Exchange rate reverberations

| by FS

(September 13, Colombo, Sri Lanka Guardian) Not unusual, the regular International Monetary Fund (IMF) statement on the economy this week had its pluses and minuses on the country’s financial health. It however raised a few more concerns this time, essentially the need to limit intervention in the foreign exchange markets saying non-borrowed assets which includes remittances from migrant workers have declined, “reflecting foreign exchange sales by the Central Bank.”

The IMF policy has always been to cut imports and encourage exports; essentially to limit spending on imports as it hurts reserves.

The fund said, “This policy does not seem to be in line with the current fundamentals of the economy. In responding to market pressures, the Central Bank should henceforth limit its intervention and allow more exchange rate flexibility. Flexibility in the exchange rate, which has appreciated substantially in real terms over the past two years, is also an essential component in ensuring Sri Lanka’s export competitiveness.”

The debate over an effective exchange rate policy and allowing the market to dictate the rate has been going on for many years with exporters demanding an appreciating US dollar (and other most-traded currencies) while the Central Bank has been ‘holding’ the dollar rate down to avoid galloping import costs. The core of the issue is a stable exchange rate policy which the Central Bank says it follows to tackle the needs of all stakeholders – importers, exporters and consumers.

It’s a catch-22 situation: Any appreciation in the dollar (the most-traded currency) would help exporters generate more rupees on their export consignments and migrant workers the same benefit. On the reverse side, food prices would go up as importers have to furnish more rupees for their dollar purchases. For example a female domestic worker may get more rupees for her monthly remittances but those extra rupees would be negated by increasing food costs!

Everyday, the Central Bank announces an indicative rate of the most-traded currencies with an approximate 30 to 50-cent band in which banks are encouraged to buy or sell foreign exchange. Banks fix their own rates based on this indicative rate but if the market moves below or above this band, the Central Bank steps in to either sell dollars (if there is a shortage which leads to the dollar going up more than 50 cents over the daily indicative rate) or buys dollars (if the market drop to below the 30-cent band which implies banks are flushed with dollars).

The IMF policy has always been to cut imports and encourage exports; essentially to limit spending on imports as it hurts reserves. However, Central Bank officials argue, that the current IMF plea to limit intervention is based on the Central Bank’s dollar sales in July and August when huge import bills particularly owing to high oil prices led to a sharp draw in dollars.

With water levels in the reservoirs falling dangerously low due to lack of rains in the catchment areas, the Ceylon Electricity Board (CEB) is compelled to resort to more fuel generated power than hydropower, putting pressure on foreign exchange reserves. Rather that resort to power cuts, the Government is running fuel-power turbines to the maximum and with oil prices peaking at over $110 a barrel, that’s an issue. The drama at the Ceylon Petroleum Corporation (CPC) where the import of sub-standard fuel will now cost the Government millions of rupees in compensation payments and other costs, and the dispute over tenders where well-laid out guidelines are opened floutly, too is not helping the country’s financial health.

Mounting losses at the CPC and the CEB has also been referred to by the IMF, with these two institutions being a constant source of worry to policymakers just as the budget is being prepared for presentation in November. Without a doubt, these two loss-making institutions will eat into Government coffers in the 2011 financial year though much of it becomes a ‘book’ transfer entry because state agencies like the CPC for example are heavily taxed by the exchequer due to large volumes in this business, making it an easy and lucrative source of taxation.

One of the biggest import components – which also draws huge dollar reserves – is vehicles and showing a 1,000 % increase in growth in some categories of vehicles due to demand rising exponentially in the post-war era. At least 5,000 new vehicles enter the roads every month clogging traffic and the traffic snarls on all roads in the capital tells the story of the mismatch between demand and speed of road expansion.

There simply doesn’t seem to be any discussion between city planners and state agencies involved in vehicle imports as the roads are bursting at the seams unable to cope with the rising vehicle population. The Government policy of more one-way roads in the city has created chaos and confusion and bumper-to-bumper traffic – an issue that has been ably commented on by our expert columnist, Prof Amal Kumarage.

While imports like fuel, wheat, sugar and other essentials cannot be reduced, imports or usage of foreign exchange arising out of a political need must be avoided unless there is an added economic benefit. At the end of the day, all stakeholders – consumers, importers, exporters and migrant workers – must be convinced that the Central Bank and the authorities have their interests at heart in ensuring an exchange rate that would be balanced and equitable.