ECONOMYNEXT – Sri Lanka’s unstable exchange rate is making it difficult for businesses to price output across time to foreign counter parties 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 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 deployed 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 economists 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 sterilized.

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.

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 is 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 could happen when private credit recovers, as had happened in the past decade, if inflationary rate cuts resume, analysts using classical principles (impossible trinity/ISLM-BOP) have warned.

Related Sri Lanka interest rates are dictated by the IMF reserve target, not inflation

Excess liquidity from dollar purchases (coming from the lack of a clean float), could also lead to depreciation if the exchange rate is not defended when private credit using the liquidity resumes.

Under so-called flexible inflation targeting, interest rates are bureaucratically decided based on historical 12-month inflation and statistical models, apparently without regard to current or future domestic credit trends in a bid to generate 5 to 7 percent inflation.

Data shows that Sri Lanka has triggered multiple currency crises and capital flight by the time money is injected to generate 4 percent inflation, since the end of the war with the country not having 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 bureaucratic policy rate, analysts say.

There appears to be 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 and 16 percent policy rate at the moment.

The Bank of Russia was the central bank that invented modern style exchange controls in 1906 and communism arrived within a decade.

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 IMF reserve targets (ISLM-BOP + IMF/NIR target), analysts have warned.

Countries that have external anchors eventually end up with very low interest rates as Sri Lanka did before a central bank was created and the external anchor was dumped in 1977.

Unit of Account

Ondaatjie 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 the customer eventually paid.  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 at 350, 360 (to the US dollar). But when the remittance comes, it is at 300.”

The rupee, which was around 365 to the US dollar in January 2023, fell to 303 to the US dollar by June 2023. Since then the exchange rate has been broadly stable after spiking to 320 to the US dollar.

The currency appreciation had also led to a fall in electricity prices and fuel this year, key inputs for the tourism sector.

Exchange rate stability will also reduce the cost of building materials and vehicles if the rupee is kept stable beyond the 12-month short-term horizon of flexible ‘inflation targeting’.

Global currencies were fixed with self correcting central banks or free banks until the 1920s, with all gold area countries for example maintaining exchange rate parity with a common anchor, except when money was printed during wars, leading to instability.

However, with the bureaucratic policy rate and active open market operations being devised by the Fed in the 1920s, currencies started to depreciate during peacetime in the 1930s, and money began to lose key attributes that made it useful for businesses, including 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 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.

The soft-pegs 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 by mostly running deflationary policy (selling central bank securities to banks and taking in ‘deposits’ instead of buying government securities) and building up foreign reserves bigger than the domestic monetary base.

The Euro area solved the unit of account and medium of exchange problem by setting up a currency union and enabling a large free trade regime.

Several countries in Europe outside the currency union also 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 arrangements to solve both the unit of account and domestic stability problems.

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,” Ondaatjie 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. The US was also hiking rates to counter ‘Great Inflation’ coming from its floating rate at the time.

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 colonial civil service liberals 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 Jayawardene not to depreciate the currency.

He was going against the doctrine that was prevalent after the Second Amendment to IMF articles, of depreciating the currencies of countries without a doctrinal foundation in sound money and therefore susceptible to basket, brand, crawl and similar statistical doctrines.

“Exchange rate policies involve many complicated technical issues which I do not want to discuss here,” Goh, who had a deep knowledge of operational frameworks of note-issue banks and had re-created a currency board on separation from Malaysia, told JR in his report.

It will not be 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 disadvantages of a depreciating rupee will, I believe, outweigh the advantages”, he said, rejecting IMF’s post 1978 doctrine of monetary debasement.

“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.”

Related How Sri Lanka rejected Singapore monetary advice and politicians, people paid the price

He warned in 1980 that Sri Lanka could slide into 100 percent inflation like Poland at the time, if the central bank continued to inject money by purchasing Treasury bills. In 2022 the central bank created 70 percent inflation, 30 percent short of 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.

At the time the exchange rate externally anchored at 360 to the US dollar, through a surrender rule and dollar sales for imports including oil.

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 the 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 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 a foreign currency.

Cambodia has become progressively more externally oriented in the low 3 percent inflation coming from the fully fixed exchange rate (dollars) 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 with currency competition and is expected to easily trade with the rest of the world.

Dollarization is also happening in other ways with renewable energy firms also asking for and getting dollar denominated tariffs.
(Colombo/May25/2024)