With the receipt of the first installment of the IMF loan foreign exchange dealers are predicting that the rupee will appreciate to Rs 113 to the dollar. But those who go by the fundamentals of the economy argue that the rupee is over-valued in terms of its Purchasing Power Parity and that the real exchange rate is not at its true value.  The Central Bank has been managing the exchange rate although it has moved away from the rigid fixed rate regime of last year when it lost Foreign Reserves heavily.

Free float or dirty float?

The Deputy Minister of Finance explained on TV that the IMF money cannot be used for development but only for balance of payments support. Can the Central Bank (CB)  use IMF funds to intervene in the foreign exchange market to keep the rupee from either appreciating or depreciating? That would mean it is still pegging the rupee to a fixed value. But didn’t the IMF want the rupee to float? Central bank interventions, hitherto, has been both ways- to prevent both appreciations as well as depreciations of the rupee.

Stability is needed not in the nominal exchange rate but in the real exchange rate. This means it must control inflation and keep it below 5% which is the rate prevailing in our markets and in competitor countries. This really means that it must give up an independent monetary policy to achieve other objectives like promoting economic growth. What economists say is that to maintain the real exchange rate the nominal value of the rupee must follow the Purchasing Power Parity value (PPP). This means that the rate of exchange say between the dollar and the rupee, which is a ratio, must conform to the relative purchasing power of the two currencies so that Rs 114 (present dollar value ) should buy the same amount of goods as one dollar in the USA.

The basic tenet is that the relative price levels of Sri Lanka and USA and their ratio constitutes the equilibrium rate of exchange.  There are of course difficulties in applying the concept but economists say that it is the equilibrium value of the exchange rate which is both desirable and sustainable.

Market intervention and sterilization

When the Central Bank intervenes in the foreign exchange market to buy dollars it pays for them with newly created rupees  which adds to the Reserves the banks have to maintain with the Central Bank -the monetary base. When the Reserve Money increases through the CB operations in buying dollars, the money supply tends to increase. So to counter this increase the CB sells Treasury securities in its portfolio to withdraw such rupees from the market fully or partly. This is called sterilization. This counters the expansion of Reserve Money due to the original purchase of dollars.

Similarly when the CB intervenes in the market to prevent a depreciation, it sells dollars from its Reserve holding and checks the tendency for the rupee to depreciate. This action withdraws rupees from the Reserve Money or monetary base. So, as the dealers predict, it is possible for the CB to continue its intervention in the foreign exchange market in the same old way, to maintain a value which will be the above the Purchasing Power Parity value. Then the over-valuation of the rupee will continue with its adverse consequences to exporters and import substitution domestic industries.

PPP under a managed float

The PPP rate of exchange cannot be achieved under a managed float as presently followed by the CB unless the CB follows the PPP determined Real Exchange rate as a norm. It is easier to achieve this under a free floating rupee where the CB intervention is at a minimum. But there could then be over-shooting owing to market speculation. So the CB intervention should be confined only to smoothen out any excessive volatility but not to maintain a fixed value (unless the real exchange rate norm has been reached).

Such volatility often arises from the market players who seek to guess what level the CB would consider acceptable. There are differences of opinion but one view is that uncertainty about the intentions of the government and the CB and about monetary policy in particular is the cause of volatility. Perhaps it is better for the CB, after working out the appropriate real exchange rate , to announce it to the market. The market would then have much less cause for speculation and know at what levels the CB would intervene.

Depreciation not appreciation is needed 

Given our present current account deficit in the balance of payments there is no doubt that the rupee has to be depreciated if we want the deficit corrected. But depreciation alone is not enough. It must be followed by a period of deflation where the CB allows the money supply to contract as stated above.  The CB has to decide whether to allow the depreciation to depress the money supply after the original rise in prices due to the depreciation.

If and when it supplies dollars to the market, it must decide at what price to sell. If it asks more rupees for the dollar, then the rupee depreciates and the money supply will temporarily expand. If the commercial bank dealers too have surplus dollars, they may sell them to those who are short and they may do so at a lower rate for the rupee without the need for CB intervention. In recent months the CB has been monopolizing the dollars in the holdings of the commercial banks and it’s therefore obliged to supply any shortage in the market. In short the CB must allow the rupee to depreciate.

Any expansion in the money supply will increase prices in the domestic market causing higher inflation. It is at this stage that the CB has to take a key decision. Will it accommodate the extra demand for money caused by the higher prices or will it refuse to do so? If it does accommodate the increased demand then the corrective action of the depreciation will not take place. If it does not, then the depreciation of the rupee will induce a deflationary process which will tend to deflate prices after the original increase due to the depreciation. But if it accommodates the demand for more money to cope with the higher prices, then the whole exercise of depreciation as a corrective fails.

This is what the CB has been doing throughout the past and a PPP rule for exchange rate management would be useful for it would prevent monetary accommodation. It would also assist the CB to maintain an inflation target announced beforehand. The CB has been claiming credit for the decline in inflation although it has followed an accommodating monetary policy instead of a contractionary policy required for control of inflation. Fortunately the world oil and food prices have fallen. But this trend may be reversed and then inflation would climb again, worsening the over-valuation of the rupee and calling for greater depreciation.

How the CB intervenes in the market will be critical. The sterilization policies applied hitherto may no longer be desirable if the government is keen to implement the targets agreed with the IMF. The sterilized interventions represent signals of future monetary policy and thus affect exchange rate expectations. If there is no monetary contraction, the seriousness of government’s intentions to restore equilibrium in the current account of the balance of payments will not have credibility in the market. To retain credibility in the future, sterilized interventions must be accommodated by corresponding subsequent downwards changes in the money supply. The CB could intervene in the market but avoid sterilization. Then there would be higher inflation followed by deflation. A free float without sterilization would be the best way to win the confidence of the markets. Further the CB must give up an independent monetary policy and allow the external deficit to reduce the money supply. 

No haste to buy dollars

 The CB needs to build up Foreign Reserves but it should buy dollars only after the rupee has achieved its PPP or Real Exchange rate value for then it would be buying dollars earned instead of dollars borrowed or flowing in as hot money which could also depart hastily. As long as the dollars are held by the commercial banks, they are still part of the country’s Reserves though not of the Official Foreign Reserves. Such reserves held by the banks will be made available for imports. So there need be no undue hurry for the CB to intervene in the market to buy dollars to replenish the Foreign Reserves.