The Central Bank governor must be commended for the prompt action taken by the bank to come up with a sufficient rescue package for the Registered Finance Companies. It is not often one sees timely action by any government institution. The companies themselves are sound and deserve to be protected from the sudden loss of confidence caused by the antics of  rogue financial institutions which had accepted deposits and run Ponzi schemes.

The guarantee of their borrowings from the commercial banks, an important source of funds for them, is particularly useful. So is the scheme to buy properties they hold which they are unable to dispose of owing to the collapse of the property market.  But these companies can no longer confine their lending to property developers and vehicle leasing. These businesses were over-extended and it was not economically feasible for them to expand. A natural correction was overdue for these markets. Finance companies should look for alternative economic opportunities which are sustainable in the long run. These could be in agriculture, plantations, industry, tourism etc.  They will have to take risks for there can be no development without risk taking although proper risk management is critical.

Both tea and rubber export prices have collapsed and given the still high inflation, the over-valued Exchange Rate and appreciation of the Real Exchange Rate,  our exporters will find it difficult to compete in foreign export markets. Both India and Kenya depreciated their currencies by 20% in a global environment of falling consumer demand in our export markets. The CB is opposed to depreciation of the rupee because it would cause an immediate rise in imported prices and cause problems for the government budget since it would raise the cost of foreign debt servicing in terms of rupees. This would have to be funded by printing more money.

The World Bank this time opposes depreciation because it reduces global demand. It does not want China to depreciate but appreciate the Yuan. No country today wants appreciation of its currency.  But an over-valued currency and monetary expansion will worsen the deficit in the current account of the balance of payments.

It is correct that the point-to-point inflation has come down below 10%. It must be zero if the price level is to stop rising. It will take some time to do so if ever. Meanwhile the general price level will continue to rise and average level of inflation will continue to be high and well above the corresponding levels in export markets and countries competing with us in our export markets. Countries to which we export have very low inflation now. Inflation is actually negative with their prices falling.

But there is very little that the CB can do to bring down the average level of inflation because of the very high budget deficit. With the global economic recession beginning to bite, corporate profits are coming down and the incomes of high net worth individuals are shrinking. They will therefore pay far less income tax. Similarly with the reduction in imports, customs duties and VAT revenue will also come down. There are few other avenues for increasing tax revenue without raising prices and the cost of living.

With the war expenditure,  infrastructure investments on top of free education, free health care, Samurdhi and subsidies, the fiscal deficit is bound to escalate and  the budget deficit can be funded only from bank borrowings as the government’s borrowing requirements already exceed the savings available for investing in government securities.

Barack Obama is able to borrow to fund his $700 billion stimulus package only because the Chinese are still willing to invest in US Treasury securities. Britain has already found that it cannot borrow sufficiently from the markets and Gordon Brown has said he would print money if necessary for Britain is now facing a severe deflation with prices actually falling.

But we entered the global recession with a massive budget deficit and any stimulus packages will have to be funded by printing money, a tripwire to hyper-inflation.  What effect it would have on inflation will only be seen in about nine months to a year. It is the over-expansion of the money supply which caused our present predicament although the global financial crisis was the immediate cause.

Borrowing externally to fund the current account deficit in the balance of payments has already shown up as highly risky. Short term borrowings even if they were available are volatile and any risk of currency depreciation or downgrading of our rating would lead to a sudden withdrawal of funds as we saw in September and October 2008.

The CB is happy that it is controlling inflation because it has achieved the Reserve Money targets.  But when there is a deficit in the over-all balance of payments the money supply should shrink not increase, not even marginally, if we want a corrective to the current account deficit in the balance of payments and relieve the downward pressure on the rupee in the foreign exchange market.

Under the Currency Board arrangement we had no inflation and no current account deficits because the money was linked to the Foreign Reserves and the money supply declined when there was a deficit in the balance of payments. But with the establishment of the Central Bank this nexus was broken. The CB could expand the money supply by lending to the government or buying domestic or foreign assets against newly created money which adds to the Reserve Money.

The Governor of the CB who was interviewed by Chaminda Rodrigo of Art TV pointed out that we have practiced depreciation for the last fifty years and each time it has failed to provide the expected results. Yes, he is right about the failure of exchange rate depreciation to correct our balance of payments problems. But we must ask why it was so. It was because the necessary deflation that should have accompanied the depreciation did not take place. Instead what followed was more and more inflation due to monetary expansion. Depreciation of the nominal rate of exchange is only a proxy for the depreciation of the Real Rate of Exchange that is required. This has not happened owing to the continued budget deficits which worsened the macro-economic imbalances.

There is another factor at work. This is the import content of exports. In our export industries particularly garments but even in other industrial exports, the import content is around 50%. So depreciation, while providing more export revenue in rupees, means more of such rupees will flow back as import content of exports.

Exchange rate depreciation hurts where the rise in import prices outweighs the effect of the increase in export prices.  Just because export prices are better, export earnings in dollars cannot be increased unless there are more goods to be exported. Unfortunately we do not have nor do we have the potential or capacity to increase them because of limitations in extent of land devoted to plantations crops.

In the case of industrial exports we just don’t have spare capacity either. But depreciation can allow us to maintain the level of our exports only until the next bout of inflation. There are countries like China or Japan or Germany which have the spare capacity or the potential to increase supply and in their case depreciation gives them the opportunity to expand exports. In these countries monetary expansion can take place without detriment since they can combine weak currencies and low interest rates. But the situation is different in countries like ours.

We face a conflict during recessions: the lower interest rates will not boost the economy while a weaker exchange rate reduces real incomes. An exchange rate depreciation increases real activity in the former countries since the positive effect on exports outweighs the negative effect of the rise in import prices. Moreover, in these countries, domestic manufacturing output can be substituted for foreign production to a large extent resulting in a major positive effect of depreciation on external trade.

Countries handicapped by the lack of export surpluses or the capacity to produce them, cannot benefit from depreciation of the exchange rate nor the reduction in interest rates. So the Governor is right in refusing to depreciate. The real solution is to restore macro-economic stability.

Earlier the CB bought dollars to prevent appreciation of the rupee and then sterilized to prevent expansion of the money supply. Now it is forced to sell dollars from the Reserves and sterilize to expand the money supply. ``Attempts to hold markets away from a fundamental equilibrium will leave the country more vulnerable than need be."

Hanke and McLeod.