The devaluation or even the depreciation of the rupee has been a controversial issue among academics and politicians for a long time. Economists and politicians of the left have often opposed devaluation on the grounds that it would increase the costs of living and the economic burden on the poor while not benefiting the country's trade balance appreciably. In fact, some ministers of the government openly opposed the decision to devalue the rupee by 3 percent at the last budget.
However, never before has there been an open controversy at the helm of government on whether the Rupee should be depreciated or not. Whatever differences there may have been between the Central Bank and the Treasury regarding the management of the currency previously, they were well kept secrets in the past.
The current controversy is also a change of conventional roles. The Central Bank that is often of the view that the currency should be depreciated has taken the opposite position. The Treasury that tends to be biased towards political consequences of a depreciation or devaluation is normally reluctant to espouse depreciation. This time around, the Secretary to the Treasury is of the view that a further depreciation of the currency and an increase in interest rates are needed to correct the large trade deficit.
The issues
Three issues are significant in the present context. First: the country is having a massive trade deficit that is a serious strain on the balance of payments. This situation is unlikely to change during the course of this year as the factors that created the situation of a large trade deficit are likely to persist or even perhaps worsen. While last year's trade deficit was expected to be about US$ 9 billion, this year's trade gap is expected to increase to about US$ 11 billion.
Second: the magnitude of the trade deficit is such that unlike in the past, worker remittances, tourist and other earnings from services and capital inflows are unlikely to offset it. This means that there would be a current account deficit that would have to be financed by drawing down the reserves or by foreign borrowing.
While this is the likely outturn in the 2012 balance of payments, the Central Bank expects a balance of payments surplus in 2012 owing to expectations of increases in foreign investments, earnings from tourism, worker remittances and other capital inflows. Thus, the Central Bank considers the current deficit in the balance of payments to be a temporary problem.
Third: the paramount question is as to whether the depreciation alone would resolve the balance of payments crisis. One contention is that without depreciation of the currency the country's export competitiveness would be adversely affected.
The opposing view is that the depreciation will not help the country to increase export earnings or decrease import expenditure adequately as both exports and imports are inelastic. In other words, the increase in prices of imports, it is argued, will not cause a drastic reduction in imports because most imports are essential items such as food, fertilizer and oil. In the case of exports, it is contended that the demand for our exports and the exportable surpluses too are inelastic.
However, many economists would argue that this would not be so in the long run as suppliers would respond to changes in price.
Furthermore, they contend that if the currency is not depreciated, the country's export competitiveness would be adversely affected, thereby increasing the trade deficit further.
Opposing positions
The two opposing positions are:
(a) There is no serious problem in the balance of payments that requires the depreciation of the currency.
(b) The trade deficit is of such proportions that unless it is corrected by a depreciation of the rupee that it will get worse and pose a serious threat to the country's external reserves.
The Central Bank Governor insists that the external finances of the country are healthy. This is perhaps based on the fact that in the past the trade deficit has been offset by remittances and service incomes. Although the country has had trade deficits in the past, in many years these incomes have resulted in the country posting a balance of payments surplus. This was so in 2009 and 2010 but unlikely in 2011 and 2012.
There are two weaknesses in this argument. First is the undeniable fact that the trade deficit is massive in 2011 and likely to be even more in 2012.These trade deficits are of an unprecedented magnitude than in recent years.
It is likely to be about US$ 9 billion in 2011. In 2010 the trade deficit was only US$ 3.7 billion and consequently remittances alone were able to of offset as much as 80 percent. Other services incomes had to bridge only 20 percent. Therefore a balance of payments surplus was achieved.
Consequently the current account in the trade balance did not pose a balance of payments problem.
The situation is different in 2011 when the deficit is of such high proportions that remittances are likely to bridge only about 55 percent of the trade deficit. Fortunately earnings from tourism have increased but these are likely to offset only about 11 percent of the deficit. Foreign direct investment would at most bridge another 11 percent. This means that other foreign capital inflows would be unable to bridge the current account deficit in the region of about US$ 2 billion.
What this means is that this large deficit has to be financed by drawing down of the country's reserves or through fresh borrowings. The plain truth is that this state of external finances would lead to the country's foreign debt increasing. The foreign debt servicing costs imply continuing strain on the balance of payments as interest costs would absorb a large proportion of the country's export earnings and be a crushing burden on the country's finances.
Treasury's point of view
The Treasury Secretary's point of view takes off from the preceding argument. His point of view is that the massive trade deficit must be contained and that the depreciation of the currency and an increase in interest rates are needed to achieve this. The depreciation of the rupee will increase import prices and thereby curtail import expenditure.
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.
Dr Jayasundera's argument is that because Sri Lanka was having a large trade deficit that there was a need to depreciate the currency so as to bring down imports, the cost of which is much more than the cost of exports, and to make exports more competitive in international markets.
Impliedly unless this is done the trade deficit would continue to expand and result in a large current account deficit. There is a demand for dollars to pay for these imports. Therefore there is a need to devalue the rupee.
The devaluation or the depreciation of the currency will increase prices of imported goods. There is no doubt about it. That was, in fact, the objective of the devaluation. This is why some politicians opposed 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 Treasury Secretary also wants an increase in interest rates so as to curb the demand for imports. Decreasing government expenditure too would have an important bearing on the trade deficit.
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. A realistic and flexible exchange rate is needed to increase exports in the long run.
Conclusion
The plain truth is that the country is facing a serious balance of payments problem. Whatever be the arguments for and against the depreciation, the ultimate verdict will be given by economic forces. The impending huge trade deficit this year will ultimately determine the course of action. But the policies that may be adopted then may be too little.
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