I read the above-titled article published by Mr. R M B Senanayake in the Sunday Island Business on August 24, 2008 and appreciate his contribution to improving the public awareness on various dimensions of the economic subjects of the public interest. Mr. Senanayake’s regular writing on economic issues is commendable as it provides important inputs to authorities by drawing their attention on certain principles underlying the issues. The above article is a response to my article published in the Daily Mirror Financial Times on Saturday August 16, 2008. A view expressed by me in the article was that foreign exchange dealers’ speculative trading and arbitraging for profit without underlying foreign payments and receipts are also major variables determining the movements of exchange rate. In contrast, Mr. Senanayake argues that there is a true social function of speculation by promoting exchange rate/price stability and the present level of exchange rate stabilized through Central Bank intervention is not sustainable. His major views are as follows.

* Speculators either stabilize prices or must self-destruct. According to basic economic theory, speculators by buying when prices are relatively low and selling when prices are relatively high make prices less volatile than they otherwise would be and, therefore, act as price stabilizers. If they lose often enough, they must stop destabilising the markets. In the financial markets, it is the lack of speculation through derivatives trading that makes for the wild fluctuations in securities’ prices.

* The present level of exchange rate/its stability is due entirely to the intervention in the foreign exchange market by the Central Bank and its strength is due to liberalization of foreign capital inflow into Treasury securities of short-term duration. Therefore, the present exchange rate of Rs. 107/108 (for US$) is not sustainable without continuous lending of foreign exchange by foreigners. The current account deficit which continues to worsen will determine the exchange rate in the long run.

* According to economic theory, the exchange rate in the long-run cannot be maintained above the purchasing power parity levels. The Central Bank controls heavily the foreign exchange forward market for the local banks although not for the foreign banks.

I wish to express my views based on my experience as follows.

* Mr. Senanayake presents the role of speculators based upon certain economic theories. However, the authorities such as central banks while knowing such theories intervene in the markets to promote market discipline and stability in terms of the discretionary powers given to them under specific statutes. For this purpose, they have the access to latest information on real world market trends which can be quite different from economic theories because such theories are based on certain assumptions that simplify the real world.

* The meaning of speculation adopted by the authorities is quite different from the theory interpreted by Mr. Senanayake. Speculation is a dealing/trading strategy to make profit out of a price change expected in future. A speculator, while being engaged in buying and selling, maintains a net buying position (over-bought or long position) or net selling position (over-sold or short position) in a currency or a financial instrument or a commodity depending on his expectations on prices in future. It is not a speculator but an arbitrageur who buys in the low priced market and sells in the high priced market to make a profit out of current price differences across the markets.

* The empirical results on the speculators’ role in stabilizing markets are hard to establish yet. However, the authorities possess ample experiences and information on destructive effects of speculators on markets, economies, financial institutions, investors and cost to tax-payers on market resolution and bailout of risk-takers. For example, the immediate cause for currency crises in many countries such as the Asian financial crisis was the speculative purchase of foreign currency. The credit/financial market turmoil in USA, UK and European countries reported since August 2007 has been due to speculative selling of credit derivatives/securitised financial products. This turmoil has led to asset market bursts, loss of public/investor confidence in credit derivatives markets and banks and a credit crunch. Several runs on stocks and deposits of banks have occurred and some more runs are expected in due course. To arrest the contagion effects, the central banks in those countries have been printing a huge amount of money to rescue banks and credit markets through lender of last resort facility, despite the rising inflation that requires a tight monetary policy. Investors including small and big pension funds and hedge funds have lost a great deal of money invested in financial markets due to declines in prices of stocks, bonds and derivatives. Further, there are many instances of huge damages to some global banks due to speculative dealings in financial derivatives such as stock index futures. Financial derivatives are not risk free instruments. Therefore, speculation even through derivatives has caused destabilizing effects on markets.

* In Sri Lanka, the behaviour of foreign exchange dealers of some banks just after the float of the rupee on January 23, 2001 is also a fine example for destabilising effects of speculative trading. At the time of the float, the Central Bank’s buying rate and selling rate for US$ were Rs. 77.40 and Rs. 85.13. Some foreign exchange dealers of banks who were reckless of the market discipline started quoting exchange rates around Rs. 100 within a day or two. To resolve the situation, the Central Bank used moral suasion strategy to discipline the dealers and introduced several policy measures to reduce the exchange rate volatility and speculative buying of dollars. As a result, the exchange rate started stabilizing around Rs. 90. Although some economists may advocate permitting the speculators to stabilize the market under floating exchange rate regime, no such economist could predict the exchange rate and its real effects on the economy if the foreign exchange market was not disciplined through new regulatory measures introduced in January/February 2001.

* Regarding Mr. Senanayake’s view that the present level of exchange rate of Rs. 107/108 (for US$) is not sustainable, he himself accepts that the current stability in the exchange rate has been promoted by the Central Bank’s intervention and its strength is due to recent liberalization of capital inflow. Therefore, the Central Bank has taken and will continue to take appropriate policies for stable and strong currency in line with its statutory public duties and there is nothing wrong with the stability and strength of the currency achieved through such policy intervention which is a regular function of the central banks in the globe.

* The view that the present level of exchange rate is not sustainable is a very subjective statement unless those who express such views have the ability to predict sustainable levels of exchange rates. The central banks have the targets of the exchange rates desirable for the economy based on its available information and perform necessary intervention. Since there is no generally accepted empirical results regarding the applicability of the purchasing power parity (PPP) theory and the economists’ inability to specify the time period of the short-run and long-run that the general public should wait to see the benefits of market mechanism, the authorities cannot depend on the PPP theory to ensure exchange rate stability. According to PPP, the exchange rate between two currencies is determined at a rate where the price levels in the two countries are equal when stated in one currency and, therefore, the currency of the country with higher inflation will depreciate and vise versa. The implied view of the PPP is that the exchange rate is determined by the foreign trade flows of goods between the two countries, i.e., exports and imports, or the current account balance since trade balance is the dominant item in the current account. However, in reality, the exchange rate is determined in macroeconomic perspective and dynamics of factors involving foreign exchange receipts and payments (on goods, services, transfers and capital), speculation, arbitraging, market discipline, investor confidence, credibility and effectiveness of foreign exchange policies and other relevant policies. Therefore, the level, strength and stability of the currency/exchange rate should not be anlaysed in isolation of micro factors such as inflow of foreign capital or exports or intervention.