30th November 1997

A case against devaluation

The Governmetn must take a definite stand on whether to devalue or not. Any uncertainty could harm the balance of payments and investor confidence. Indications are that the Government has decided not to devalue. Yet the business community seems unconvinced. This issue must be put to rest.

At a symposium on 'Budget Highlights and Trends in Fiscal Policies', last Wednesday, both Minister G.L. Peiris and the Deputy Secretary to the Treasury, Dr. P.B. Jayasundera reiterated emphatically that Sri Lanka did not need to devalue the currency in the face of other country devaluations. We hope the business community and foreign investors would accept that position. We also expect the Government to stick by that stand.

The Minister pointed out that the country's foreign exchange position was strong, that the country was experiencing a balance of payments surplus and has faced up to the bomb blast and the East and South East Asian crisis, without a serious dent on its economic fundamentals. In fact he said the devaluation in these countries was coupled with increased rates of interest. Demands for higher wages owing to the higher costs of living were beginning to adjust costs in these economies to a situation which did not require us to devalue. He stressed that there was no question of a capital flight as we had not freed the capital account.

Dr. Jayasundera addressed the issue of devaluation very directly. He contended that Sri Lanka's economy was unique and did not have the vulnerability of the East Asian countries. The devaluation of other countries would reduce our import costs. He pointed out that imports for our exports contributed a very large proportion of export value. Therefore a devaluation would immediately act to increase production costs of exports. The figures quoted by him indicated about a 75 per cent import content. The thrust of his argument was that a devaluation would do more harm than good.

The bottom line of these arguments is that a devaluation is not in the offing. We hope this position is sustainable and credible. Now that the Government has taken this position, it should convince the public that it will defend it. Impliedly the IMF supports this stand. If so, that too should be made explicit as it would add much to the credibility of the decision not to devalue. If the Government is unable to establish a credibility, then it could create pressures on the balance of payments despite controls on the capital account. Credibility of sustaining the Government decision not to devalue is the crux of the issue.

Currency crisis exposes fragility of global economic order

"Two years after the Mexican devaluation crisis, the east Asia financial crisis has demonstrated yet again the fragility of an international economic order in which countries finance themselves through large inflows of potentially mobile capital.

This observation is made an article by David Hale, the global chief economist at Zurich-Kemper investments in Chicago in an article appearing in the London Financial Times.

At the outset the author points out that although there have been many occasions in the 20th century when stock market developments in New York and London depressed equity values in east Asia, the recent developments were the first time the casualty worked in reverse.

Mr. Hale cites several reasons why the east Asian exchange rate crisis has had global implications. In the first place, he says, countries of east Asia, excluding Japan, have accounted for half of the growth in world output since 1991 even though the countries account for only about 20 per cent of the world's gross domestic product. In the circumstances, he says if their growth rate slows sharply because of banking problems and reduced access to foreign capital they will more than offset the upturn that is projected to occur next year in the depressed economies of western Europe.

The second reason, according to Mr Hale, is that investment has accounted for about 30-35 percent of east Asian growth during the 1990s compared with 15-20 percent in other regions and in 1996 east Asian capital investment excluding Japan was equal to about 82 per cent of US business investment compared with only 30 percent in the mid 1980s. Furthermore since east Asia accounts for about 26 percent of world exports compared with 17 percent for the US the newly enhanced competitiveness of east Asia " is likely to be a significant disinflation shock to the world economy."

Thirdly, says the author since east Asia has been a leading capital importer from the global banking system during the 1990s the result of the financial crisis now taking place could very well result in international banks having loss ratios as high as 20-25 per cent on their Thai loans and 5-10 percent on loans elsewhere in the region.

Mr. Hale says that the deflationary shock would not be as great as happened in the 19th century when the opening of America, Australia and Argentina and other emerging markets encouraged such large increases in output that global commodity prices fell by 40 percent over three decades.

The reason is, he says that the world has moved from the gold standard to a floating exchange rate system with discretionary monetary policy enabling central banks to respond to deflationary shocks by reducing interest rates, expanding money supply and devaluing.

The author then comes to the main point he wishes to make regarding the repercussions of the East Asia financial crisis.

He says that "the systemic risk to the global economy posed by the east Asian devaluations is likely to be trade conflicts". He points out that the US sends about 20 per cent of its exports to east Asia and 12 percent to Japan, while deriving about one-third of its imports from the region. Japan also sends about 37 percent of its exports to the region deriving about 35 percent of its imports from the region. (This is in contrast to the countries which conduct less than 10 percent of their trade with east Asia excluding Japan). As a result of this exposure to the region," says Mr. Hale , "the US will be vulnerable to several potential trade shocks during 1998."

He says that American exports to east Asia will slump while exports from that region will become far more competitive in US markets.

Furthermore,he envisages a devaluation of the yen and of the currencies of other developing countries outside the region which will encourage further growth of import penetration in the US economy without generating any offsetting growth of American exports. And, he says, "when all the exchange rate adjustments resulting from the east Asia crisis work their way through global markets, it is not difficult to imagine the US trade deficit expanding to US$ 250 bn- U$ 300 bn by early 1999 from US$ 192bn in 1966.

But, says the author, as the US has a full employment economy, the trade deficit is actually a potential inflation safety valve. It provides the US with a larger supply of goods at low prices than would be possible if the country depended solely on domestic manufacturing capacity.

As regards the devaluation itself, Mr. Hale says the US and the IMF could not have prevented the devaluations without offering such large amounts of financial assistance that the rescue package would have created moral hazard problems for other developing countries with large external deficits.

The challenge facing the IMF he says is to restore the health of the local banking systems and the capital markets without driving the economies of east Asia into unnecessarily severe recessions.

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