The perils in the appreciation of the rupee

by R. M. B. Senanayake
Recently the Sri Lanka rupee has appreciated with the US dollar which was trading at Rs. 96-97 has suddenly appreciated to Rs. 94. Is this good for the economy? Does this show a strengthening of the economy as the Minister of Finance has stated? Is it the good work of the government that caused the rupee to appreciate? How after all these years when the rupee has been on a one way slide against the dollar, has this change of fortunes taken place.

The rupee has strengthened because of an imbalance between the supply and demand for foreign exchange; the demand for rupees or the supply of dollars has increased relatively to the supply of rupees or the demand for dollars in the foreign exchange market. In this case the supply of US dollars has increased.

Is it due to an increase of exports? No, because our exports particularly industrial exports have still to recover to the level of 2000 although it has increased from the low level of 2001 when there was negative growth in the economy. The increase in the supply of US dollars or foreign currency is due to an inflow of foreign exchange on the capital account and not on the trade account. In spite of the boom in the stock market the foreign investors are still net sellers and whatever foreign funds that have flown to the market have not been from the foreign investment funds or Pension Funds but from funds of Sri Lankans abroad and pools of their funds.

Unlike inflows of foreign exchange on the trade account which are due to our earnings, the flow of foreign funds on the capital account can and in developing with their fragile politics, do in fact reverse their flow. So these funds are not going to be permanently invested in the country unless they are direct investments. There has been an increase in direct foreign investments since last year. If there was peace and political stability, we could expect such foreign capital inflows to last for some time. But the Peace Process is fragile and the forces opposed to peace and stability are doing their darndest to disrupt the economy with their strikes and agitations.

The strengthening of the rupee is by no means an indication of the strength of the economy although the government would like to say so. Short-term capital movements are fickle and can reverse themselves at the first sign of political instability. The Central Bank has argued that the real effective exchange rate has depreciated although the nominal exchange rate has appreciated. This argument is to lull the exporters. Other countries compare the trade weighted exchange rate with the nominal exchange rate to determine whether the currency is over-valued or under-valued or is just right. One will have to compare the current appreciated rate with a base rate where it was in equilibrium. But has our effective exchange rate ever been in equilibrium? If so the Central Bank should say when before it argues that the movement of the real effective exchange rate shows all is well with the rupee appreciation.

Gross Foreign Reserves will of course increase but even borrowings from abroad increase them. Are we accumulating short term liabilities in foreign currency which will deplete them if and when the capital inflows reverse?

Implications for the economy

What does an appreciation of the rupee do to the economy. It benefits the importers who can import cheaper. This could lead to more imports into an economy which is already suffering from an adverse trade balance which is chronic. We have had such adverse trade balances for years and have been able to carry on with them only because of the remittances from the workers labouring abroad as housemaids in the Middle East and elsewhere. But is it prudent to depend on such a source of funds to fund our ever increasing imports? These imports could also reduce inflation since imports play such a large role in our economy. So one can expect more of the same- more luxury cars, more foreign luxury goods will flood the local market.

But what of exports? For the last several years the dollar price of our tea exports has been unchanged while our costs of production have increased with every round of trade union demands by the Ceylon Workers Congress being conceded by the government. The average export price of tea declined from US$ 2.34 per kg in 2001 to US$ 2.26 per kg in 2002. How did the tea industry manage to give all those wage increases to the plantation workers when the tea export prices in US dollar terms has been stagnant all these years? It is because of the continuous depreciation of the rupee by around 10% each year for the last several years except the last year. How will the tea industry now face the workers demand for the usual wage increases? Will the tea plantation companies be able to survive as profitable enterprises if the rupee appreciates further. What about the industrial exports particularly garment manufacture? Can this industry afford to increase its dollar price? No since our garment industry firms are price takers and have no say in determining their export prices. In fact they have to reduce their export prices in dollar terms to face up to the competition from China and other low cost producers after 2005 when quotas under the Multi-Fibre Agreement are removed. So the euphoria of the Minister of Finance is misplaced.


If the appreciation of the rupee is not desirable for the economy, can it be prevented? Yes, the Central Bank can do what is called sterilising operations. It can prevent the appreciation of the rupee in the foreign exchange market by offering to buy at the previous price. But the foreign exchange market is an instantaneous market and quick decisions are required. The Central Bank has apparently failed to check the appreciation that has already taken place. A bureaucratic outfit like our Central Bank which takes weeks to pay a bill is incapable of taking quick decisions. It is no better than other government departments. Its best men have taken to voluntary retirement and been replaced by the products of our local universities who belong to the lost generations. In any market once the price has moved up or down its more difficult to bring it back to the previous level. So the rupee will stay at Rs. 94 unless the foreign inflow is replaced by an outflow and the demand and supply conditions change again.

Currency interventions by the Central Bank can take two forms. The first is what economists call "unsterilised" which means that the intervention is allowed to affect the size of the money supply. But this triggers a change in interest rates and could run counter to the present policy of low interest rates.

The second sort of intervention is called "sterilised" which means the effect on the money supply is offset through an open market operation by the Central Bank. Open market operations refer to the sales or purchases of securities from its portfolio by the Central Bank. Not that the portfolio of government securities that a central bank holds at any given time is limited and then the question arises whether the bank will be constrained in its open market operations to mop up money supply when its supply of securities runs out. The Central Bank can of course issue its own securities which are as good as government securities.

So to explain the operation of ‘sterilising’ the Central Bank may sell or buy foreign exchange for domestic rupees. In this case we are talking of selling securities to mop up the money supply which would increase as the Central Bank buys foreign exchange for rupees in the first instance. This original purchase of foreign exchange to support the currency causes an expansion of the money supply and hence the subsequent sale of securities from its portfolio reduces the money supply to offset the increase caused by the purchase of foreign exchange. In short the impact of the foreign inflow of foreign exchange will have no effect on the money supply since it is being sterilised by an equal sale of securities.

So in theory it should have no subsequent second round effects on the exchange rate. ( the money supply expansion may according to theory increase the demand for imports and reduce exports). But with sterilising there should be no permanent effect on the exchange rate. So the Central Bank can and must sterilise the flow of foreign capital inflows. Whether it is successful or not depends partly on its competence. But more important the government must back up the bank by an austere fiscal policy. This is where the Minister of Finance comes in. The government intends to give salary increases to public servants. Where will it get the money from? It has raised a foreign loan through Citi-bank according to newspaper reports. This means the money comes in as dollars and is a foreign inflow. Does it hope to fund the salary increases to public servants through the proceeds of this loan. Loans should be for capital expenditure not for current consumption.

The government has been running current account deficits in the budget for many years. These deficits are already too high amounting to about 3-4% of the GDP. So further salary increases will worsen the current account deficit of the budget unless the government increases taxation.

So intervention by the Central Bank cannot work except for a short time unless it is backed by the government fiscal policy. If the government increases the money supply by its deficit finance even if it is funded by foreign loans intervention, it is unlikely to work for long. Intervention cannot control the market for long unless it is backed by changes in monetary policy. Of course if the foreign funds inflow is a purely temporary, a one-off affair then the appreciation may reverse itself without too much fuss.

There is another way in which intervention works. That is through the signal it sends to the foreign exchange market that will change the expectations of the foreign exchange traders. The government must proclaim its intention to maintain the exchange without allowing it to appreciate and it must back its announcement by changes in monetary policy. If intervention is to work through such change of expectation then the low interest rate policy may have to be reviewed. If the market is not convinced that the Central Bank and the government means business then this signalling effect will be dulled. But unless the economic fundamentals are sound no amount of intervention will be effective. So the Minister of Finance must prove that the economic fundamentals are improving to convince the foreign exchange traders.
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