ECONOMYNEXT – Sri Lanka’s unstable exchange rate is making it difficult for businesses to price output across time to foreign counter partes and widely expressed fears of future instability also dented investor confidence, a private entrepreneur said.
Sri Lanka’s central bank has since September 2022 provided monetary stability including the elimination of forex shortages with deflationary policy by overshooting its 5 to 7 percent domestic inflation target, providing a strong foundation for growth and economic activities to recover.
However, volatility in the exchange rate was proving troublesome for some businesses as the currency could no longer be used as a unit of account to denominate future prices.
No Credibility?
“I heard the word price stability. Yes, that’s good we have we have got that,” Gerard Ondaatjie, a business executive and hotelier said at a recent forum at the Central Bank.
“But would that be would there be a more important word: exchange range stability? Because I’m not convinced that we are on an exchange rate stability path.
He said that the head of Sri Lanka’s Standard Chartered Bank has said at the same forum, that once imports are opened the exchange rate will start sliding.
Economic analysts using classical principles have pointed out that the current exchange rate stability and also appreciation is an outcome of deflationary monetary policy employed by a reserve collecting central bank amid weak private credit, enabled by a market interest rate.
Exchange rates and the balance of payments are an outcome of monetary and exchange rate policies of a note issue bank, and credit as explained by classical economist before the emergence of inflationist ideologies led to external trouble from the last century.
When a BOP surplus is created by consistently mopping up liquidity from dollar purchases, at a market interest rate, a reserve collecting central bank can either fix the exchange rate, depreciate or appreciate the currency by purchasing more or less dollars against the intervention currency, than the domestic money it has recently sterilize.
Sri Lanka had the worst import controls since the 1970s from 2020 to 2022, but they failed to halt forex shortages and a currency collapse, due to inflationary monetary policy, involving liquidity injections to maintain a policy rate, including to neutralize forex market interventions.
The current monetary stability comes as imports except cars are re-opened, commercial banks are repaying credit lines and also collecting dollars for government forex loans repaid in rupees and the central bank itself collecting billions of dollars in reserves while also repaying forex swaps.
Regime Warning
But some analysts have warned that Sri Lanka is likely to face forex shortages and depreciation and a second default, as soon as inflationary operations (reverse repo or standing liquidity facilities backed injections) resume to enforce rate cuts made to boost ‘growth’ by denying monetary stability.
This happens when private credit recovers, as had happened in the past decade, analysts using classical principles (impossible trinity/ISLM-BOP) have warned.
Under so-called flexible inflation targeting, interest rates are bureaucratically decided based on historical 12-month inflation and statistical models, without regard to current or future domestic credit trends in a bid to re-flate the banking system by generating 5 to 7 percent inflation.
Data shows Sri Lanka has triggered multiple currency crises and capital flight in the course of injecting money to generate around 4 percent inflation since the end of the war as the country does not have a clean float to accommodate a domestic anchor.
There is unlikely to be a different result this time as statistics cannot defy laws of nature, discovered by classical economists, which brought sound money, free trade, free capital flows, as well as individual freedoms before the buraucratic policy rate, analysts say.
There is also no successful clean floating country with a 5 to 7 percent inflation target. Russia, the latest entry to clean floats after the US froze its reserves, is also on a learning curve stumbling along with a 4.0 percent inflation target.
Sri Lanka has to run sufficiently deflationary policy at a market interest rate irrespective of what the historical 12-month inflation rate is, not only to keep the BOP in balance but also to meet an IMF reserve targets (ISLM-BOP + IMF/NIR target), analysts have warned.
Unit of Account
Ondaatje said the recent appreciation had also created problems for businesses that make transactions with foreign customers.
Tourism was an example.
Hotels were finding it difficult to price because the exchange rate was at one level when the price was given but at a different rate (stronger) when customers came. In hotels, customers may book six months or more ahead, industry officials say.
“I look at this in terms of looking at a planning horizon of let’s say your revenue channels. You are doing your costing on your exchange rate,” Ondaatjie explained.
“The tourist industry is saying right now we did our costing on at 350, 360 (to the US dollar). But when the remittance comes, it is at 300.”
The rupee has appreciated from around 360 rupees in June 2022, to 303 to the US dollar by December 2023.
However the currency appreciation had also led to a fall in electricity prices and fuel, key inputs for the tourism sector. It will also reduce the cost of building materials and vehicles if the exchange rate is kept stable in the future.
Global currencies were fixed until the end of the 1920s, with all gold area countries for example maintaining exchange rate parity with a common anchor, except when money was printed during wars.
However, with the bureaucratic policy rate and active open market operations being devised by the Fed in the 1920s, currencies started to depreciate in countries during peacetime in the 1930s, and money lost the key of attribute of being a unit of account.
Depreciation also triggered a wave of tit-for-tat import protectionism in the 1930s, with inflationists, who were growing in number, spreading an ideology that depreciation boosted manufactured exports, despite the industrial revolution being founded on fixed exchange rates.
After the end of the World War II, to re-establish free trade and the usefulness of money as a unit of account and a medium of exchange for external trade, the Bretton Woods system of soft-pegs was set up.
It also collapsed in 1971 amid aggressive macro-economic policy through open market operations – mainly by the US – to boost growth or employment.
Most East Asian nations in the 1980s including larger countries like China from 1993 to 2005 maintained highly successful exchange rate anchors and imported US stability of the 1980s and 1990s mostly running deflationary policy (selling central bank securities to banks instead of buying government securities) and building up foreign reserves bigger than the domestic monetary base.
The Euro area solved the unit of account problem and medium of exchange by setting up a currency union and creating a large free trade area.
Several countries in Europe outside the currency union ran orthodox currency boards (they were running fixed exchange rates with Deutsche mark earlier) or currency board like regimes, until they switched to the Euro itself.
Denmark (7.46 to Euro), Bulgaria (1.95 to Euro) are still running currency board like or orthodox currency board arrangements to solve both the unit of account and domestic stability problem.
External Anchor
Meanwhile Ondaatjie said having a stable exchange rate would bring domestic monetary stability to Sri Lanka.
“That is also more important, because the exchange rate will create price stability,” Ondaatje said.
“Because we are an import driven country. Essential items, are imported.”
Ondaatjie was eerily echoing the words of Singapore’s economic architect Goh Keng Swee who advised then President J R Jayewardene in 1980.
At the time the IMF’s second amendment had deprived Sri Lanka of an exchange rate anchor without a credible replacement, helping macro-economists drive the island into a fresh IMF program amid a strong economic recovery and US rate hikes to reduce floating rate ‘Great Inflation’, critics say.
The IMF program came within two years of the most radical economic reforms made in the island perhaps since trading monopolies inherited from the Dutch East India Company were abolished by the British civil service over a 100 years earlier, analysts say.
Goh noted that Jayawardene’s reforms were considered ‘politically impossible” by many.
Goh, who believed in strong exchange rates for domestic stability without a policy rate, advised President Jayawardane not to depreciate the currency, going against the doctrine that was prevalent after the Second Amendment to IMF articles of depreciating the currencies of countries without a doctrinal foundation is sound money and therefore susceptible to basket, brand, crawl and similar statistical doctrines.
“Exchange rate policies involve many complicated technical issues which I do want to discuss here,” Goh, who had a deep knowledge of operational frameworks of note-issue banks and had recreated a currency board on separation from Malaysia, told JR in a report.
It will not be a possible to stop depreciation until inflationary policy is stopped, he said. Goh told JR that the central bank’s Treasury bill stock was the most important indicator to watch.
“On balance, the disadvantage of a depreciating rupee will, I believe, outweigh the advantages”, he said rejecting IMF doctrine.
“About a quarter of rice consumption is imported. All wheat from which four and bread are produced is imported.
“The same holds true of kerosene and milk powder. Bus fares ware largely determined by the rupee price of imported oil and spare parts. Fertilizers are also mostly imported.”
He warned in 1980 that Sri Lanka would slide into 100 percent inflation like Poland at the time, if the central bank continued to inject money by purchasing Treasury bills to inject money. In 2022 the central bank created 70 percent inflation, 30 percent below the level warned by Goh.
Sri Lanka was sliding into hyperinflation and possible dollarization, analysts say when Central Bank Governor Nandalal Weerasinghe hiked rates, killed private credit and restored rupee stability by generating a BOP surplus from around September 2022 and the exchange rate externally anchored at 360 to the US dollar.
No Exchange Rate Anchor Under Current Regime
Meanwhile Governor Weerasinghe said under the current doctrine the central bank was not providing a fixed exchange rate.
“The core objective is price stability,” he explained. “The argument, is can price stability, or low inflation be by maintaining a stable exchange rate? In very simple terms, price stability is what you measure as inflation.
“In an economy like here, if you look at the overall price level, about 75 percent of the prices are domestically produced and exchange rate has about a 25 percent impact.
“If we think that we can fix prices by fixing 25 percent of the prices, I think that is not going to work. You need to stabilize domestic prices, because this is a larger domestic economy, compared to the external economy.
“That is why we have this monetary policy regime.”
Currency Competition
Some nations have found absolutely fixed exchange rates and got over the problem of bad central banks with a policy rate, and restored domestic stability by using more than one currency, one of the latest being Cambodia in East Asia (US dollars and the Riel without monetary policy).
Dollarization usually happens when people have no confidence in the central bank’s notes and the agency loses the ability to enforce legal tender laws, with politicians no longer willing to protect its money monopoly by punishing the public for transacting in foreign currency.
Cambodia has become progressively more externally oriented in the low 3 percent inflation coming from the fully fixed exchange rate over the past two decades.
Since the Riel collapsed in 1999 leading to market dollarization, Cambodia’s exports have climbed from very low levels to 34 billion US dollars, according to IMF data, or 77 percent of GDP as foreign investment also came with the stability coming from the fixed exchange rate.
In 2023, the country of 16 million people welcomed 5 million tourists.
Sri Lanka’s Port City area is also expected to have absolutely fixed exchange rates and currency competition and is expected to easily trade with the rest of the world. (Colombo/May25/2024)