods of ups and down but by and large, as long as there is no peace, it will always be difficult to get stable economic growth of over 8% and sustain it over a long period of time.

Thirty years later, rather that gaining in strength or holding its own against other currencies, the Sri Lanka rupee has depreciated by a staggering 1668%, averaging around 55.6% a year. Despite the highly touted and much publicized Gross Domestic Product (GDP) growth of 7.4% in 2006 by the government, the rupee continues its downward spiral.
The Sunday Times FT sought the views of a cross section of people to ascertain the reasons for the steady deterioration of the local currency.

Eminent economist Dr. Nimal Sanderatne said a distinction has to be made between devaluation and depreciation. "Devaluation is when you consciously change the exchange rate. What has been happening since November 1977, when it was devalued is a depreciation of the currency," Sanderatne explained. Market forces have tended to depreciate the currency because export earnings have been inadequate at financing the import demand. Consequently, there has been a balance of payments deficit every year since 1978. In most years, the deficit has been counter balanced by capital inflows which are remittances, aid, foreign direct investments and such inflows.

High costs
Sanderatne attributes the problem to an increase in the cost of production. With a fixed exchange rate, export prices rise. "This means the foreign consumer has to pay a higher price but as we are in competition in the international market, we can't raise our prices by anything higher than our competitors," he said. "If our competitor's rate of inflation and production cost is less, then we lose. One of the ways of adjusting is by adjusting the exchange rate."

The internal cost of production has gone up and to remain competitive in the international market, it has become a necessity to depreciate the rupee. For example, Sanderatne said if the cost of production rises from Rs.100 to Rs.110 and the exchange rate is Rs.100 to a dollar and the rate remains unchanged, the export item will cost US$1.10. "If competitors still sell at a dollar, you can't sell at US$1.10. This is what has been happening."

The country faces similar problems when it comes to imports. "If the exchange rate is constant, your domestic price will be higher relatively to imports and if you don't depreciate, you will be importing more and more and the balance of trade gets to be worse," Sanderatne argued. "In the current situation, the currency is depreciating because the domestic rate of inflation is high and the cost of production is increasing. Unless there is real productivity gain, you have to depreciate in order to cut down your imports and maintain or increase your exports."

Principal researcher at the Point Pedro Institute of Development, Dr. Muttukrishna Sarvananthan attributes the depreciation of the rupee, on the demand side, to an increase in military procurement and capital outflow or flight through formal and informal channels. On the supply side, a reduction in foreign aid and reduced tourist traffic is fuelling depreciation. Furthermore, he says there is a moderate balance of payments problem in the country which remains unacknowledged by the government or the authorities.

Free float
Sri Lanka partially floated the rupee in 1977 although it was not a 'free float' but a 'managed floating rate system.' In other words, the Central Bank determined the daily exchange rates (in terms of market rates) and informed the commercial banks (both private and government banks). However since January 21, 2001Sarvananthan said the rupee was freely floated. That allowed commercial banks, public and private, to determine its exchange rates on a daily basis and transact accordingly. "Hence, the cause or causes for the devaluation or depreciation of the rupee under different policy regimes would differ. Therefore, it is a time consuming exercise to find out the causes for the depreciation of the rupee since 1977."

Depreciation takes place when demand for foreign currencies outstrips the supply of foreign currency in the foreign exchange market. Since October 2006, there has been a rapid depreciation of the rupee for a variety of reasons. According to Sarvananthan some plausible reasons could be the increasing demand for foreign currencies due to the rise in imports, capital outflows, outward remittances and the decreasing supply of foreign currencies. The decreasing supply could possibly be due to a drop in exports, foreign investment, foreign remittances and a decrease in tourism earnings.

However, Sarvananthan says exports have been quite buoyant last year and early this year. Imports have dropped in the first two months of 2007. Thereby the trade deficit has declined in the first two months of the year. "Besides, net inflow of foreign remittances has been high last year as well as this year so far. Official figures also suggest that total foreign investment last year was the highest ever (US$600 million).

However, there has been a significant drop in foreign aid during last year compared to the previous year." This trend has continued into this year as well. There was not only a drop in official development assistance but also drop in flow of funds to Non Governmental Organizations (NGO's) due to the anti-NGO sentiments expressed by the government and others. Tourism earnings have also dropped during the peak tourist season from October 2006 to April 2007 because of the bomb attack in Habarana and the Galle naval camp attack in October 2006 and more recently, the air raid on the Katunayake Air Force base this year.

Balance of payments
The overall balance of payments dipped into the red by the end December 2006 and end January 2007 but recovered and posted a surplus of US$53 million by the end of February 2007. Sarvananthan says that the fact that the balance of payments was negative indicates that the demand for foreign exchange was greater than the supply.

Depreciation of the rupee could be caused outside the official balance of payments situation as well. "My hunch is that due to the deterioration in the security situation, there is considerable capital flight from Sri Lanka which has led to heightened demand for foreign exchange, both in the formal as well as informal markets." This is a primary reason for the recent depreciation in the past six to seven months. Furthermore, the heightened procurements of military hardware compound the demand pull depreciation of the rupee.

Depreciation not only raises the cost of living (because of higher cost of imports including fuel) but propels exports by reducing the cost of exports in foreign currency. Depreciation also increases the cost of foreign debt servicing.

"That is, more rupees need to be spent to pay off one dollar of foreign debt," Sarvananthan said. "Rise in the cost of debt servicing increases public debt, which in turn fuels inflation. Thus, it is a vicious circle. However, depreciation could boost tourism and perhaps foreign investment as well."

Staying competitive
Head of Global Markets at Commercial Bank Dudeepa Ratwatte said the rupee has to stay competitive in order to boost export growth. "The country is a net importer so hence there will always be pressure on the rupee and a degree of depreciation," he said. The rupee will continue to depreciate until trade figures improve or there is a large influx of capital to the country. Ratwatte pointed out that the rupee appreciated after the 2004 tsunami.

Lead economist at Lirneasia Harsha De Silva said the rupee should have actually depreciated a lot more than what it is currently at. "Recent calculations by the Central Bank (CB) indicate that the real exchange rate is overvalued," he said. "In other words, the rupee has been uncompetitive from early 2005 to the tune of about 13%." "This is a political decision," De Silva, who has also been advising the UNP on economic issues, said. "Because we have such high inflation, we should have let the rupee fly. However, the government does not want the rupee to fly because the cost of imported materials will go up." He pointed out that this is clearly the case with the Ceylon Petroleum Corporation (CPC). Oil prices are dropping globally but are increasing within Sri Lanka.

Real Effective Exchange Rate (REER)
De Silva said the CB has developed an index to measure the Real Effective Exchange Rate (REER) where the rupee is not measured solely against the US dollar but rather by the weighted basket of trade between Sri Lanka and other countries. The CB website states that two widely used indicators to measure exchange rate changes are the Nominal Effective Exchange Rate (NEER) and the REER. The website says the NEER is 'a weighted average of major bilateral nominal exchange rates, with weights based on the trade shares reflecting the relative importance of each currency in the effective exchange rate basket.' The REER is 'obtained by adjusting the NEER for inflation differentials with the countries whose currencies are included in the basket.'

As the inflation rate in each country is assumed to broadly indicate the trends in domestic costs of production, the REER is expected to reflect foreign competitiveness of domestic products, according to the CB. The website also further explains that 'the selection of the countries in the basket is based on bilateral trade shares and the importance in terms of competitiveness of those countries exports with Sri Lankan exports in international markets.' A rise in the indices indicates appreciation of the rupee and vice versa, the CB website states. According to statistics provided by the CB, the REER for March 2007 stood at 109.09, down from January 2007 which was 113.73. Similarly, the NEER for March 2007 was 60.43, down from January 2007 which was 61.21.

Capital account
"Supposing we trade a lot with the United States, the US dollar will have a greater bearing than Spain," De Silva explained. Based on historical trading patterns, trading partners reflect a certain weight in the index. "It's a very theoretical construct." The CB says the NEER and REER are based on trade composition with 24 trading partner countries and computed on a regular basis by the bank.

De Silva said that if capital accounts are liberalized where money can flow between countries without any restrictions, the exchange rate will adjust on a constant basis to align itself with the interest rates in other countries. This is called 'interest rate parity.'

"Theoretically in a free market where money can flow between countries, the interest rates offered by differing countries will, after considering the increase or decrease of the value of that currency based on depreciation, be the same," De Silva explained.

"The important question to ask is what is the reason for the expectation for depreciation?" It is an expectation because you invest for the future. Whatever depreciation was last year is immaterial for the next year. "If someone in the UK wants to invest in the US, they would want to know by how much the pound will appreciate or depreciate against the US dollar during the time the investment is in the bank."

Depreciation
A certain amount of depreciation is expected due to the difference in inflation between two countries.
For example, if there is high inflation in Sri Lanka and low inflation in the US, the rupee will have to depreciate by that difference. De Silva said this is the theoretical argument but again, it doesn't happen exactly that way." Generally over a period of time, it can be observed that the depreciation is simply the difference in inflation between two countries.