COULD SRI LANKA CONTROL DEPRECIATING RUPEE VALUE (PART 1)
Posted on September 28th, 2018

BY EDWARD THEOPHILUS

Many newspapers, electronic websites and TV news in Sri Lanka frequently report that the foreign and domestic value of the national currency unit is being radically and continuously depreciated and the general price level of the country daily increases in response to the depreciation incurring economic predicaments to people. This unfortunate situation has created tremendous plight to lower income earners, especially in rural and semi-urban poor community. It also reflects the economic instability in the country, despite the promises given.  The public is quite uncertain whether Sri Lanka can go back to previous exchange level and regime controlling depreciation of the national currency unit. Current situation shows the economic instability has gone too far and the weakness of the management of the economy by the Yahapalana regime has gone from bad to worse.

The practical experience of the world indicates that the depreciation of national currency units is not an unnatural exposure specifically in Sri Lanka, but it’s a common plight in many countries in the Asian region as well as in African and Latin American countries.  Recent increase in interest rate by the Federal Reserve in USA has badly impacted to currency value of India, Australia and many other Asian countries. Although the domestic currency unit depreciation incurred many countries, they were able to go back to previous level when the instability changed, for example during the 2000 Sydney Olympic period, Australian dollar depreciated to US $ 0.50 level, but Australian Dollar recovered after the crisis of stability   Sri Lanka has an enduring depreciation trend for a long period and the experience after 2015 appears that it is an unmitigated tragedy like a specific experience.  The other point that significant to consider is like in stock market the past information is not relevant to present and the future. Is this a beginning of a new Asian crisis or a problem with the management of economy and political leadership of the country? The adapting to the dynamism is a successful policy development relevant to the present and the future.

In this gloomy situation, common people of Sri Lanka must understand a vital point that the determination of the domestic and foreign value of Sri Lanka rupee relates with abundant macroeconomic factors, which are not analogous like microeconomic determinants.  The relationship between foreign value of Sri Lanka rupee and macroeconomic variables is not a direct simple correlation identically between X and Y.  According to the textbook economic theory the demand for a product or service is determined by limited variables based on an assumption that the other factors remain silent, and the determination of foreign value of Sri Lanka rupee is not so a simple process, but it concerns with multiple correlated factors. The nature of influence of each factor is not linear and the relationship couldn’t be easily estimated at 99.9% accurate level by a research.  The identification of dependent variables for the foreign and domestic values of Sri Lanka rupee for a multiple regression analysis need accurate historical data for each variable and it should have been a continuous practice during the last five decades.  In fact, the identification of macroeconomic factors is quite a difficult task due to dynamic conditions of the modern environment and using such research data for the development of successful practical policies might not be efficaciously worked in Sri Lanka’s economy. I also suspect whether the Central Bank of Sri Lanka, which is responsible for maintaining the stability of the domestic and foreign value of Sri Lanka rupee has been maintaining a database of macroeconomic factors which are influencing to the currency value.

The second vital point that public needs understanding is, Sri Lanka is not an economic and trade giant in the international market, this means that Sri Lanka has not absolute power to aggressively react and participate in manipulative and natural policy responses as it is not an economic and trade power base, and financial manipulator with a huge quantum of forex reserves.  With this point, people also need to understand that Sri Lanka has confined competitive power and legally Sri Lanka has signed several free trade agreements with assorted countries. Despite the legal conditions related to free trade agreements the government of Sri Lanka cannot act like a bull in a shop of clay cooking utensil. Sri Lanka is a disciplined country respecting international conventions. Therefore, the people of Sri Lanka must understand the process of the international trade and financial framework and the limited capability of the country taking policy options for preventing the depreciation of rupee value, this doesn’t mean that Sri Lanka is impotent without potential policy options, it has many practical alternatives, however they are not teaching theories of textbooks and potential policy options are practical solutions and initiatives with international co-operation.

When Sri Lanka received independence in 1948, the foreign value of a Sri Lanka rupee was equivalent to US Dollar 0.21 or one US $ was valued at Rs 4.76 and now it has changed to Rs 170. Policymakers expect that the price of one US $ would rise to Rs 200 soon.  In 1948, Sri Lanka Rupee was linked with British Sterling Pound through the Currency Board System, which was a dependent currency management (Please read the book From Dependent Currency to Central Banking System in Ceylon by H.A.de S Gunasekera) and at that time, when the British pound was in a stable condition, Sri Lanka rupee also was stable preventing radical fluctuations. The favourable condition for the rupee value was supported by macroeconomic factors such as the well-managed balance of payment which had a US $35.0 Million overall balance and the current account had a positive balance of US$ 28.8 Million and the value of foreign assets was the US $ 237.16 Million. In this condition, Sri Lanka’s money supply, the rate of interest and highly positive fiscal operations and very lower unemployment, lower level of foreign and domestic debt, low level of inflation, good business and investors’ sentiments contributed to the stability of the foreign value of Sri Lanka rupee. The purchasing power of rupee remained in higher and the country was not involved in international politics and trade wars. Because of the combined effect of such macroeconomic factors, Sri Lanka was enjoying a higher value of rupee and there was a favourable market condition for rupee in the foreign exchange market.

Internationally, financial stability reasonably maintained by the regulations of the International Monetary Fund preventing the unstable situation had in 1930s.  Therefore, America did not play games like how Donald Trump plays his political and economic stability.

Before 1950, Sri Lanka had a dependent financial authority, which was called a Currency Board System, that was changed after establishing the independent Central Bank. Under the independent Central Banking system, the monetary authority was given a broader responsibility to achieve four specific objectives primely focussing on   the stability of national currency unit and the economy (Please read Central Bank and Financial institutions of Ceylon by HNS Karunatilake and Economic Development of Ceylon by HNS Karunatilake), the first challenging test to the Central Bank was the economic and trade conditions created after the Korean boom.  The government of Sri Lanka at that time wisely acted with the support of China.  As Sri Lanka rupee was linked with Sterling pound, the domestic and foreign value of rupee survived until 1967, the official depreciation of British pound.  On the advice of the International Monetary Fund, the foreign value of Sri Lanka rupee was officially depreciated by 20%. The official depreciation of the national currency unit resulting the problem of British Pound was 24.58% compared to the rupee value had in late 1940s and it was a very high depreciation.

After settling this problem, Sri Lanka was encountered another financial and trade problems with the oil crisis in early 1970s and the national currency unit linked to US dollar with a view to preventing fluctuation. Soon after the change, the national currency unit faced a crisis resulting from the US dollar depreciation. The US economy followed monetarist advices of economists mainly Milton Friedman and others.

During the late 1960s, Sri Lanka’s government, as well as the Central Bank clearly understood the weak symptoms of the economy and the financial system of the country. Sri Lanka highly concerned on the increasing unemployment, increasing population, weak foreign exchange market, and many other matters. Sri Lanka began diversification of the export market, import controls, and a dualistic foreign exchange market introduced through Foreign Exchange Entitlement System (FEECS) in 1968 and the Central Bank maintained an Adjustable Peg System to maintain the foreign value of Sri Lanka rupee. According to the Adjustable Peg System, Central Bank gave the exchange rate for 16 currencies including purchasing and sales rates to commercial banks and non-bank financial institutions. The commercial banks had the authority to slightly change the peg when buying and selling foreign exchange and there was a rule that excess foreign exchange should have been sold to the Central Bank after balancing the foreign cash flow. The system has been successfully operated, despite criticisms and weakness until 1978.

Adjustable Peg System to determine the foreign value of the domestic currency unit was an effective foreign exchange management strategy in many countries. Despite criticisms, the historical behaviour of the determination of the foreign value of Sri Lanka rupee abide since 1968 with a FEECS, which was a positive management strategy for a developing country.  It was a managed exchange rate determination with a higher level of controls.  In fact, it created a black market and a dualistic market for foreign exchange, but they were good to the country and the size of the black market was smaller than the currency frauds in the modern open system.

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