Even as late as September 2008 it seemed crazy to devalue the rupee notwithstanding signs that the export sector, notably garments, was suffering from a strong currency. The reason was simple. The fear was that with inflation at over 25% a year and rising, any significant devaluation would worsen inflation and require further devaluations. By November the facts had changed. A significant devaluation of the currency (vis a vis the US dollar) seemed good for the economy.

What had changed in a few short months was the deepening global economic crisis. Oil prices fell precipitously from a peak of $147 a barrel earlier in the year to less than $50 a barrel. Prices of other commodities, both raw materials and food, in world markets tumbled too. Likewise, prices of manufactures and semi-manufactures were softening. Shipping costs crashed.

The implication for Sri Lanka of the deepening global recession is a dramatic slowdown of import-driven inflation, fueled in the past few years by huge budget deficits and increasing global commodity prices. The effects are not as yet fully reflected locally. However there is already a small but perceptible month by month decline in the cost of living index since the peak in September 2008.

The implications of the global economic recession for the main economic indicators in 2009 if the rupee continues to be linked to the dollar could be described succinctly:

=The total value of exports (f.o.b.) would fall reflecting lower prices in world markets for Sri Lanka`s main exports (garments, tea, rubber) compounded by a decline in the volume of exports as world demand shrinks for Sri Lanka`s exports.

= The total value of imports (c.i.f.) would decline primarily, though not exclusively, because of the dramatic fall in the price of oil.

= Total foreign exchange from remittances (around Rs 290 billion in 2008), a key factor that has helped the country to remain solvent in recent years, would almost certainly be less in 2009 because of the rather sharp fall in economic activity, notably construction, in countries where migrants from Sri Lanka work.

=Total foreign exchange from foreign direct investment, foreign borrowing by Government and tourism could be expected to fall in 2009. Private investment flows would be constrained by the global recession. The liquidity crunch in the global banking system would reduce the availability of foreign credit (foreign borrowings). Tourist arrivals would be hit by the recession.

= Output and employment in key areas of the private sector such as garment manufactures and construction (office building, housing, tourism) would decline.

=Unemployment and under-employment would rise because of diminished employment opportunities in Sri Lanka and abroad.

All the signs are that in 2009, the Sri Lankan economy is likely to operate at a lower level of economic activity (exports, investment, consumption, employment) compared with 2008. The economic deterioration may well get worse during the course of 2009. The country seems, however, unlikely to face a balance of payments crisis. The demand for foreign exchange can be expected to fall more sharply (for reasons such as the fall in import prices of oil) than the decline in the supply of foreign exchange, buoyed by remittances albeit at a reduced level.

Presumably the top policy objective of the Government is to minimize, if not prevent, economic activity in 2009 getting progressively worse, incomes falling and unemployment rising. A stimulus package of higher Government expenditure over and above that budgeted for 2009 to pull the country out of the impending domestic recession, now that inflation is falling, is one policy option. Most of the major economic power-houses such as the United States, EEC countries, Japan, China and India are doing just that (a massive fiscal stimulus by "printing money" and sharp interest rate reductions) to stop, inter alia, a global economic slump.

Sri Lanka cannot afford an additional fiscal stimulus. The country has had for years large budget deficits that have been a prime cause of high inflation even though the balance of payments outcomes have been relatively benign, a feature that has confounded the Jeremiahs. However, an additional substantial fiscal stimulus to boost domestic activity by increasing the budget deficit is, in present circumstances, more likely than not to lead straight to higher inflation, higher consumption, little investment and a balance of payments crisis. With the changed global environment, notably diminished access to foreign borrowings, the country lacks the wherewithal in the short term to earn or borrow the foreign exchange to pay for increased demand for foreign exchange arising from an additional stimulus package at current exchange rates.

The question is what can be done? Achieving the Government`s policy objective of high growth and low unemployment requires measures to mitigate any decline in total foreign exchange earnings arising from the global recession, and to reduce the outflow of foreign exchange. In present circumstances, the best option to do so is a "once and for all" devaluation of the rupee of say 20% to 25% against the US dollar. (A downward floating rupee would be counter-productive as it would give rise to speculative leads and lags in respect of both imports and exports).

The impact of a 20% to 25% devaluation on domestic price inflation, ceteris paribus, would be attenuated because of the likely decline mentioned earlier in import prices of internationally traded goods, particularly of oil.

The devaluation would, however, slow the fall in inflation that would occur in its absence. As regard imports, the devaluation most likely would reduce imports for two reasons. One is that import prices in rupee terms would be higher than in its absence (the higher the import price the lower the domestic demand and consumption for many items). The other is import substitution by higher domestic output as higher import prices provide an incentive for higher competing domestic production.

At the same time, exports would rise in rupee terms after devaluation. Exporters would be better placed to compete in international markets. Profit margins of exports too would rise. As a consequence, production would be higher than it would be in its absence even if world markets prices fall in dollar terms. Higher domestic production to supply exports and to substitute imports means higher employment than with no devaluation. Moreover, with increased liquidity in the economic system there would be a multiplier effects in increasing economic activity and employment in the service sector such as trade, transport, banking and construction.

Devaluation would also be a great incentive for Sri Lankan migrant labour to remit their earnings to Sri Lanka. The foreign exchange would be exchanged for more rupees than in the past. Likewise new foreign investment for the export sector would be more attractive because of cheaper manufacturing costs in Sri Lanka in foreign exchange terms. Tourism could also be expected to benefit as Sri Lanka would be a more competitive destination in currencies of other countries.

Devaluation would raise both government revenue (benefiting from ad valorem taxes on trade) and expenditure (on Government imports and subsidies on imported products). On balance, there would be a net gain of revenue unless the Government is further constrained in taxation policies by the Courts. The positive effect on revenue, and a concomitant reduction in the fiscal deficit, may also come from other factors such as higher tax revenue from increased economic activity.

There is no doubt that with a significant devaluation the rupee cost of servicing or liquidation of foreign debt in 2009 would soar in rupee terms because foreign debt accounts for about 45% of total government borrowing. Provided there is enough foreign exchange to pay for servicing or repayment of foreign debt——devaluation is likely to improve the foreign exchange reserves—-does it matter in economic terms that the Government has to pay much more in rupee terms for such servicing or repayment? A simple way is for the Government to increase the budget deficit to pay for the higher rupee costs by borrowing directly from the Central Bank ("printing money") at zero interest rates. It is not self-evident (despite a resemblance to Mugabeian economics) that there are wider economic effects (e.g. domestic money supply) of such increases in the budget deficit and associated "money printing" by the Central Bank except that there would be less Central Bank foreign exchange reserves for other purposes.

Devaluation probably would also have a positive effect in reducing interest rates as the fiscal deficit (excluding additional payment for foreign debt) can be expected to fall. If so, the spin-off of lower interest rate would be lower government expenditure to service domestic debt; and a boost to borrowing for investment.

A case could be made that a significant devaluation now is not only good economics but good politics as well. There would be an immediate positive impact on economic activity. On remittances alone, a 20% devaluation would imply a cash injection to the economy of some Rs 50 billion (Rs 50,000 million), the primary beneficiaries of which being the less affluent in society spread widely across the country. The profit margins of many sectors in the economy (trade and other services, manufacturing) would also rise. Consequently, a distinctly feel good factor would emerge that is positive for: higher investment and consumption, construction, the property and stock markets.

There is one factor that may deter a major devaluation of the rupee at the present time. The cost of living would rise and the Opposition politicians would raise a hue and cry about it. It is probable that this fear is exaggerated if one assumes a world-wide economic recession gathering speed in 2009. In any event, the Government could "kill the Opposition fox" by guaranteeing that after devaluation the price of a basket of five or six basic foodstuffs (e.g. rice, dhall, potatos,onions, maldive fish, milk foods) in 2009 would not be higher than the average level of prices in 2008 levels. This could be done by flooding the market with imports to maintain 2008 prices for the selected items or by an island-wide rationing scheme at fixed prices.