Content on this page requires a newer version of Adobe Flash Player.

Get Adobe Flash player

n
e
w
s

f
e
a
t
u
r
e


Understanding the expected depreciation of the currency

There is widespread expectation of a depreciation of the currency. This is subsequent to the announcement of a bailout package by the IMF, and the visit of the IMF team to negotiate for the facility. This interpretation is neither correct about the causes for the most likely depreciation of the Rupee nor the sequence of events leading to the inevitable depreciation. The reasons for the depreciation of the Rupee are, the fundamental weaknesses of the economy that have resulted in an erosion of the country’s foreign exchange reserves, and rendered the current exchange rate unsustainable. The Sri Lankan business community itself has pointed out repeatedly, that the Rupee is over valued and that, it is, consequently, hurting the country’s exports, especially, manufactured exports. The depreciation of the Rupee is needed to correct this state of affairs. The economy would not be able to sustain itself, without a fresh infusion of foreign exchange and a depreciation of the currency.

It is true, that the IMF would place currency depreciation as one of the conditions of the bailout package, for good reasons. The bailout package is to rescue the country from its low reserve position that has, itself been created by the trade deficit that has, in turn, been caused by the non-competitiveness of the country’s exports. Therefore, making the IMF the scapegoat is quite misleading. More to the point is that, Sri Lanka’s balance of payments faced a stressful situation, owing to the high prices of food and oil in the last two years and, in about the last six months, the country’s exports have suffered, owing to the global recession and therefore, the lesser demand for the country’s agricultural and industrial exports. While these external shocks impacted on the external finances of the country, there were inadequate countervailing measures to mitigate the problem.

The expectation of a depreciation of the currency is itself fraught with danger, as this expectation would itself create a problem for the balance of payments. Export proceeds would be withheld, in order to benefit from higher Rupee proceeds; importers would buy foreign exchange forward to save money; those wanting to remit money would withhold their remittances till the depreciation occurs. Therefore, it would be best to depreciate the currency quickly, and keep the currency relatively stable at an exchange rate that enables exporters to compete internationally. Such confidence would benefit the economy.

The other fear is that, the depreciation would usher in a new wave of inflation. This expectation has some validity. The depreciation will increase the Rupee costs and prices of imports. This is the means by which imports are contained. Unfortunately, the increase in import costs will affect a number of commonly consumed commodities such as wheat flour, bread, sugar, milk, dhal and some other foods. It will also affect petrol and diesel, kerosene and other imports. Whether the government would take some countervailing measures to offset prices of essential commodities is left to be seen. Such an expectation is unrealistic, at a time when Government finances are in a bad state of affairs, with Government revenue inadequate to meet budgeted expenditure. Therefore, higher prices appear to be on the cards. This is indeed unfortunate, as the high inflationary trend witnessed for sometime is tapering off. According to the Central Bank, the country has reached the lowest rate of price increases in recent months.
The serious situation, with respect to the foreign reserves, has also given the kiss of life to moribund ideas in economics. There is a resuscitation of the idea of controls. Simple thinking is that, controls would curtail imports and solve the balance of payments problem. This would be an economic disaster for a small import-export economy. There are several reasons why import controls are not the way of achieving a better trade balance or reducing the trade gap. There are few possibilities of curtailing imports, without adverse effects on the country.

There may be a possibility of selectively cutting some non-essential imports such as import of large vehicles and a few high valued luxury items. The banning of large high petrol/diesel consuming cars and vehicles would not only reduce their high import costs but also oil consumption. Yet this should be done without any exceptions. However, the overall impact on the balance of payments of such restrictions is likely to be insignificant. The controlling of imports, in general, could have serious repercussions, as witnessed in the 1970-77 era. Control of imports would give economic power and a means for corruption to those who hold import licenses. This would distort prices and distort economic efficiency. Since the country is an export economy, dependent on imported raw materials, import controls would hamper the development of export industries.

What is also, generally, not recognised is that, import controls will also not help with net capital flows position in the BOP. A controlled economy is one into which investors would be reluctant to bring in funds for investment. The perception of a country that has import controls is one that is not financially stable and risky to invest. Therefore, the balance of payments would suffer, owing to the lesser inflow of funds in the short run, and lower foreign investment in the long run.

The foremost reason for the balance of payments problem is the excessive public expenditure that is much above Government revenue. The fiscal deficit is the fundamental cause for increasing imports directly, through such expenditure and, secondarily, through the impact of the deficit financing on creating inflationary pressures that make imports relatively cheaper and exports too expensive to compete in the international market. Consequently, the country faces a serious imbalance in its trade. It is true that, there are some extenuating causes as well, such as the sharp rise in oil and food import prices. Yet, there are other domestically created causes that have also prevented the Government from taking appropriate actions such as the depreciation of the currency that is now contemplated.

The IMF bailout and the depreciation of the currency are short term means to stave out a serious problem. It is absolutely essential for there to be remedial measures to handle the fundamental disequilibrium in the balance of payments and the economy in general. Chief among these measures is to revert to fiscal discipline. There is a need to cut the fiscal deficit to manageable proportions, by cutting down wasteful and unproductive expenditure. This is the crying need in economic management. Fiscal consolidation, as it is called, is vital to save the country from an economic collapse. What this means is that Government expenditure must be brought in line with Government revenue, to reduce the fiscal deficit. The IMF facility is a good opportunity for the Government to pursue prudent fiscal measures. The end of the war would indeed be an opportune time to pursue good economic policies that would benefit the country in the long run. If, financial reforms, to enable a lower fiscal deficit, are not put in place, the country will delve into deeper economic depths.