By Walter Nanayakkara and Kesara Abeywardena
Floating of the rupee is not altogether a surprise move, said Minister of Constitutional Affairs and Industrial Development and Deputy Finance Minister Prof. G. L. Peiris who on Friday made a special statement in Parliament on the floating of the rupee by the Central Bank on January 23.

"It is only the latest in the chain of changes the rupee underwent since the liberalisation of the economy of Sri Lanka in 1977 and the exchange rate regime was first changed from a fixed exchange rate system to a managed floating system" the minister explained.

The statement was made by Minister Prof. G. L. Peiris following an undertaking given to the party leaders represented in Parliament.

UNP’s Colombo district MP Tyronne Fernando reminded Prof. Peiris that he agreed to the party leaders to make a statement also as to why the Parliament was not informed of the decision to float the rupee.

But the minister told the House that he had undertaken only to make a statement on the floating of the rupee and that he was not obliged to make any other statement.

The minister also said that though the proposal to change the exchange rate system was extensively discussed between the Ministry of Finance and the Central Bank, it was not announced in advance either to the Parliament or the public because had the proposal was announced in advance it would have negated the purpose of the proposal and would have given an opportunity for interested persons to make undue advantage of it.

The minister’s statement in full is as follows:

"With the liberalisation of the Sri Lankan economy in 1977, the exchange rate regime too was changed from a fixed change rate system to a managed float. As floating exchange rates were new to the market in order to avoid the undue fluctuation of the value of the rupee the Central Bank announced the rates at which it would buy and sell foreign exchange from and to the market. These rates, in effect placed upper and lower bounds for the market rate. The margin between the buying and selling rates has gradually been increased to provide the market a greater flexibility in the determination of the exchange rate.

In 1982, this margin was only Rs. 1.50 for 100 US dollars. By 1995 it had been widened to one percent. With increasing volume of foreign exchange transactions in the market, the margin was widened to 2 percent in 1995. With a view to supporting the policies for ensuring macro-economic stability, the Central Bank further widened this band to 5 percent in June, 2000, allowing the market greater freedom to determine the exchange rate.

After June, 2000, the bank widened the margin several times. In November, it was widened to 6 percent, in December to 8 percent and in January 2001, to 10 percent.

These changes were effected partly to allow greater flexibility to the market and partly to reduce the pressure in the foreign exchange market that emanated from the increased demand for imports. This demand for imports was, in a significant measure, due to increasing expenditure on petroleum products and defence equipment.

During the transition period after June, 2000, the Central Bank observed that in the current economic environment, maintaining a widening intervention band would lead to the formation of market expectations of further depreciation of the exchange rate, thus exerting an unnecessary pressure on official reserves.

The continued outflows and purchases of foreign exchange from the Central Bank contributed to a decline in the foreign reserves. At the same time, the increase in the interest rates implemented to provide further stability to the exchange market could not be maintained for a long period as it was observed that high interest rates would be detrimental to economic activity in the long run.

Hence from 23rd, January, 2001, the Central Bank refrained from announcing the buying and selling rates for the US dollar in advance. At the same time, it announced that it would participate actively in buying and selling of foreign exchange at or near market prices to avoid undue fluctuations in the rates.

With the intention of reducing market volatility and avoiding unnecessary speculative activity the Central Bank also implemented the following measures:

1. Imposing limits on daily working balances maintained by commercial banks in foreign exchange, on the basis of past import and export credit transactions. This was to prevent banks from building up foreign exchange balances for speculative trading.

2. Instructing banks to ensure the settlement of export loans by exporters with export proceeds within 90 days. Banks were instructed to charge an additional interest rate of 10 percentage points where the settlements were overdue by one month and 2 percentage points per month thereafter.

3. Requiring forward sales and purchases of foreign exchange to be backed by a rupee deposit of 50 percent to discourage speculative types of forward contracting.

4. Advising banks not to permit customers early or prepayment of import bills in anticipation of a depreciation.

5. Instructing banks to limit their forward market operations only to trade based transactions.

Following the change in the system, the rates in the foreign exchange market increased. The average market rate for the US dollar which was Rs. 85.13 on 22, January rose to Rs. 87.16 on 23, January and to a peak of Rs. 93.69 on January 25, a depreciation of 9.1 percent.

Such an overshooting was not unanticipated and not excessive compared with the experience of many countries that moved from a fixed or managed system to a floating system.

For example, Brazil’s currency depreciated by 40 percent on the first day of floating and by 21 percent in the first month of floating in January 1999. The Indian rupee depreciated by 16 percent in the first month of floating in January 1993 and Korean won by 31 percent in the first month of floating in December 1997 and Swedish kroner by 28 percent in the first five months of floating in 1992.

The foreign exchange marker in Sri Lanka has shown signs of stability within a short period of time.

The volatility in the market has declined significantly and margin between the minimum and maximum inter-bank rates has narrowed drastically, the highest being Rs. 8.00 and lowest hovering around 6 cents.

The rupee is now trading in the foreign exchange market at around Rs. 86 to Rs. 87 per US dollar. The average exchange rate of the rupee on February 19,2001 indicated a depreciation of only 1.1 percent from pre-floating level. The change in the exchange rate system has also stopped the drain on the foreign reserves of the Central Bank. In addition, with restoration of the stability in the exchange market and the decline in the expectations about further devaluation the Central Bank would be in a position to gradually reduce its interest rates too.

Changes in the exchange rate system was not announced in advance. Such announcement would not only negate the very purpose of the change but could provide opportunity to market players to take undue advantage of the situation.

Hence, although extensive discussions relating to the changes in the exchange system have been held between the Ministry of Finance and Central Bank, no announcement of the proposed changes was made either in Parliament or to the public".