What is exchange rate?
An exchange rate is the value of one nation’s currency versus the currency of another nation. When an economic zone has a currency like Euro, exchange rate defines the value of the nation’s currency against the currency of the economic zone. Up to 09, March 2022 official exchange rate of the Central Bank of Sri Lanka (CBSL), against US dollar was about 200 Rupees per Dollar. On March 10 Rupee was floated and exchange rate became about Rs. 250 per Dollar Present day exchange rates all over the world are changing all the time due to changing economic conditions. This happens only if a country has a floating exchange rate. Sri Lanka maintain a has a fixed exchange rate up to 09 March 2020. That means Rupee dollar exchange rate has to take place at a value determined by CBSL. Figure 1 shows the exchange rate (Rupee/Dollar) during the post independent period. It clearly shows that Sri Lankan Rupee has been gradually depreciating during the post independent history. Depreciation means that for every dollar we have to pay more rupees. Is depreciation of a currency bad for the economy and people? This article attempts to answer this question. It also explains the negative impacts of a fixed exchange rate on remittances.
Figure 1: Historical Data on Exchange Rate
History: Gold Standard
In the post second world war history there were two types of exchange rates in practice; fixed and floating exchange rate. In a fixed exchange rate system, a currency is pegged or held at the same value relative to another currency. The Bretton Woods Conference in 1944 established a gold standard for currencies, and it also set out guidelines for a fixed exchange rate system. The system established a gold price of $35 per ounce, with participating countries pegging their currency to the dollar. Adjustments of plus or minus one percent were permitted. Thus the U.S. dollar became the reserve currency through which central banks carried out intervention to adjust or stabilize rates. But in 1971 USA suspended gold standard due to dwindling gold reserves and a mounting deficit in its balance of payments. This resulted in floating exchange rates in which demand and supply of currency decides the exchange rate.
How is the Exchange Rate Determined?
Similar to good and service markets, demand and supply of currency determine the exchange rate. In a pure floating exchange system, a local currency is demanded when export items are purchased by foreign buyers, remittances are sent as a foreign currency, capital inflows when foreigners purchase local physical or financial assets (such as bonds), tourists come and convert foreign currency to local currency or externally borrowed foreign currency is converted to local currency for implementing a project. Foreign direct investments (FDI) also increase the demand for local currency. In short, whenever Dollars are converted to Rupees, demand for Rupee increase and the value of Rupee goes up (Rupee appreciation). On the other hand, supply of local currency occurs when a country imports foreign goods. Local currency has to be converted to foreign currency to import goods. Capital outflows and loan repayments also increase the supply of local currency. In other words, when Rupees are converted to Dollars, value of rupee goes down (depreciation). In a clean or pure floating exchange rate system, demand and supply determine exchange rate. Any increase in the demand factors will appreciate local currency (fewer Rupees per Dollar) and expansion of supply factors depreciate the currency (more Rupees per Dollar). The long-term depreciation of rupee as shown in the figure 1 was due to Rupee supply expansion at the rate higher than the Rupee demand.
Is Depreciation Bad for the Economy?
Depreciation affects exports and imports differently. When Rupee is depreciated, our exports become cheaper and demand for them increase in foreign countries. Dollar earnings per unit of exports declines but if exports increase by larger volume total dollar earnings may increase. Similarly, depreciation promote tourism. On the other hand, depreciation make imported goods more expensive and as a result local cost of living will increase. Another important impact of currency depreciation is that more rupees have to be paid in servicing the external debts. For example, if Sri Lanka borrowed $ 100 million in 2010, its value will be Rs 14 billion (at 140 Rupees per Dollar). If we assume one time repayment in 2020 with zero interest (at the exchange rate of 200 Rupees per Dollar), we have to pay Rs. 20 billion. The net impact of depreciation can be positive or negative depending on structure of the exports and imports and the extensiveness of external debt in the economy. Unpredictable currency depreciation create uncertainty for the businesses. Therefore, Central Banks smoothen the process by buying and selling Dollars in the market. In a floating exchange rate system smoothening will change the exchange only by a small percentage while allowing the demand and supply of currency to mainly determine the exchange rate.
Politicizations of the Exchange Rate in Sri Lanka
As explained above, currency depreciation may not necessarily bad for the economy. If a currency like our Rupee depreciates consistently at a faster rate over time, it indicates demand for the currency doesn’t grow at a sufficient rate. Long term solution to this problem is not central bank’s intervention in the currency market. The country should promote its exports (particularly industrial exports), tourism and ensure increase in remittances. It should also create enabling environment to FDI and capital inflows to the country. In Sri Lanka currency depreciation was misunderstood and politicized. Particularly during the last two decades, currency depreciation was viewed as a downfall of the economy and failure of the incumbent government. Opportunistic politics and lack of understanding of the costs and benefits of currency depreciation created a belief amongst the public that currency depreciation means downfall of the economy. As I will explain, this is a very costly belief.
There are plenty of examples that countries purposely depreciate their currency to remain competitive in the export market. In early 1970s US depreciate its currency by about 20% because increasing demand for Dollar during the post second world war appreciated Dollar significantly. As a result, US exports became expensive and US purposely depreciate its currency to make US export cheaper and competitive. It is well known that there has been a trade war between China and US. US always accused China for keeping Chinese currency depreciated. These examples clearly show that currency depreciation is not necessarily bad for the economy.
Fixed Exchange Rate, Dollar Shortage and Drop in Remittances
During the pandemic, CBSL imposed a fixed exchange rate of Rs 200 per Dollar. Given the exports, remittance, tourism income were near zero due to lock down of local and foreign economies, this was a justifiable decision to avoid sudden and very sharp depreciation of Rupee. Together with the fixed exchange rate an import ban was also introduced to protect the limited foreign currency reserves. As explained in my previous article the government failed in its attempt to control imports; imports increased by about 28.5% in 2021 and some “said to be banned” items such as 2200 luxury SUV cars have come to Sri Lanka. While some essential food items like milk power for children are not available in the market, importing luxury items raised eyebrows of many and confirmed wide spread cronyism in our economic management.
Figure 2: Fixed Exchange Rate and Dollar Shortage
Fixed exchange rate in the currency market is similar to a price ceiling, in a normal goods market. It fixes a value for a foreign currency at lower value than that is determine by the market. As in the case of goods market, that create a shortage of the foreign currency and create a black market. CBSL fixed the dollar at Rs. 200 and a lucrative black market developed and as a result now the Dollar is traded in the black market at around Rs. 250 260. On top of that CBSL made it a requirement to convert the dollars coming to the country within a month. This fix exchange rate and other restrictions adversely affect all the dollar earning avenues such as tourism, exports, FDI. The negative effect on remittances was the most prominent.
Figure 2: Decline in Remittances
In January 2021 Sri Lanka received $ 675 million worth remittances and it steadily decreased to $ 259 million by January 2022 (63% reduction). This reduction is due to the Hawala and Undial systems which bypass the banks. Through these systems expatriate workers get about Rs 250 per dollar and in a high inflationary time like this one cannot blame the expatriate workers for trying to get best for their hard-earned money. Many economists requested to seek the help of IMF and float the Rupee against dollar repeatedly to avoid the current economic crisis. Had the CBSL listened to this, and floated the Ruppee at least by mid 20201, the country would have continued to receive over $ 600 million per month from remittance and that is sufficient for importing Diesel, Petrol, Gas, Coal, essential foods like milk power and some of the essential industrial inputs like cement. The country could have avoided fuel shortage and power cuts too. As some experts point out power cuts may be inevitable but 7-8 hours long power cuts would have been avoided had the economy was managed based on economic principle. Now the fuel shortages and power cuts have crippled the entire economy. It may take a long time for the banks to get expatriate workers to send their money through official channels. Once they are used to this new system, they wouldn’t come back to banks unless there is some incentives. Moreover, signals provide by this bad management of the financial markets and unpredictability of the monetary policy will deter any Sri Lankan origin foreign residents depositing their Dollars in Sri Lankan banks.
As we have seen, floating the Rupee after keeping it at 200 per Dollar for some time has increased the price of many items. This will also increase the required amount of Rupees for debt repayment. These are painful outcomes. But how long can we keep this fixed exchange rate? The bitter truth is that it is not possible to maintain the fix exchange rate forever. Further we keep it greater would be the shock and the pain on the cost of living. Had we kept the fixed exchange rate till end of the 2022, exchange rate may have reached 300-400 Rupees per Dollar. Although late, it was a wise decision to float the Rupee. However, this is only one step toward better management of the economy, much more need to be done. Now what Sri Lanka need is a long-term program of reforms to avoid shortage of Dollars in the future. We have to accept the fact that we lived beyond our means, and some painful adjustments to our consumption pattern is inevitable.