This column has warned several times that this was an inevitable outcome of money printing, and in Thrift Column – On the Brink it showed how the BOP crisis was developing and gathering pace and said it would become worse if the Central Bank continued to print money to finance the deficit.

It is at times like these that the fuss-budgets of this world sometimes wish that their predictions do not come true.

How far?

So how far will the rupee fall?

Hopefully, not too far now that the dollar is at 107.

How far it will eventually fall depends on several factors, including how overvalued the rupee now is, and what kind of fiscal prudence and other adjustments the authorities can make.

The falling rupee in itself is a major adjustment that is needed. If the central bank has decided to let the rupee go, it will be one of the few wise decisions it had taken in a long time.

But, even if the central bank stops printing money immediately and fiscal authorities take steps to cut the deficit, the rupee will have to depreciate because it is now clearly overvalued.

Though short term movements in the exchange rate are severely influenced by money printing and absolute inflation, in the long term it is relative inflation that matters.

Overvaluation Overhang

Simply put, if our inflation is higher than our trading partners, our exchange rate has to fall to compensate. This is because inflation increases the cost of production of our exporters they will lose competitiveness when domestic inflation is high.

Over time therefore export growth will slow and imports will grow (because imports are now cheaper) and a widening trade deficit will eventually force the currency down. This eventually allows exports to grow faster.

The central bank measures the export competitiveness of our currency through the Real Effective Exchange Rate index, which compares our inflation with that of a trade weighted basket of 24 countries.

(A fuller explanation of the REER is given inThrift Column – Great Escape. Read also the last section on Prospects for 2006)

During the last 22 months, overvaluation of the REER has been getting steadily worse, and export growth has been falling to single digits.

In 2003, the rupee appreciated, but because Sri Lanka’s inflation was very low, on account of prudent fiscal policies and complementary monetary policy, it did not affect the REER or exporters.

In 2004 the REER was competitive because, despite the Rata Perata inflation caused by an expanding budget deficit and money printing, rapid depreciation overcompensated for the rise in cost of production.

But from January 2005, tsunami dollars propped the rupee, and the overvaluation started to build up.

An adjustment of the exchange rate is therefore necessary to allow exporters to survive and get more orders. We have three years of double digit inflation to be worked out.

Now the REER is around 108 to 110 percent. Ideally it should be around 100 or below, but maybe even 102 could be neutral.

That means the rupee does not have to go below 110 – though sometimes a short term overshoot does happen- provided prudent policies return thereafter, and money printing stops.

Impoverishment

After this fall, an export pick-up happens over the longer term.

Immediately however, a devalued currency will help impoverish the people of this country and reduce their purchasing power. This will result in a contraction of import demand. Exporters will also stop betting against the rupee as short-term expectations of a devaluation ends.

This is how exchange rate depreciation reduces pressure on the BOP almost immediately.

Until now, only domestic inflation was there to impoverish the public and take away purchasing power, while the exchange rate remained rock steady. This of course has the effect of favoring imports even more.

While domestic inflation or even high interest rates favour foreign producers against local producers, rupee depreciation will favour domestic ones over foreign producers.

So depreciation is a good option, except for the impoverishment of the people. But at least firms won’t collapse, and there will be a job and we will live to fight another day.

Tangled Web

What about oil? Oil prices are falling. This should help the balance of payments surely?

Here we come to the crux of the problem.

Politicians, bureaucrats, analysts and even ‘economists’ have been claiming forever and a day, that our BOP crisis is all caused by the oil bill.

Of course now they have been caught in their own lie.

Like the myth that inflation in Sri Lanka is caused by drought, supply bottlenecks or oil prices; here is where they have got tangled in their own web of lies.

How do the pundits explain this 2.4 billion dollar question?

If oil prices are falling, how come the rupee is under pressure?

Brent crude, which was 73 dollars a barrel in August, is now about 58 dollars in the second week of October, according to Central Bank’s own data.

CPC prices are a couple of dollars below that because we buy a mixture of Iranian Light (cheaper) and Miri Light (more expensive).

The bottom line is, oil prices are about 15 dollars cheaper now than it was two months ago.

But lower oil prices will only help the BOP to the extent that the government does not reduce fuel prices.

If the government cuts fuel prices, more money will be left in the hands of economic players to buy other types of goods and imports will continue to surge.

(For a detailed explanation of how this happens read Thrift Column – Balancing Act..)

As long as retail fuel prices are cut, it will neutralize any benefit on the balance of payments.

That said, cutting fuel prices is not entirely a bad thing, because especially in terms of maintaining export competitiveness, we cannot overprice energy if our competitors are cutting energy prices.

That means maintaining high fuel prices will create another imbalance in the economy.

Policy Options

What the government should now do is to immediately re-impose the value added tax on diesel and bring its price closer to petrol.

This will have several benefits in the form of a virtuous cycle.

For one thing it will reduce the incentive for vehicle users to use diesel instead of petrol which results in massive revenue losses to government, in terms of lost VAT and excise duty because petrol is heavily taxed while diesel is not.

(About 30 percent of petrol price is made up of taxes; see Thrift Column – Expensive Plug).

A VAT on diesel will not affect exports because it is recoverable; this is why VAT is preferable to an excise duty.

Of course this being a third world country with third world policies and weird economic myths, we do not know whether it will happen. But this columnist would be the first to cheer if it does happen.

But more importantly, the VAT on diesel will improve the fiscal side (i.e. transfer purchasing power from diesel users to the Treasury) and reduce the need to print more money to finance the war and subsidies.

Now here we come back to the same old problem.

In order to take the pressure off the balance of payments the Central Bank has to stop monetizing debt and printing money.

At the moment Central Bank is printing money like mad to maintain base money as well as finance the deficit.

This only makes the situation worse, as it sets off a mutually re-inforcing vicious cycle.

Reserve Loss

Fuss-budget estimated in June (Thrift Column – On the Brink) that the central bank must have lost at least 85 million dollars, probably more, defending the currency in May. Subsequent data showed that the bank had lost 95 million dollars in May.

Now let’s do the same calculation for the last few weeks.

This shows that the central bank has lost about 120 million dollars defending the rupee during the period 6 September to 12th October.

If the central bank continues to maintain low interest rates and buy T-bills to finance the deficit, and maintain base money, the BOP problem will not go away.

On the Boil

Printing money is like boiling a kettle. First the water gets heated up, and shows up as inflation. Then steam starts to escape, like the dollars are escaping now.

The answer is to tighten monetary policy and stop printing money. You have to cool the monetary system. That means interest rates will have to go up, after the currency depreciates.

Depreciation has to happen whether or not rates go up, to get rid of the effects of earlier printing.

Last Friday the Bank issued a statement saying the following:

“The Central Bank has allowed the market forces to determine the exchange rate since 2001, and has been intervening only to mitigate excessive volatility in the foreign exchange market.�

Of course we all know that the Bank has been intervening, so this is presumably a signal to say it is now really allowing dealers to fight it out.

Dealers will eventually stop hitting on the currency when the Central Bank stops intervening. You cannot clap with one hand.

Instead of betting against the central bank, dealers will now have to bet against each other and find equilibrium hopefully under 110 rupees.

In a situation like this, the most damaging thing that can happen is a serious loss of confidence. Then you do not know where the currency will end, because people will start to hoard dollars.

On Monday, a large stock of National Development Bank shares went to what brokers jokingly call a ‘local foreign’ buyer. That means money previously stashed away abroad still thinks it is worth buying rupee denominated assets.

Of course, whether such money thinks it worth buying rupee treasury bonds, remains to be seen.

Central Bank had the option of allowing a free float now, or it could lose more reserves, print more money, and stop intervening when reserves fall to 1.5 billion dollars.

But if we had waited till then (actually this is ideally what a home-grown-policy-third world-country would have been expected to do) we could have earned ourselves a nice big rating downgrade.

As it is, we possibly have a chance of getting the current rating affirmed with a negative outlook. Let’s hope so anyway.

In any case with the war hotting up, we need to conserve our foreign reserves.

Banana Option

So far, our forex reserves have been maintained by the government borrowing commercial dollars, in what we may call the banana republic option.

This is what Latin American countries do. Argentina is the most famous exponent of it. (See Thrift Column – Going Bananas.)

We were earlier toying with the idea of issuing a billion dollar sovereign bond. That would have given us a considerable war chest.

That would have allowed us to kill more of each other, and also allowed us to postpone adjustments for another year or so, until the overvaluation destroyed more export and domestic industry.

In 1997 Argentina got a rating of BB. In subsequent years the country borrowed and printed its way to economic collapse and ended with a DDD default rating.

What we have been doing is issuing Sri Lanka Development Bonds to the private sector, getting their dollar savings and using it to plug the budget deficit and also the hole in the BOP.

While the Bank of Ceylon has been raising money through a syndicated loan, other banks have just used their NRFC dollars to buy SLDBs.

Aggregate Movement

If you look at the way different monetary aggregates are behaving you can see the effect of SLDBs and the reserve outflow.

From a purely academic point of view, it is interesting to note that any perceived link between inflation and M2b growth is now well and truly broken.

M₁ or narrow money growth is also falling, because it is very sensitive to the loss of foreign reserves.

M₂ which more sensitive to domestic credit/assets is still growing fast while growth in M_2b which includes NRFC units, is plummeting.

Even up to August total external reserves had fallen to 3,888.7 million US dollars from 3923.6 million dollars, though official reserves were still up 4.1 from the beginning of the year at 2,558.8 million dollars from 2,458.1.

This is because private reserves were transferred through the SLDBs to official reserves after Treasury sells the proceeds to the central bank.

Central Bank is probably now allowing the rupee to float not really because of this so-called free float decision of 2001, but because official reserves are now below three months of imports.

Of course in true third world style we can allow it to fall further. Following the 1999/2000 money printing binge we allowed reserves to fall below one billion dollars before taking corrective action.

Corrective Action

Going back to 1999, we can anticipate what else the central bank may do. It can increase margin requirement on letters of credit. Put restrictions on forward currency trades, overnight dollar positions and so on.

The treasury can also put punitive import duties as had happened before.

Rates should be raised because dealers can bet in the forward markets against the rupee using cheap money from the reverse repurchase window.

Forward volumes climbed to 922 million last week.

The real answer of course is to fix the problem in the budget and cut the deficit. The budget is the root of all evil.

But that may be difficult because then we will have to change our home-grown policies.

Actually these are not really home-grown policies, any number of mismanaged poor countries follow them, and not just Zimbabwe.

Even India did that until recently, and still does to some extent.

We cannot easily change these policies because they are badly needed to keep us in the third world.

However some things have changed from the bad old days of Rata Perata.

The biggest policy shift since the Rata Perata fiscal fiasco we have seen is in fuel pricing. If the ‘plug’ was in place we would have been in worse trouble.

Giving subsidized fertilizer distribution to a government corporation was also a smart move. That is a good way to foul up the works and make sure that timely fertilizer distribution is disrupted.

The treasury in a statement released last week said an objective of the upcoming budget will be to generate fiscal savings. This is also a good sign and a reversal of the previous policy of glorifying harmful deficits.

Our brand of collapse

In an interview with Central Bank founder John Exter (Read interview here) he mentions two outcomes of excessive money printing, or the use of what he calls IOU nothing money.

That is; inflationary blow-off or deflationary collapse.

What we are seeing now is the inflationary blow-off part.

When inflation goes to 15 percent, wage earners have seen the bottom fall out of their pockets.

Then the exchange rate also collapses.

Then we suddenly see light and change our home-grown third world policies and stabilize the economy with or without IMF, World Bank and/or tsunami aid.

Inflation improves government revenue, reduces national debt a little, and then we are ready for another set of home grown polices and economic collapse. (Thrift Column – Roots of Poverty)