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.
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.