By Hema Senanayake –

Hema Senanayake

Sri Lanka is an interesting country. Its currency, the rupee has been depreciating for a while. The Minister of Finance Ravi Karunanayake, it seems was convinced that rupee was depreciating due to depleting “foreign reserve levels.” So, the obvious common-sense solution was to boost foreign reserves. He did find an innovative solution. He got a rich Belgian man to deposit U.S. dollars one billion in Sri Lanka – And as a result official foreign reserves were increased by one billion dollars.

Someone told me that there are signs that rupee is getting strengthened. I being macroeconomic analyst was not convinced because I know for sure that this kind of gimmicks do not work in economics. The most unfortunate thing is that economists in Sri Lanka, it seems, are not dare to analyze this kind of gimmicks.

This new government has a habit in finding microeconomic solutions (i.e. business type solutions) for macroeconomic problems or issues. These solutions cannot prevail and would not strengthen the macroeconomic situation in the country. The mega show of “Davos” too went in line with the same approach. Why do I say so?

It is because the prudent macroeconomic management must begin within the country. The government is not doing enough in this regard. It looks like that the subject of macroeconomic management is a devolved subject; it seems that it is being devolved not to provinces but to rich racketeers in the world. The said deposit of dollars one billion would do more harm than good to the macroeconomic situation in very near-term. Let me explain this point a little further.

In the world market, the crude oil prices hit the lowest by now. A few days ago, the price of a barrel of crude oil was 29 dollars. In late January of 2011 the crude oil price was USD 135 per barrel. What does this mean for Sri Lanka in terms of country’s current account and Balance of Payment (BoP)?

Anyway, why the above question is important? It is because that these two accounts posted or maintained by the Central Bank of Sri Lanka (CBSL), directly relates to the value of rupee. Now you might immediately think as follows:

“Oil prices in the world market have come down and as a result there should be positive effect on the current account and BoP. If this is so, then the rupee cannot be depreciated.” If this is what you think, you are right. But the opposite has happened, the rupee had depreciated significantly. This can only happen when the country’s monetary management and macroeconomic management are not proper. This justifies my point.

The government increased salaries and I liked it. Increased salaries can boost private credit growth for which I do not like that much. The increased salaries and private credit growth can be beneficial only if we can increase domestically produced sellable output. This means that without increasing domestic production there will be no usefulness in increasing salaries and wages.

The country should produce more and more. If we do not do that non-oil imports could rise creating a negative pressure on BoP even though the bill of oil import could decrease. As a result the rupee should fall. This is what has happened while the import bill of oil has been decreasing. The decreasing level in foreign reserves is the resultant effect of increased imports. Would this dynamic in the economy change positively due to the deposit made by the Belgian national, which deposit is not an investment?

I do not think so. On the contrary, the rupee could strengthen in short term due to the illusionary increase of foreign reserves resulting in increasing imports. This cannot prevail for a long time. The rupee should begin to depreciate when the illusion faded away.

So, what is the solution if we can’t increase production in short term? Then we do have only one alternative which is to contain private sector credit growth. In this regard CBSL has two policy tools. One is the customary tool known as the rate of interest which is a demand-side tool. When the interest rate is increased the demand for money decreased and as a result imports would be contained. CBSL has determined to keep the rates steady. If possible that is good.

The other policy tool is a money supply-side tool which is known as Statutory Reserve Ratio (SRR). When the reserve ratio is increased the loanable funds available to banks will be reduced so that by increasing SRR the CBSL can reduce the domestic credit growth. A few weeks ago CBSL decided to use SRR to contain credit growth. CBSL increased the ratio to be 7.5% from previous 6%.

Unfortunately this is not a tool that works fast enough. I frequently argued that CBSL should acquire a new policy tool to regulate the creation of monetary substitute known as “credit money” in the system. It works fast and sometimes proactively, and is the key to stabilize rupee until the domestically produced sellable output is boosted.

Hence, prudent macroeconomic management begins within the country and with the local business community.