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Sri Lanka rupee undervalued, good for producers: CB Governor

ECONOMYNEXT – Sri Lanka’s rupee is undervalued based on a real effective exchange rate index which is good for owners of export and import substituting businesses, Central Bank Governor Indrajit Coomaraswamy has said.

“Right now the real effective exchange rate is below 100 and so the rupee is undervalued, which is favorable for exporters, and producers of import substitutes.” Governor Coomaraswamy said, at a forum on International Trade Agreements: Policy Options for Sri Lanka.

According to central bank data Sri Lanka’s REER index number was 92 in February.

A real effective exchange rate index is calculated by measuring the (nominal) changes in exchange rates of a basket of currencies (usually trading partners) against a domestic currency and adjusting it for inflation.

REER calculations make no distinction whether the currencies in the basket are true floating rates, or are pegged strongly with complementary money and exchange policies, or are unstable soft-pegs with contradictory policy that depreciate permanently.

A genuinely floating currency like Australia or Canada may temporarily fall against another currency like the US dollar, based on their credit cycle.

Critics have also said that if a large weight goes to currency produced by a bad central bank like that of India, which has a history of depreciation, the domestic currency will be hostage to the monetary policy of that agency, when the REER is targeted.

When currencies collapse due to central bank policy errors (printing money to target interest rates, while targeting the exchange rate to create ‘reserve buffer’), in Sri Lanka and elsewhere claims are made that a currency is ‘undervalued’.

The collapse of the US dollar in 1971-73 along wth the Bretton Woods soft-peg system, which was due to printing money to target an output gap among other policy errors during the administration of President Richard Nixon, was later blamed on an ‘overvalued’ US dollar by Mercantilists.

If the basket is changed, or inflation is re-based, the REER index will change, raising questions about past claims. A REER index is usually based on historical trading patterns.

In late 2015 then central bank Governor Arjuna Mahendran, blamed the collapse of the rupee in that year, on a weak economy and ‘overvaluation’ and said it was ‘corrected’.

In April/May 2018, when Sri Lanka’s most recent collapse was triggered by liquidity shocks, the REER index was at 100.4 according to an index that was published at the time.

Sri Lanka’s central bank had depreciated the currency from 4.70 to 182 since its creation, which is the worst depreciation in South Asia.

In East Asia when global production chains were built in the 1980s and 1990s, most of the currencies were pegged strongly to the US dollar. Indonesia and the Philippines, which had more monetary instability exported labour.

Meanwhile Governor Coomaraswamy said Sri Lanka had started cutting so-called para-tariffs which had contributed to keeping the island out of global production chains.

“Now, Para- tariffs and over 1300 import items were removed in 2016 and 2017,” he said.

“The Budget 2019 proposed to continue phasing para-tariffs over a five year period and this is what really deprived us from participating in these cross border production sharing networks, which has been the most dynamic contributor to international trade.”

“We can now participate in cross border production sharing networks,” he said.

Sri Lanka also had to diversify its export basket, Governor Coomaraswamy said.

He also said that Sri Lanka does not have a fragrance industry as of date even though it has the finest cinnamon in the world.

“I could never understand why we haven’t got some of these leading brands to come and produce fragrances in this country.”

“Diversification of services and exports with the support of new infrastructure and skilled labor are vital in cushioning the deficit and on increasing merchandise exports, which cannot be implemented immediately.”

He said emphasis should be placed on the IT, business process outsourcing and tourism sectors. Analysts had warned that collapsing currencies and monetary instability which leads to falls in real wages may trigger brain drain. (Colombo/Sep26/2019)