Once again the question has arisen as to whether the exchange rate should be allowed to depreciate. In the face of adverse developments in the trade balance and balance of payments, the Central Bank has intervened to stabilise the exchange rate of the rupee.
Recent interventions by the Central Bank to support the rupee by selling dollars have raised apprehensions about the advisability of this policy. According to conventional policy prescriptions of the IMF such interventions are considered ill-advised and the IMF has warned the Central Bank that it should refrain from doing so.
However, the Central Bank is of the view that its policy on exchange rate is appropriate in the circumstances and will continue to follow such prudent policy. According to a Central Bank statement, "the (IMF) mission has commended the significant macroeconomic achievements and stability of the economy and has indicated the need for more flexibility in the exchange rate with limited intervention by the Central Bank." The IMF, on the other hand, states that such interventions are reckless.
The Central Bank position
The Central Bank defends the interventions on the grounds of having adequate reserves to do so. The Central Bank in its statement says that it "wishes to emphasise that the gross official reserves of the CBSL has now reached the historically highest level of US dollars 8.1 billion, substantially above the desired levels and sufficient to cover 5.8 months of imports."
Impliedly, the view of the Central Bank is that a relatively stable exchange rate is good for the economy. This is counter to the view that a flexible exchange rate involving depreciations and appreciations of the currency are needed to ensure that the trade balance and the balance of payments are not adversely affected.
The Central Bank statement adds: "The exchange rate policy of the Central Bank has been consistent where Central Bank intervenes in both sides of the market to maintain stability while also allowing adequate flexibility.
So far during the year, the rupee has marginally appreciated against the US dollar and has depreciated against other major currencies; at rates of 4.7 per cent against Euro, 3.2 per cent against Sterling Pound; and 5.0 per cent against Yen.
During July and August this year, the Central Bank had to intervene in the foreign exchange market as there were some pressure mainly to absorb the proceeds of the sovereign bond of US dollars 1.0 billion and to ease some pressure attributable to significant increase in import demand particularly in the backdrop of increased oil imports."
A further justification is the expected capital inflows. On this, the Central Bank says that: "Going forward, it is evident that significant inflows of foreign exchange are forthcoming on account of investments in various projects including in the areas of tourism, ports, and telecommunications, manufacturing and assembling industries as well as to the debt and equity markets. Inflows to the government to finance various infrastructure projects are continuing. Foreign remittance inflows as well as inflows to the services account, which includes earnings from tourism, port and airport services, continue to be strong. At the same time several commercial banks have also indicated that they would raise their Tier 2 capital and a part of that would come from foreign sources. These will lead to substantial increases in foreign exchange liquidity in the market."
It is on the basis of the adequate reserves and the expected inflows of receipts of services and capital inflows that the Central Bank has justified its interventions in the foreign exchange market.
In contrast, the IMF position is based on the adverse effect the overvalued exchange rate would have in lessening the country's competitiveness in the international market and the inflow of imports owing to the lower rupee import prices.
The IMF view
The IMF is of the view that Sri Lanka should adopt a more flexible exchange rate policy. What this means is that when there is pressure on the balance of payments, it should allow the rupee to depreciate and vice versa. Such movements in the exchange rate are expected to correct the trade balance and the balance of payments. It has said that a central bank that continues to spend reserves to defend a currency, without allowing rates to go up can trigger a currency crisis. They have cautioned that balance of payments crisis is triggered when a central bank tries to defend both an exchange rate and interest rate target simultaneously.
The Central Bank's intent on maintaining the value of the rupee has made it sell dollars. In July the Central Bank sold 416 million US dollars while in August it is estimated that the Central Bank sold around 300 million US dollars. This would further strain the foreign reserves even though they are strong at US$ 8.1 million.
The IMF has warned the country of the dangers of this policy and suggested that the country has a more flexible exchange rate. This may be particularly necessary due to the current adverse developments in trade and remittances. The IMF has pointed out that a central bank that continues to spend reserves to defend a currency, without allowing rates to go up can trigger a currency crisis. Often balance of payments crises are triggered when a central bank tries to defend both an exchange rate and interest rate target simultaneously.
Central Bank policy
The Central Bank has followed a strategy of not changing its policy interest rates. For most part of 2011, Sri Lanka's policy interest rates have been around or below inflation. The IMF is of the view that at current interest rates the banking system is not generating enough deposits, creating an imbalance in the domestic monetary system that is weakening the dollar peg. However inflation has been in control. According to the statistical compilation of the Department of Census and Statistics, inflation in August fell to 7.0 percent from 7.5 percent a month earlier. Perhaps the IMF is not convinced of this statistic, especially as the consumer price index has been changed once again.
Economic context
It is important to place the exchange rate policy in the context of Sri Lanka's trade and balance of payments situation, as well as the country's debt in relation to its reserves. In the first half of the year, imports have expanded to such an extent that despite an impressive growth in exports, there is a widening gap in the trade balance. The trade deficit has already reached a massive US 4.25 million and at present trends likely to exceed US $ 9 million.
The magnitude of the trade deficit is of such proportions, that the worker remittances although still increasing are not likely to finance more than about 55 percent of the trade deficit.
Tourist earnings are definitely increasing and will lend a significant support to the balance of payments. If the capital inflows that the Central Bank expects materialise, there is still the chance of a balance of payments surplus or the balance of payments deficit being small.
However the trade imbalance must be recognised. The overvaluation of the exchange rate implies that imports would continue to increase unless this is corrected by increasing tariffs on imports.
On the other hand, the overvaluation of the exchange rate could affect the competitiveness of the country's exports. This would apply especially to industrial exports. The tea industry is facing a crisis due to the turmoil in the Middle East that has disrupted exports to some of the important markets for Sri Lanka tea. Tea prices have consequently fallen. To make matters worse there has also been some labour unrest that has disrupted production. The recent increase in labour costs coupled with the drop in international prices is causing a cost price squeeze. The depreciation of the currency would have helped tea exports at this point of time.
Although the country's reserves are high at over 8 billion dollars, much of this is formed by borrowing in international capital markets. Resting on the laurels of the reserves in the trade and balance of payments context that has been outlined, may not be a prudent policy.
A more carefully thought out exchange rate policy is necessitated by the emerging international developments. The Central Bank may have to consider raising policy interest rates especially if the current rates of interest do not attract adequate deposits to the commercial banks. The management of the exchange rate is at a critical period. An improvement in the international developments discussed earlier would be the best hope for the country.
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