Economic fundamentals suggest rupee should depreciate :Strong rupee hurts exports, ‘Dutch Disease’ looms


Analysts call for balanced approach

Sri Lanka needs to understand the underlying causes for movements in the exchange rate and bring in effective management in order to avoid catching on the Ditch Disease which could destroy the export sector as increasing foreign currency inflows put pressure on the rupee to appreciate against the dollar.

Previously highlighted in The Island Financial Review (July 26), the Dutch Disease refers to the situation where short term foreign investment appreciates a country’s currency, destroying the competitiveness of exports which leads to a deterioration of macroeconomic fundamentals. When short term investors pullout, there is little left but a lot of damage to the domestic economy.

The Institute of Policy Studies in its recent flagship report ‘Sri Lanka: State of the Economy 2010’ takes a look at the Dutch Disease through a post-conflict lens.

Since the end of the conflict last year, foreign currency inflows have increased, especially investment in to government securities and the stock exchange, this has put pressure on the rupee to appreciate and Central Bank intervention is preventing a sharp appreciation. For exporters, still recovering from the dip in demand caused by the global financial crisis, the appreciation of the rupee could spell disaster as exports of competitor countries become much cheaper.

"What is of concern is that the real effective exchange rate (REER) is showing a steady increase in 2010. Heavy intervention in the foreign exchange market to prevent a nominal appreciation has helped to ease the upward real appreciation. In view of the need to promote a rapid recovery of the export sector, the underlying causes for movements in the exchange rate need to be understood and managed effectively," the Institute of Policy Studies said in its latest flagship report ‘Sri Lanka: State of the Economy 2010’.

Sri Lanka’s external current account improved sharply in 2009, recording a deficit of 0.5 percent of GDP as opposed to a deficit of 9.5 percent in 2008, due to a near 50 percent reduction of the trade deficit and strong remittance inflows (US$ 3.3 billion).

"The improvement in Sri Lanka’s current account deficit hides the more disturbing feature of export sector performance. The narrowing of the trade deficit was not due to an increase in export earnings, which grew by 12.6 percent, but rather due to the greater contraction of imports, which declined by 27.6 percent," the IPS said.

"What is of concern is whether the export sector is seeing a sustained recovery," it said.

According to latest data from the Central Bank, The trade deficit expanded by 103.7 percent during the first eight months of this year with export earnings growing by 10.8 percent and imports growing at a much faster pace at 36.9 percent.

Export earnings for the first eight months of this year grew by 10.8 percent to US$ 5,040.4 million from US$ 4,551.3 million during the corresponding period of last year. Tea exports grew by 17.8 percent to US$ 869.8 million. Apparel export earnings fell by 4 percent to US$ 2,076.1 million from US$ 2,162.3 million a year ago.

"The economic fundamentals underlying Sri Lanka’s external account performance strongly suggests that the rupee should be on a depreciating trend. However, the reality for the most part has been otherwise, with the rupee coming under upward pressure, particularly in view of inflows from the capital account of the Balance of Payments (investment inflows)," the IPS said.

Getting the right balance...

Analysts point out that a depreciation of the currency would help exporters, but it would still hurt the economy.

"We are heavily dependent on imports. If the rupee depreciates imports would be expensive resulting in rising inflation. Public debt repayments to foreign sources too would be more expensive. Added to this, the dollar is taking a hit as many countries depreciate their currencies and this would have a cascading effect on inflation and public debt repayments. This is why we need to strike the right balance. The Central Bank would continue to intervene in the market to prevent volatility, but we should not ascribe to appreciating or depreciating the currency, we need to find the right balance," a dealer said speaking to The Island Financial Review.

The dollar traded at Rs. 111.60/65 yesterday. In January 01 this year, the dollar traded at Rs. 114.38/40.

"Dr. P. B. Jayasundera said exporters should take in to account the dollar falling to Rs. 100 in the near future, while exporters and some analysts suggest the rupee should depreciate so that the country’s industrial sector could grow. These are two extremes that could hurt the economy badly," a dealer said.

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