There have been considerable confusion and controversy over the exchange rate since the budget devalued the rupee on November 21.
Admittedly, it is not an easy issue to understand. Sometimes even economists get the mechanics of exchange rate adjustments wrong. There are complexities that are not easily comprehended. Then there are contextual considerations that add to the complexity. Ideological issues obscure the economics even more and form the basis of evaluating changes in the exchange rate. Pragmatic economic considerations and realities of international trade are often the least considered.
One of the reasons why people get the exchange rate issues confused is the terminology itself. A depreciation or devaluation connotes an action that is unfavourable or undesirable. Appreciation of the currency appears a favourable development in total disregard to the functions of an exchange rate. Some get it wrong because they are committed to an ideological position that devaluation is bad economic policy. Oppositions in parliament would generally oppose devaluation or depreciation of the currency as there is political mileage in opposing depreciation, as consumer prices rise.
Microeconomic considerations and how it affects a group of persons colour views on depreciation. For instance, exporters welcome the devaluation of the currency as it increases export earnings and their incomes.
The confusion with respect to the recent devaluation was even more this time around. There is an additional controversy as to whether the devaluation should have been the responsibility of the Central Bank and whether it is the practice to announce it in a Budget? Was the devaluation effected without the knowledge of the Governor and the Monetary Board of the Central Bank? The all important question is, however, whether the devaluation of the currency would help reduce the trade deficit and ease the balance of payments problem.
The exchange rate
First and foremost we must be clear as to what the exchange rate means? The exchange rate is the price of one country's currency expressed in terms of another country's currency. In other words, it is the rate at which one currency can be exchanged for another. For example, the higher the exchange rate (the higher the amount of Sri Lankan rupees) for one US dollar, the lower the relative value of the Sri Lankan rupee. For example, if 100 Sri Lankan rupees are needed at one time for a US dollar and later Rs. 110 exchanges for a US dollar, we say the value of the rupee has depreciated.
This much is well known.
What requires to be defined is the equilibrium exchange rate that is sometimes called the realistic exchange rate. The equilibrium exchange rate is the rate at which a country's exports and imports balance over a period of time. If at a particular exchange rate the country suffers persistent trade deficits, then that currency is described as overvalued. A correction in the exchange rate (depreciation) is needed to bring the country's trade into closer balance. A country's exchange rate has to be relative to the exchange rate of other countries, especially its trading partners.
It is because Sri Lanka was having a large trade deficit that there was a need to depreciate the currency. Because imports were so much more than exports, there was a demand for dollars to pay for these imports. Therefore there was a need to devalue the rupee.
The devaluation will increase import prices. There is no doubt about it. That was in fact the objective of the devaluation. This is why some politicians who do not have any remedy for the trade deficit oppose the devaluation.
The increases in prices of imports are expected to decrease import expenditure. Whether there would be a significant curtailment of import expenditure depends on a number of factors that economists call the elasticity of demand.
The devaluation is also expected to improve the country's export competitiveness by reducing export prices in foreign markets and increasing profit margins of exporters. The devaluation was essential as other countries that compete with us on exports had depreciated their currencies and therefore our exports were relatively more expensive.
Devaluation or depreciation?
The change in the exchange rate has been called depreciation sometimes, devaluation at other times. What is depreciation of a currency and how does it differ from devaluation? The depreciation of the currency is the adjustment of the exchange rate so that more of your currency is needed to exchange for a unit of the foreign currency. For instance, if the rupee -US dollar exchange rate is Rs. 110 = $ 1 and it changes next week to Rs. 110.75 = $ 1 and the week after to Rs. 111 = $, 1 this is a depreciation of the currency. The opposite phenomenon when the amount of rupees exchanged for a dollar becomes less is known as an appreciation of the currency.
Devaluation is when a country changes its exchange value by a fairly large amount at once. For instance in November 1977, Sri Lanka devalued the currency from about Rs. 5.95 = US $ 1 to Rs. 16 = US$ 1. This was a devaluation of the rupee. Since then the value of the rupee has gone down gradually. This gradual change in the value has been a depreciation of the currency. The rupee had depreciated from Rs. 16 to a U.S. dollar in 1977 to about Rs. 110 to a U.S. dollar, when it was devalued by 3 percent on November 21. The opposite action of reducing the amount of units of a currency to be exchanged for a unit of foreign currency is known as a revaluation.
Central Bank responsibility
It is no doubt the responsibility of the Central Bank to manage the exchange rate. However, despite the massive trade deficit the Central Bank did not allow the rupee to depreciate as the Central Bank took the position that the external finances were sound. Therefore the depreciation of the rupee that was a means of coping with the trade deficit was resisted by the Central Bank. It spent about US$ 1 billion before the devaluation to defend the value of the rupee. There was obviously a difference of view between the approach of the Central Bank and the Finance Ministry with respect to the exchange rate. That was the reason for the devaluation of the rupee by the government. There is continuing pressure to depreciate since the devaluation on the rupee.
Although the country has a large foreign exchange reserve, these have been developed largely through foreign borrowings, rather than earnings. Expending these to defend the rupee is a serious mistake. The International Monetary Fund (IMF) has warned the Central Bank that this policy could lead to a financial crisis. They have pointed out that some Latin American countries faced a financial crisis by following such interventionist policies in the foreign exchange market.
Will the devaluation improve
the trade balance?
Whether the devaluation is adequate to improve the trade balance significantly is not an easy question to answer. Quite apart from the extent of the devaluation, there are other factors that may limit the adjustment. About 24 percent of import expenditure is on oil imports. The curtailment of the amount of oil imports would be necessary to make a dent on import expenditure. This is difficult to achieve as oil imports are needed for electricity generation, public transport and as energy for industries. Government expenditure on oil is likely to be high as government vehicles and air transport is a significant expenditure.
Devaluing the currency alone will not improve the trade balance. There is a need to curtail consumption. In the case of food imports that account for about 12 percent of import expenditure, the government expects the price increases to result in import substitution. This, however, is likely to take time. The most forceful argument for devaluation was to ensure the competitiveness of exports. The question here is whether the extent of depreciation would be adequate to ensure that the real effective exchange rate would ensure competitiveness.
The exchange rate of competitors and the rate of inflation would matter in ensuring a competitive exchange rate.
Conclusion
The devaluation of the rupee was needed to ensure export competitiveness. The continuous management of the exchange rate to ensure export competitiveness is essential for a country so dependent on exports. A reduction in exports could affect the economy seriously as a decline in exports could affect economic growth, employment and incomes.
A realistic exchange rate that encourages exports and reduces import expenditure is the rationale for the depreciation of the rupee.
Those opposed to the devaluation have an obligation to suggest how the trade balance could be contained by other means. Do they still espouse the ban on imports?
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