Causes and Consequences of a Depreciating Rupee
The rupee has depreciated sharply against the US dollar since the beginning of this year. The weakening of the currency is an outcome of the continuing setback in the external sector characterized by the wide trade gap and heavy external debt commitments. In recent times, the Central Bank (CB) has allowed the rupee to fluctuate depending on the foreign exchange market conditions instead of intervening to defend the currency as previously done. The weaker rupee is partly a reflection of this policy shift. The strengthening of the US dollar in international currency markets since April also contributed to weaken the rupee.
The CB had attempted to defend the rupee until around 2015, and it led to widening of the foreign exchange deficits. Hence, its recent policy shift towards a more flexible exchange rate regime is commendable.
While the currency depreciation has the advantage of fostering the export sector and discouraging imports, thereby helping to ease the foreign exchange pressures, it also has several adverse socio-economic repercussions such as raising the inflation and cost of living and aggravating the external debt burden.
Exchange rate as a policy tool of forex management
Freer movement of the exchange rate is helpful to minimize the imbalances in the external payments front. A weaker rupee means that more rupees have to be surrendered to purchase a dollar. Thus, a weaker rupee discourages imports, since the rupee value of imports are higher. It encourages exports, as exporters can earn more rupees for every dollar they earn from products they sell abroad. Thus, in a theoretical sense, a flexible exchange rate system brings down the trade deficit, i.e. the excess of imports over exports.
In a liberalized trade system where there are no import or exchange controls, the exchange rate is the main policy tool available to achieve equilibrium in the balance of payments, i.e. the country’s transactions with the rest of the world. This means that the rupee should be allowed to depreciate when there is a deficit in the balance of payments. If the exchange rate is fixed in such a situation, the rupee tends to be overvalued making imports cheaper for locals and exports expensive for foreigners. This will widen the external payments deficit.
The SL rupee fell by 3.7 percent against the dollar this year, compared with a drop of 2.5 percent last year. In April alone, the rupee fell by 1.1 percent reflecting a sharper depreciation of the rupee. The US dollar appreciated against several key currencies reflecting the forex market reactions to recent changes in US trade policies.
In comparison with the currencies of India and Pakistan which depreciated by as much as 7.46% and 10.07% respectively, the Sri Lankan rupee depreciated at a much lower rate of 3.66% in the last 6 months, as shown in the Table. Chinese Yuan, Euro, Japanese Yen, Malaysian Ringgit and Thai Baht appreciated whereas the British Pound depreciated against the dollar during this period. Overall, the appreciation of the US dollar since April is evident reflecting the impending US trade policy reforms and other market reactions.
Until around 2015, the Central Bank had attempted to prevent a sharp fall of the rupee by selling dollars to the market using its foreign reserves. In the context of a weakening balance of payments situation, that policy led to overvaluing the rupee and to aggravating the foreign exchange deficits as explained above. Since then, the CB has been moving towards a flexible exchange rate system. In terms of the Extended Fund Facility (EFF) arrangement with the IMF, the Central Bank is committed to pursuing a flexible exchange rate regime with intervention limited to preventing wide fluctuations and building up official reserves.
This policy shift is part and parcel of the CB’s recent decision to adopt a new monetary policy strategy, known as the inflation targeting monetary policy framework. Inflation targeting is a monetary policy framework under which a country’s central bank aims to keep a pre-announced inflation rate over a specific time frame. Inflation means a sustained increase in prices of goods and services in an economy over a period of time. An increasing number of advanced countries have switched to inflation-target based monetary policy frameworks in recent decades, following the success story of New Zealand which began inflation targeting in 1990. Inflation targeting has been increasingly adopted by the central banks in several developing countries as well.
The Central Bank cannot have any target or nominal anchor other than inflation in a pure inflation targeting regime. By and large, this prevents the Central Bank interfering in the foreign exchange market to defend a pre-determined exchange rate, as practiced in the past. This is the reason why the CB is less interfering in the foreign exchange market now.
Balance of Payments is in crisis
The country’s external sector is in a dismal state. The trade deficit widened from $ 8.9 billion in 2016 to $ 9.6 billion in 2017. The rapid increase in imports outpaced the slower export growth. The export sector, which still depends largely on garments and commodity exports, has failed to increase its share in the global market with innovative, knowledge-based, high-tech products, unlike our fast-growing neighbouring countries. In contrast, imports rise at a faster pace facilitated by various types of bank financing.
The larger surplus generated in the services account in 2017, which was due to increased earnings from transport and tourism, was inadequate to offset the negative impact of the huge trade deficit on the balance of payments. The situation is being worsened by a slowdown of worker remittances due to unsettled conditions in the Middle East countries.
Overall, the current account recorded a deficit of $ 2.3 billion amounting to 2.6 percent of GDP in 2017. This had to be financed mainly through foreign borrowings consisting of Sovereign Bonds, Treasury Bonds and long-term loans. In the absence of dynamism in the export sector and the weak macroeconomic fundamentals which hinder foreign direct investments, the balance of payments situation is unlikely to improve in the near future.
While the rupee depreciation helps to ease these external payments imbalances, it has various socio-economic implications, as discussed below.
Exchange rate pass-through to inflation
The rupee depreciation obviously has cost-push effects on import prices and consequently, on domestic consumer prices. This process is usually measured through the ‘exchange rate pass-though’, defined as the effect of exchange rate changes on domestic inflation.
Evidently, rupee depreciation has varying upward effects on both wholesale and consumer prices with the maximum effect occurring in the second month of the shock on wholesale prices and between the second and the third month on consumer prices. Around 25 percent of the variation in consumer price inflation could be explained by external shocks including exchange rate, oil price and import price shocks.
The initial round of inflationary effects of the rupee depreciation is already evident with the recent price increases in milk powder, LP gas and fuel, although prices of some of these items were reduced later. Inflation is likely to escalate further in the coming months owing to the currency depreciation. Needless to say, high inflation has adverse spill-over effects on the living standards of the poor and lower middle-income class families.
Exchange rate pressures on foreign debt burden
The effects of currency depreciation on foreign debt burden are well known. Although the depreciation does not cause any rise in the foreign debt stock in US dollar terms, the external debt stock as well as its service costs in rupee terms go up proportionately to the depreciation causing severe burden on fiscal operations. The rupee depreciation resulted in a rise in the foreign debt stock by a staggering Rs. 225.2 billion at the end of 2017, according to the Central Bank’s latest Annual Report. This year’s depreciation to date has led to increase the foreign debt stock more than Rs. 150 billion.
The main reason for the rise in foreign debt is the financing of budget deficit through foreign sources, mainly commercial borrowings. As a result of these continuous foreign borrowings, the debt service payments have bunched heavily at present costing the government a whopping US $ 17.8 billion for the period 2018-2022; $ 2.8 billion 2018, $ 4.2 billion in 2019, 3.7 billion in 2020, $ 3.3 billion in 2021 and $ 3.7 billion in 2022.
In rupee terms, the external debt service payments for this year is likely to go up by over Rs. 14 billion as a result of the exchange rate depreciation that has occurred to date. These costs will increase further during the rest of the year depending on the extent of the depreciation.
Drastic policy reforms imperative
The rapid exchange rate depreciation during the past couple of months reflects Sri Lanka’s external finance fragility. Such fast depreciation, of course, is inevitable given the grave balance of payments situation, as discussed here. Nevertheless, its adverse socio-economic implications cannot be underestimated. The depreciation has far reaching repercussions on debt service payments from the viewpoint of fiscal balancing. The supply-side effects of exchange rate depreciation on inflation and cost of living too are undeniable.
The policies followed hitherto by the successive governments have had a bias in favour of import trade discouraging exports. Hence, drastic policy reforms are necessary to tackle the external payments problems. The exports sector needs to be diversified to increase the share of high-tech products which are negligible now. This is not an easy task, as the authorities have not given sufficient attention to promote such products through a knowledge-based economy backed by a strong technology and innovation driven growth framework. These policy reforms need to be given top priority even at this later stage.