21 July, 2024


A Disorderly Depreciation Of The Rupee

By Dr. Arujuna Sivananthan

Dr. Arujuna Sivananthan

Sri Lanka’s Central Bank (CB) is now engaged in a rearguard action to stop the rupee from overshooting on the downside. Its first attempt was to use ‘moral suasion’ to establish a trading range. Dealers have reported it intervening several times by selling dollars to prevent sharp moves lower. Now, it has capped forward rupee transactions at 90 days; and, this will not be the last of many controls the CB will use to prevent a disorderly depreciation.

In a Federal Reserve Bank of San Francisco working paper on exchange rate overshooting and the costs of floating; Michele Cavallo, Kate Kisselev, Fabrizio Perri and Nouriel Roubini analyse the impact of such a move on emerging economies. Their conclusions do not portend well for Sri Lanka’s short term economic health.

Disorderly collapses of currency pegs of countries with high levels of external debt for their national income, Sri Lanka being one such example, result in an abrupt seizure of capital flows. The exchange rate overshoots both its real and nominal equilibrium levels. Also, asset prices sell-off; and in Sri Lanka’s case is reflected in both falling stock and property prices. Additionally, contrary to conventional economic theory, such sell-offs result in severe output contractions.

The only question which needs to be answered is whether Sri Lanka’s policy makers will remain sufficiently disciplined and ensure that there is no policy slippage under duress from their overwhelming political compulsions. This too was a risk which Fitch believed was of importance to highlight in its report.

With real ongoing devaluations, the values of domestic assets depreciate against foreign liabilities. In such instances, investors seek to hedge their wealth by selling domestic assets causing both an overshooting of the exchange rate and overreaction of asset prices. This results in real negative domestic wealth effects. In countries where external debt is a mix of public and private sector debt it causes a partial reduction in outstanding foreign currency liabilities. However, in Sri Lanka’s case where almost all of it is either national debt or that of state owned enterprises which have no significant assets to sell; the outcome is a severe adverse impairment of the public sector balance sheet with the full cost of it eventually having to be borne by taxpayers, and, consumers through administratively determined price rises.

Viewed in this context, the CB’s forecast for 2012 net remittance flows at 5.8 billion US dollars, and, 1.5 billion and 4.1 billion for Foreign Direct Investment (FDI) and Net non-FDI capital flows respectively, look optimistic. And, it is this which prompted the rating agency Standard & Poor’s to downgrade Sri Lanka last week.

Fitch ratings, also last week, highlighted three sources which could pressure Sri Lanka’s Balance of Payments over the short term. It suggests that “A surge in global oil prices, a worsening in global economic and financial conditions, and capital flight could all exert negative pressure on the ratings. None are currently in Fitch’s base case, but they need to be watched”.

The first two are exogenous factors over which the CB has no control. However, its exchange rate policy will be critical to mitigating any risks associated with ‘capital flight’. Fitch goes onto assert that “Sri Lanka’s banking system was moved into the high-risk ‘3’ category under Fitch’s Macro-Prudential Index due to strong real credit and asset price growth stemming in part from the strong growth of imports. Historical experience suggests financial systems in this category are at risk of instability. Although Fitch views such a scenario as an outside risk, the weakened state of external finances and the noticeable deterioration in Sri Lanka’s liquidity ratio suggest the sovereign’s capacity to absorb a sharp and sustained period of capital flight is limited”.

The CB being well aware of these consequences will use every tool it has in its inventory, including controls on the types of rupee transactions, to prevent a disorderly depreciation of the rupee. However, by doing so it also risks increasing the size of the unofficial rupee market which functions outside the banking system, i.e. the black market. On the other hand, the costs of inaction will manifest itself in not just worse than expected economic outcomes; but, also in the political and social spheres as well.

The only question which needs to be answered is whether Sri Lanka’s policy makers will remain sufficiently disciplined and ensure that there is no policy slippage under duress from their overwhelming political compulsions. This too was a risk which Fitch believed was of importance to highlight in its report.


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Latest comments

  • 0

    A question to Dr. Arujuna, if the investors can get more rupee’s for the dollars they pump into the country wouldn’t it be attractive to the investors to invest more? As far as I see (layman’s point of view) this is a double edged sword situation, if one could get more rupees for the dollars it is a good time for Sri Lankans living abroad to invest back in Sri Lanka (as permanent investments e.g.:- in properties). On the other hand the foreign investors may feel the pinch if they had borrowed money to invest (where they are paying interest abroad) when the rupee falls. I would like to have your opinion on these facts. P.S I am not an economic expert.

  • 0

    The finance minister has no financial experience other than the helping Hambantota scam?

  • 0

    The writer could have been the Finance Minister of Tamil Eelaam if they did not lose the war?
    Britain devalued the pound a number of times to make their produce attractive to the rest of the world. Harold Wilson is quoted to have said “The pound in your pocket remains the same”. Every Dick Tom and Harry went to town about this as a joke.

    Today Greece, Spain, Portugal, Italy, France and the UK are having to redress their financial positions and are cutting benefits to the poor and the needy. None of the politicians will have to give up their champagne style lives. The bankers whose bonuses the opposition have described as “obscene” are not willing to give into the pressure.
    jamie Robertson positively a Westerner must realise that there are huge un-investigated scams in the US, the UK and France. So who do you think needs your opinion.

  • 0

    Arjuna Sivanathan closes another one of his “scholarly” articles with concern that “The only question which needs to be answered is whether Sri Lanka’s policy makers will remain sufficiently disciplined and ensure that there is no policy slippage under duress from their overwhelming political compulsions”. Really, that much concern for Sri Lanka when in an another life he had an article titled “Sri Lanka must be subject to an independent war crimes inquiry” Arujuna Sivanathan says that “Sri L anka must be subject to a regime of punitive economic sanctions”

    You see, AS portrays himself as unbiased author writing scholarly academic analysis of Sri Lanka. I think the issue of unbiased authorship is self evident from the previous paragraph. Anyway whats a little bias among friends so long as the writing is a scholarly academic analysis. So lets have a look at his scholarly analysis.

    AS article about currency devaluation, of which Sri Lanka has expereience about 10% with respect to the US dollar. Maybe I am wrong, would not comparison of Sri Lankan currency devalualtion to a another couple of currencies have made sense. In this day and age these are not too hard to do. Below is a link to a chart/graph Indian Rupee (INR), Euro (EUR) and Sri Lanka Rupee (SLR) with respect to the USD. You know this took me just 5 minutes to create.

    Lordy, Lord looks like INR, EUR and SLR have all been been depreciating against the USD. So what could be happening. Maybe Investors having to fill dollar obligations. i.e pay up in USD, margin calls and anticipated CDS (you know the area AS used to work in) payouts. So institutional investors are liquidating their foreign investments and converting to dollars. So they will for example sell their stock in the Indian Stock Exchange (that has been down) and with the INR buy dollars making the INR depreciate.
    When I see, Foreign Investors selling all thier property in an disorderly exit from Sri Lanka, that will be day, and I personally will be dancing a little jig.

    Anyways whats a little chart/graph or two standing in the way of scholarly analysis among friends. Maybe forgeting to mention that the Fed Reserve article that forms the basis of AS’s analysis was written in 2005. You know the time Roubini (and Raghuram G. Rajan among others) were predicting increase of financial risk with the creation of Credit Derivatives and depreciation of Mortgage Backed Securities. Maybe AS could really have been analytic and used the model described in the Fed Reserve Paper with data on Sri Lanka and compared the results with the 25 odd countries analyzed in the paper.

    So may be these articles of AS have not achieved unscaled and unparalleled heights in scholarly analysis. Anway, what matters is that they have been written as AS volunteers by one whose “academic credentials you may at any point contact my PhD supervisor Professor Vito Antonio “Anton” Muscatelli FRSA FRSE AcSS who is the Principal of the University of Glasgow”. Really Arjuna, “ask my Professor”, isnt that a little puerile. Dont you think citing a peer reviwed article of which you may have even been the tenth co-author might have been better. Your Peer reviewed article does not have to be in The Economist or the Quarterly Journal of Economics, even the Bulletin of Indonesian Economic studies would suffice.

    It suddenly struck me, maybe AS is not really writing for us donkeys who look at these articles a little critically. AS is writing for like minded people who have his same agenda. This way when goes for those “voluntary political activist” meetings he can raise up his hand and like any armchair warrior proudly roar, I too have worked for the CAUSE …of a “regime of punitive economic sanctions” against Sri Lanka.

    Ta, Ta, Arjuna, please keep up the good work. Dont forget to let your PhD supervisor Professor Vito Antonio “Anton” Muscatelli FRSA FRSE AcSS who is the Principal of the University of Glasgow know of the your excellent articles of scholarly anaysis. I am sure he will be delighted to know that he has taught you well.

  • 0

    Dr Sivananthan’s correct. It’s a matter of time and (downward) speed. http://tinyurl.com/88dn5tc

    A banker friend explained SL’s situation like this:
    “Low interest rates and cheap credit drives up debt which drives up imports. However, imports are funded by debt to foreign countries, this increases trade deficit. Increase in deficit means rupee is devalued which means you have to pay more especially for foreign goods.  SL is a net importer so everything becomes more pricey which means inflation.  So for the ordinary Tom, Dick and Harispattu on the street, this means his living costs goes up.

    Central bank is trying to reduce imports by raising interest rates, thus trying to reduce cheap credit which is funding the imports.”

  • 0

    US$40,000,000,000 (40) billion rescue fund available. How about negotiating a political solution for a financial solution? No kidding, I will take on the government bond sell it to Diaspora and deliver the money personally, myself
    Want to talk? massey@tidolcorp.com

  • 0

    SL rupee is falling fast, fuel price increased recently, milk foods to be increased, unemployment was always high, cricket players unpaid since world cup and social unrest to breaking point. The demonstrations are craftily orchestrated to divert attention. Abductions, disappearances continue unabated. Law and order is no more. The rich are getting filthily rich while the poor are getting appallingly poor. Will GoSL organise demonstrations to address such issues?

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