Sri Lanka rupee appreciation in ‘national interest’: CB governor

Dec 08, 2010 (LBO) – The Sri Lankan rupee was allowed to appreciate against the dollar in the ‘national interest’ with the government having to balance conflicting interests, central bank governor Nivard Cabraal said. Steady State

“We thought by depreciating the rupee we were doing a great job, that export income goes up, but where did that get us?” he asked.

“Each year our debt increased, our balance of payments became negative every year and our macro-economic fundamentals became weaker and weaker.”

Setting the exchange rate was difficult as the central bank had to strike a balance between often competing interests, with exporters wanting a weaker rupee while importers and borrowers preferred a stronger local currency.

A stronger currency would also help ease the cost of living in an import-dependent economy.

“The exchange rate is the most difficult number for us to balance,” Cabraal said.

“It’s like somebody wants sunshine and someone else wants rain (at the same time),” he said. “The number will not be right from many viewpoints.

“Our call was to have a number which satisfies the country’s national interest,” Cabraal said. “For a long time we looked at it only from the competitiveness angle but that’s not the only angle.”

The central bank has been holding the rupee at around 112.00 to the dollar this year, the highest since December 2008, when the country was in the midst of a balance of payments crisis.

Competitiveness

Cabraal acknowledged that exporters were complaining that the stronger rupee was eroding their competitiveness but said the government had to take into account the greater interests of the entire economy.

“If depreciation causes huge imbalances to the rest of the economy, like increasing the debt burden, it means the competitiveness exporters temporarily enjoyed by the weaker exchange rate will be lost quickly.”

Cabraal also said the central bank had now built up considerable foreign exchange reserves that put the economy in a stronger position and better able to withstand shocks.

“By building up reserves, now we can withstand pressure from anywhere.”

Analysts however have warned that a central bank that sells foreign reserves to maintain a peg and injects liquidity (sterilized intervention) will end up in a balance of payments crisis and eventually lose all its reserves until the currency is floated.

In the past three months Sri Lanka’s central bank is selling dollars to maintain a peg, but it also allowed rupee liquidity to fall a process known as unsterilized intervention.

Debasing Currency and Debt

Analysts say a strong exchange rate also preserves the real value of debt held by pension and insurance funds which are the principle funders of the state and also the real value of wages, protecting the property rights and liberties of individual citizens.

Strong exchange rates forces productivity gains to flow into labour, reducing poverty, but it can make life more difficult for business and the state.

However a fast appreciating currency can kill business if enough is not given to increase productivity and re-engineer processes.

Currency depreciation is the principle tool of expropriating the wealth of savers and wage earners to sustain a deficit spending state.

A strong exchange rate can put pressure on state debt service.

Though officials are worried about the ‘increasing’ value of foreign debt stock when the rupee depreciates, analysts say it is simply the preservation of the real value debt expressed in nominal terms.

A steady exchange rate on the other had puts the real value of domestic debt on par with that of foreign debt. An appreciating currency makes the real burden of domestic debt higher than that of foreign debt, even if interest rates are the same.

Countries with depreciating currencies can divert real cashflows from domestic debt service to repay foreign debt, reducing the risk of sovereign default.

Rupee appreciation also makes the real cost of wages increase. Rupee depreciation allows cashflows to be diverted to debt service from the civil service salary bill.

The current problems in the EU region come from the inability individual profligate states depreciate their currencies and divert cashflows from the civil service salary bill to debt service.

A strong currency will force the state towards more responsible spending and get real revenue gains through real growth, to avoid future sovereign default.