Do things look “tickety-boo” now?
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Has the foreign currency crisis eased?
During the first week of the month, the Sri Lankan rupee movements against the US dollar shocked many. The rupee became “the world’s best performing currency” as the rupee value of the dollar fell from Rs. 362 to 318 – an appreciation of 12 per cent. While the importers and consumers hailed it, the exporters and those who hoard dollars began to worry.
Before it became the world’s best performing currency, it had already become, the “worst performing currency” last year! The rupee value of the US dollar rose from Rs. 200 to over 360 within two months from early March to early May – a depreciation of about 80 per cent. At that time exporters and those who had dollar hoardings hailed it, while the importers and consumers were worried.
It looks like that the country’s economic crisis is subsiding, although the rupee appreciation did not last more than a week. However, long fuel lines that we experienced last year have disappeared, while the daily power cuts too vanished a few weeks ago.
The IMF too seems to be ready with its bailout package with a US$ 2.9 billion extended fund facility, while the multilateral donor agencies would also extend their assistance again. We have already fulfilled most of the conditionalities of the IMF programme. Among these conditionalities, the most critical ones are the taxes which have been increased in order to meet government expenditure and the utility prices which have been raised in line with their costs of production. The country’s bilateral creditors and private commercial lenders have looked at the proposal for debt-restructuring favourably so that there are hopes for a successful conclusion of the debt restructuring process too.
Subdued tourist arrivals due to global travel restrictions are picking up again, while the dried-out private remittance flows seems growing again. Even though living is hard for the majority and the higher taxes have repressed the middle-class fixed income earners, many feel that the country has now escaped the economic crisis. In supplementing the “feel-good” time ahead, some of us are now back to active politics gathering in hundreds of thousands at the frequent political rallies.
In this context, the question that I raised today seems a valid one. Although I am not in a position to answer the question from a wider perspective, I would address it in the light of the country’s exchange rate and the foreign exchange market, because the foreign exchange problem is central to the economic crisis of Sri Lanka.
Demand and supply
It is the demand and supply that determine the prices in any market, including the market for foreign exchange. There is a demand for foreign exchange; individuals, business firms, organisations and government agencies, all these bank customers demand for foreign exchange from the commercial banks for various purposes.
The bank customers buy foreign exchange – US dollars, British Pound, Japanese Yen and European Euro, while the banks exchange them for Sri Lankan rupees. The banks should have enough foreign exchange to meet this demand.
There is another group of bank customers who would supply foreign exchange to the banks. They bring foreign exchange from various sources such as export proceeds, foreign incomes and grants, foreign investments, and foreign borrowings. They sell their foreign currencies to the banks in exchange for Sri Lankan rupees.
Demand and supply determine the Sri Lanka rupee price of foreign exchange, which is the exchange rate. If there is excess demand, the price would rise so that the Sri Lankan rupee gets weakened or depreciated against foreign currency. If there is excess supply, the price would fall and the rupee gets strengthened or appreciates against foreign currency.
Stability with flexibility
There are numerous parties which can influence the foreign exchange market by controlling or manipulating the demand and supply conditions: Central Bank, Government, commercial banks and bank customers.
All these parties can change their decisions, affecting either the supply side or demand side in the foreign exchange market. Some of these actions can ease the demand-supply gaps in the foreign exchange market allowing for temporary appreciation of the rupee as seen from the exchange rate movements last week.
Even though demand and supply forces determine the exchange rate, its stability with flexibility needs to be understood by looking at its long-term trend on the one hand and the short-term volatility on the other hand. What’s more important is the “long-term trend” of the exchange rate which projects the country’s productive capacity and its international competitiveness.
The long-term determination of the exchange rate is influenced more by the country’s trade performance than anything else. As the fixed exchange rate system was abandoned in the early 1970s, the Japanese Yen continued to appreciate against the US dollar mainly due to the country’s strong export growth; it started with 360 Yen per dollar in the early 1970s and declined gradually to below 100 Yen per dollar in the mid-1990s.
While this was the experience of most of the successful export-oriented economies, in some countries the pressure on exchange rate appreciation can be averted with Central Bank intervention to purchase the excess supply of foreign exchange. In doing so, these countries used to build a stock of their foreign exchange reserves.
Sri Lanka’s long-term exchange rate trend has constantly been on a downward path. The country started its flexible exchange rate with Rs. 16 per US dollar in November 1977, while so far it has been depreciating due to weak trade performance. For the same reason, Sri Lankan Central Bank was unable to build a stock of foreign exchange reserves either.
Short-term fluctuations
Short-term fluctuations of the exchange rate are a result of two things. The first is the short-term capital movements – foreign investments in the stock market and the bond markets as well as foreign borrowings. The second is the changes in the decisions of the market participants, including the public speculative actions.
Therefore, when the foreign investors decide to purchase company shares in the stock market or invest in government securities, such decisions would result in a temporary increase in foreign exchange supply. The Central Bank or the government may decide to change foreign exchange restrictions influencing either the demand side or the supply side.
The public can also influence the foreign exchange market through their speculative actions. Depending on what they believe in, they may either withdraw or supply foreign exchange to the market. More regulations to address such speculative issues, perhaps, worsen the situation. All these actions lead to a change in the short-term exchange rate, which has little to do with its long-term trend.
Next few months
We came all the way down here in making a distinction between long-term and short-term factors that would determine exchange rate trends and fluctuations in order to understand what would be the future. Where would be our exchange rate move in the months or years to come?
With the successful conclusion of the IMF programme and the foreign debt restructuring negotiations with the creditors, Sri Lanka is able to improve its “creditworthiness” again; there would be foreign exchange inflows from the multilateral lenders (IMF, World Bank, ADB and other), bilateral lenders (such as China, Japan and India), and even from the private lenders. But one thing is clear; foreign exchange flows from all these sources are nothing other than foreign borrowings!
Sri Lanka may also be able to improve its limited foreign exchange earnings from tourism and remittances. However, at the same time the country may have to start its foreign debt servicing with arrears for the period of defaulting. All these things point to one thing; we would be back in the same trap with some breathing space.
In order to get the economy out of this trap, the country needs to switch its dependence from short-term volatile foreign exchange inflows to long-term stable trade performance. It requires an aggressive export growth, while export growth requires foreign direct investment flows – the most important requirements for which we are not yet ready.
(The writer is a Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and follow on Twitter @SirimalAshoka).
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