Tuesday March 26, 2019

Sri Lanka's rupee peg crawls down in 'flexible' exchange rate

Dec 29, 2016 11:20 AM GMT+0530 | 0 Comment(s)

ECONOMYNEXT - Sri Lanka's unstable peg with the US dollar has started to crawl down amid claims that a weaker rupee will help exports powered by currency depreciating driving down factory wages, as excess liquidity also pressured the rupee.

The semi-official reference rate for the spot US dollar was brought down to 149.80 from 149.50 last Tuesday.

In money markets excess liquidity shot up There is no trading in the spot market and one week dollars were quoted at 150.05/15 during early trading Thursday.

Excess liquidity in money markets rose to 43 billion rupees on December 27, and the cash will eventually end up in forex markets as imports, unless mopped. It is not clear why the liquidity was not mopped up if it was generated with dollar purchases.

Third World Peg

The rupee has crawled down since the creation of the central bank in 1951, with money printing and dollar purchases to build up liquidity even during periods of balance of payments pressure.

The fundamental problem is that the central bank tries to control interest rates (printing money) and tries to control the exchange rate as well, leading to balance of payments trouble.

The contradictory monetary and exchange rate triggered exchange and trade controls from the early 1950s, making Sri Lanka a backward nation in Asia that runs to the International Monetary Fund every few years.

The central bank last week set the stage for Sri Lanka's downward crawling peg to resume its uni-directional journey by saying a weaker rupee makes exports 'competitive'.

The 'competitive rupee' claim is a central bank code word that comes before a depreciation of the currency.

"Some countries in the Asian region, which lagged behind Sri Lanka a decade ago, are now growing at a faster rate benefitting from higher export earnings and/or inflows of export oriented foreign direct investments," the Central Bank said.

"Accordingly, maintaining a competitive exchange rate aimed at promoting Sri Lankan exports in the international market and attracting foreign direct investment to Sri Lanka, will remain vital in promoting the country as a globally competitive export-led economy."

Sri Lanka was head of 'some countries of Asia' when it was in the British Empire and had a currency board and free trade.

However most East Asian nations now have stable currencies, other than Philippines and Indonesia. The two laggards, exports millions of people to the Middle East and elsewhere, to countries with stronger currencies.

Hong Kong which has exports of 300 percent of gross domestic product has operated a currency board at 7.75 to the US dollar since 1983. Singapore has a modified currency board.

To stop Sri Lanka from losing forex reserves and running into repeated balance of payments crises analysts and economists have called for the central bank to be abolished and a currency board re-established or reformed so that strict limits are placed on its ability to print money.

Capital Flow Buffer

The IMF also earlier called for a 'flexible exchange rate' in the face of capital outflows.

"This does seem to be a familiar concept in Sri Lanka because both the government and public seem to be used to keeping exchange rate very stable by international standards at least," IMF Mission chief Jaewoo Lee told reporter in early December.

"From that viewpoint the program has committed to increasing the flexibility of the exchange rate and we had been invoking that aspect all along."

The idea behind having 'flexible' exchange rate in most countries is to allow the currency to fall when there are sharp capital movements, eliminating further speculative pressure and imposing loses on anyone who tries go out at the time.

In theory the exchange rate will later climb back up, in the form of a floating rate.

In a floating rate, there are no interventions, either when the rate goes up or when it goes down, eliminating the need for injecting or withdrawing liquidity to compensate for forex interventions (sterilization activity).

Because there are no interventions when there are inflows (such as Treasury borrowings) the rupee will also strengthen.

In Sri Lanka however, despite a large policy rat gap with the Federal Reserves, rupee appreciation is blocked by the central banks, government inflows are surrendered to it creating new rupee liquidity and generally dooming the country to a permanently downward crawling peg, critics say.

This is despite having a large policy rate gap with the US dollar.

Which is why people have no faith in claims to a 'flexible exchange rate'. In Sri Lanka except in 2009/2010, terms like 'flexible exchange rate', floating rupee' have simply been code words for a downward crawling peg.


The central bank in a public statement last week made a statement supporting fall in the currency, claiming that the rupee will improve the 'trade deficit' in a classic Mercantilist argument.

Mercantilists believe that narrower trade deficits are somehow better, hard goods trade surpluses are unquestionably good and that domestic production rather than specialization and free trade is also good.

They take no account for other components of the overall balance of payments, especially a central bank's own activities.

"Depreciation of the exchange rate has a positive impact on the country’s trade deficit as it makes imports more expensive for domestic consumers and exports cheaper for foreigners," the Central Bank claimed.

"Such a policy would encourage domestic consumers to consume domestically produced alternative goods.

"More importantly, depreciation of the exchange rate would improve export competitiveness of the country as the depreciated exchange rate would lower the cost of goods exported from that country to the rest of the world."

Despite a permanent depreciation of the currency for over four decades, however Sri Lanka has suffered trade deficit largely due to earnings outside merchandise exports such as remittances and also net foreign borrowings and foreign direct investments, all of which can generate hard goods imports.

A falling currency improves the competiveness of exports by cutting real wages and making factory workers poorer. A temporary fall in the currency like the IMF advocates will not create a permanent real fall in wages of factory workers.

As people become poorer and unable to buy good and services, an 'export surplus' of commodities in particular was generated in the old days.

But protected 'domestic producers' in Sri Lanka will not be able to export, since there is no demand for shoddy or over-expensive goods.

Instead domestic demand for their goods can also fall or remain stagnant, due to real wage declines, especially if oil prices are adjusted upwards to make up for currency falls.

Poverty from currency depreciation can also increase political unrest as people find it difficult to make ends meet. Labour unrest will eventually push wages up, nullifying any gains in so-called competitiveness.

In Sri Lanka because water, electricity and fuel prices are not adjusted every month, export firms will also receive another subsidy in the form of lower utility prices increasing their profits, whenever the currency depreciates.

The losses will then accumulate in state enterprises which will be borne by the domestic population, through higher taxes as bailouts, of the state agencies or lower profits and dividends to the exchequer, which will reduce resources available for health or education.

In Sri Lanka with open labour markets, people are now travelling to the Middle East to earn higher real wages rather than work in factories, with wages reduced to sweatshop levels by currency deprecation.

In November the central bank also started to print money by purchasing Treasury bills outright for up to 70 days or over, significantly loosening policy and denying it the ability to collect reserves.

The move also signalled longer term rates down, giving higher profits and incentivising foreign bond holders to exit, critics say.

Under an IMF program, which has foreign reserve targets to be met, a central bank cannot operated an independently floating exchange rate, except for a brief period to get out a sterilized intervention cycle.

Major Flaw

Analyst have also pointed out that the current IMF program, contained a major flaw in not having a ceiling on domestic assets of the central bank (constraining its ability to print money and generate currency pressure).

Without constraints on the monetary authority to sterilize dollar purchases, the rupee will continue to fall, with no forex reserves collected permanently, critics say.

"..[L]imits need to be put on the Treasury bill stock (progressively lowered NDA or Net Domestic Asset ceilings) to stop runaway monetizing by the central bank, with some leeway in June and December to 'sell' foreign reserves to the Treasury to repay debt," EN's economics columnist said April 2016 before the latest program was signed (Sri Lanka needs monetary reform not just fiscal plaster).

"The last SBA lacked explicit NDA targets, which allowed the central bank more leeway to monetize debt (print money to sterilize foreign exchange sales) in 2011 even before the program was ended and precipitate a second BOP crisis."

"..if there is Net International Reserve Target (NIR) without progressively falling ceilings on Net Domestic Assets (NDA) of the central bank, Sri Lanka's rupee could depreciate further," EN's economics columnist Bellwether said in April 2015.

However analysts say at the moment, the US dollar is strengthening due to Federal Reserve rate hikes. This can reduce the negative effects of a currency fall if commodity prices continue to ease due to a stronger dollar.

After the US Fed hike, Middle Eastern central bank's with stable pegs like UAE and Qatar (GCC countries hike rates) as well as Hong Kong's de fact policy rate was adjusted up in December, while Sri Lanka loosened policy in November with outright Treasuries purchases. (Colombo/Dec29/2016)


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