Unravelling the exchange rate depreciation puzzle

By the Economist

The exchange rate continues to depreciate at a fast rate, though the country’s foreign exchange reserves are satisfactory, the trade deficit is decreasing and there is a balance of payments surplus this year. Surprisingly, these improvements in the international financial scene appear not to have any beneficial impact on the exchange rate. In actual fact they appear to be having a perverse influence. The Central Bank is crying foul and says that it should not be happening. Economists would find it difficult to explain this inconsistent economic behaviour within their conventional paradigms.

In the past 12 months, the exchange rate depreciated by 11 percent with the trend of depreciation gaining momentum in the past couple of months. Within the last month the exchange rate depreciation was at an even higher rate. This week the selling rate for the dollar was around Rs. 112 and the buying rate Rs. 116. The middle rate was around Rs.114 per US dollar. A year ago the middle exchange rate for the US dollar was 102.50.

The trade deficit that was US$ 2,140 million in the seven months of last year has been brought down by 15.6 percent to US$ 1,806 million in the first seven months of this year. Remittances are continuing to flow at a higher rate. In the first seven months, remittances increased by a handsome 19 percent to reach US$ 1,534 million, offsetting a large proportion of the trade deficit. Other capital inflows too have been high and have contributed to a balance of payments surplus.

With the containment of the trade deficit to a lower amount than last year and higher remittances from abroad, capital flows and other incomes, the balance of payments attained a surplus in the first seven months. Another important favourable development is the strengthening of the foreign exchange reserves. The foreign exchange reserves reached US $ 4,176 million at the end of July, one of the highest levels in recent times. These reserves were 13 percent more than what they were at the end of last year and adequate to finance nearly five months of imports.

Therefore, the international financial account of the country has improved. The exchange rate has, however, depreciated at even a higher rate than before. The impending US$ 500 million loan was also expected to boost the foreign exchange reserves and strengthen the currency. Yet what we observe is the opposite. What’s happening?

The Central Bank itself is quite surprised and shows that every conceivable technical evaluation and indicator does not justify the extent of depreciation. The Central Bank in a media release at the end of August 2007 described the rupee-dollar exchange rate depreciation recently as “excessive in terms of the favourable external sector developments recorded during the year.” It went further to demonstrate that the depreciation was not justified on the principle of Purchasing Power Parity (PPP) in relation to all of Sri Lanka’s trading partners.

It contends that the extent of the current depreciation is not justified on this basis. The Central Bank also points out that the Real Effective Exchange Rates (REER) with respect to two sets of countries: one set including five major international currencies and the other 24 major trading partner and competitor countries, demonstrates that the nominal bilateral exchange rates have already depreciated beyond the parity level.

The Central Bank points out that: “ Recent performance in Sri Lanka points to a healthy development with cumulative exports reaching 15.8 per cent growth and the trade deficit narrowing down to US$ 1,806 million during January to July 2007. The current account deficit also declined to US$ 478 million during the first half of 2007 from US dollars 786 million in the corresponding period in 2006.” The Central Bank expects these favourable developments in the external account to continue throughout 2007 and takes the “view that the currency depreciation is in excess of the path that is consistent with the strong external sector developments.” Furthermore, the Central Bank also contends that the behaviour of the exchange rate does not strictly follow the inflation differential.

The only way of explaining this perverse reaction in the exchange market is by going beyond the conventional financial statistics that are generally the indicators of exchange rate movements and see other aspects of the country’s economic performance and prospects. The stark economic reality is that the economic fundamentals are weak and consequently the expectations are of a deteriorating balance of payments in the fullness of time and consequent depreciation of the currency. The expectation of a continuing depreciation is based on several unhealthy economic indicators and expectations of a decline in some real sector performances as a consequence.

One of those indicators is the budget deficit. The large fiscal deficit created by spending on unproductive expenditure is one of the important weaknesses in the economy. Further these deficits are responsible for the high rate of inflation that is now reaching 17 percent. Another serious weakness is the country’s large public debt that threatens to exceed gross domestic product (GDP) for the year.

In view of these fundamental weaknesses, the favourable developments in the balance of payments and the high exchange reserves are not having the usual influence on the exchange rate. The high inflation rate in particular leads to expectations of a depreciation that itself creates pressures for depreciation. It will be in the interest of the economy if this is taken into account and corrective actions are taken to remedy the adverse economic fundamentals. To ignore these in the face of improvements in the country’s international statistics of trade and payments is unwise to say the least. Sooner or later these fundamental weaknesses would catch up to weaken the international financial statistics.

Not withstanding these observations, it must be admitted that the increasing rate of depreciation is excessive as the Central Bank has pointed out. Will the Central Bank now intervene in the exchange market to stabilise the exchange rate? Given its strong reserves this is most likely. Such intervention renders the floating exchange rate of the Sri Lankan Rupee a “dirty float”.