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Dollars and Rupees; How Does the Foreign Reserves Affect Day to Day Life of the Public?

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Economic Crisis

There is an extensive discussion about an economic crisis in Sri Lanka in both electronic and printed media. Shortage of milk power, cooking gas, petroleum products, medicine, and many other consumer items considered essential and long ques to purchase these items have become common. Small and medium enterprises are complaining about their inability to import essential items to continue their business. Construction industry is paralyzed due to shortages of many imported items including cement. Importers and garage owners grieve about looming crisis in vehicle repair sector due to spare part shortage. In short, the economy is falling apart with different sectors are being affected one by one. At the heart of this unprecedented economic crisis is the lack of “dollars” to import consumer goods and essential inputs for agriculture, industries, tourism and other sectors of the economy.  

Repercussions of the Crisis

When a country faces this type of deep economic crisis, economic reforms should be undertaken to put the economy back into a path of economic growth and development. Often economic crises occur due to mismanagement of the economy for a long time. The necessary reforms are painful for the public; there may be temporary reduction of their standard of living. However, if the problems are not solved in a timely manner, a complete collapse of the economy may result in loss of jobs, and income and millions of people may go back to poverty. Severity of the impact vary from one crisis to another. In some countries, unprecedented levels of suicide and mental sicknesses have been witnessed due to similar crises.  Understanding the causes is essential to find proper solution to this crisis as well as to avoid similar crises in the future. Any genuine and transparent attempt to solve the economic problems require public support. Therefore, awareness of the public about causes and solutions is a must. Objective of this article and a series of follow-up articles are to explain the economics related to the crisis in layman’s language.

Do We Need Dollars to Run Our Economy?

One might wonder why we need Dollars to run our economy? Being a sovereign nation with its own currency (Rupees) why can’t we run our economy using Rupees? The majority of the public never use Dollars in their life. Particularly those who believe in “home grown” solutions to local problems may even argue that it is a wrong policy to depend on Dollars. They may further speculate that dependency on Dollars is a main reason for the current economic crisis.

In order to understand the relevance of Dollars to our day-to-day life, one needs to understand as to how the modern economies function. Almost all the countries in the world engage in foreign trade. No country can produce all the goods and services required by its population. Even if this is technically feasible, producing some of the goods is costly. Therefore, purchasing such goods from other countries at a lower price is inefficient. Every country produces goods that are cheaper to produce locally and export part of these goods to other countries and purchase cheaper good from other countries using the export earnings. In economics we use the term “comparative advantage” to describe this phenomenon.

International Trade: Menace or a Path to Prosperity?

Skeptics about this trading economy may suggest to produce all the goods and services in our country. Let’s see why this is not feasible for Sri Lanka. If you think for a moment, and prepare a list of the goods and services we consume today, it will be a very long list starting from needle, to your entire basket of food, your TV, washing machine, three-wheeler, car etc. Do we have capacity to produce all these things? Let’s assume yes. How about electricity? If we only use hydro-power wind and solar to produce electricity, we will have power cuts. In the future we may be able to totally depend on renewable energy, still we will have to import wind turbines and the other inputs. Even if we produce all the cars motorcycles etc, in Sri Lanka, we still need to import oil to run them. Many inputs to produce cars such as iron have to be imported too. So, it is not feasible to be self-sufficient in every item we consume. Not only that, it is inefficient to produce everything locally. We should produce and export things for which we have the comparative advantage. For our spices, for example, we have a comparative advantage provided by the nature. Comparative advantage is dynamic, an economy can create comparative advantage for new commodities through education and innovation.

Thus, the international trade is unavoidable on one hand. On the other hand, the countries excelled in producing and exporting goods for which they have comparative advantage improved their economies and standard of living of the people. China is one very good recent example and all the advanced European countries, USA, Australia, Singapore, Japan, South Korea and many more countries developed their economies through export expansion. In fact, no country in the world developed its economy applying import substitution or self-sufficiency, the opposite of export expansion.

Demystifying the Need of Dollars

Once we established that international trade is not only unavoidable, but also the way to improve the living standard of the people, we can understand the relevance of “Dollars” to our economy and day today life. When we import a good we cannot pay for that good using our currency, Rupee. We need a “reserve currency” to make the payment. For variety of economic and historical reasons, currencies in the world cannot be traded on one-to-one ratio. In other words, currencies have different values. For example, to buy Indian Rupees 100worth onions we have to pay Rs. 271. To purchase  Japanese Yen 100 worth motor spare part we have to pay 176 Sri Lankan Rupees. If we buy something from Norway, for  Kroners 100, we have to pay Rs 2255 according to current values of currencies. There are about 180 different currencies in the world. Maintaining bi-lateral exchange rates for international trade is not pragmatic given the real value of currencies are changing all the time. Therefore, all the international trade is undertaken using a stable  intermediate currency, which is U.S. Dollars. This is known as a the “reserve currency” and the bilateral exchange rates are determined by the exchange rate of the two countries with US dollar. After the second world war, US dollar was the most stable currency backed by the largest gold reserve. So, most of the countries adopted US dollar as the reserve currency for international trade. Even after the Gold Standard was abandoned, countries continued to use US dollar as the global reserve currency.

It is clear now, when we purchase any goods from abroad, we need to pay using the reserve currency i.e., in Dollars. Let’s see how we earn dollars and spend dollars.  We earn Dollars mainly through exports, remittance, tourism and foreign direct investments. When we export goods or services, the buyers pay us in dollars. When Sri Lankan work abroad, despite the currency in that country, remittance he sent back to the country, come as Dollars. When tourists visit Sri Lanka, they pay hotels restaurants etc. in Dollars. When private investors invest in Sri Lanka, they bring dollars to the country. How do we lose Dollars? Imports is the main source of outflow of the dollars from an economy. In addition to these external borrowing sources (for example from the World Bank), our borrowing are in dollars so dollars come to our economy. When we repay our loans, dollars go out of the country.

As explained above, in order to undertake international transactions, we need dollars in our commercial banks. When we import milk powder from New Zealand, for example, the importer pays his bank in Sri Lankan Rupees. The local bank release dollars, based on the prevailing exchange rate, to the bank of milk exporting agency in New Zealand.  Under normal circumstances, the local banks have sufficient amount of Dollars to facilitate this transaction. Therefore, the transaction takes place without any problems and the milk power market function smoothly.  When our commercial banks don’t have dollars to pay for the milk exporting agency, I New Zealand, we have milk power shortages and long ques. The same applies to all the other commodities like oil, cement, cooking gas, medicine, spare parts etc. I will explain how did the Dollar shortage developed in our economy in forthcoming articles.

Will the Dollar Shortage End Soon?

A citizen Sri Lanka who used to purchase milk power for his entire life didn’t know or even didn’t want to know there is an intermediate reserve currency is involved when he purchases his milk power. When the economy functions smoothly, we earn enough Dollars through exports, remittances, external borrowing, tourism, and foreign direct investments. The pandemic stopped economic activities completely for a while and as a result, our economy didn’t ger enough dollars to support importing essential goods to maintain our day today life. Now that pandemic seems to be subsiding. Will our dollar shortage go away after the pandemic is over? Unfortunately, the end of the pandemic will only solve the problem partially because there are deep rooted economic issues which resulted in more dollar outflow from the economy than the dollar inflows during most of the post independent history. On top of these structural issues in the economy, we are facing a huge debt crisis. Sri Lank has to may back about 7 Billion Dollars to its external lenders. Loan repayment is one of the major Dollar outflows from the country. Thus one needs more information to understand the current economic crisis.

Prof. Herath Gunatilake
Prof. Herath Gunatilake
Former Director, Environment and Safeguards Division, Asian Development Bank. Philippines. Professor at University of Peradeniya, Senior Economist. Writer

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