July 24, 2012 (LBO) – It is difficult to say whether Sri Lanka’s rupee is ‘overvalued’ and any specific level no longer matters because the exchange rate is now flexible, an International Monetary Fund’s official said. “There are models economists run to measure overvaluation of a currency,” IMF’s resident representative Koshy Mathai said.
“Those models are sometimes a bit difficult to interpret because they do not account for capital flows.”
Sri Lanka’s rupee fell from around 110 to 134 rupees over the past year under pressure from sterilized foreign exchange sales, which pushed up credit to unprecedented levels.
But the rupee has since stabilized and is strengthening and has reached around 130 rupees by Monday, shortly after the IMF approved a last 415 million US dollar tranche under a 2.5 billion US dollar bailout started in 2009.
IMF money does not affect the exchange rate as it flows directly in to the balance sheet of the Central Bank with no ‘reserve pass-through’ via the domestic monetary base.
“It is difficult to say with any great degree of certainty whether the currency is overvalued or not,” Mathai told reporters Monday.
“I mean, I suppose we would say that last year, the rupee was probably overvalued to some extent. Now there has been a correction. Whether it currently is overvalued or not, I haven’t run the numbers recently to relate what our models say.
“Now we have got a flexible policy framework. Which means, in a sense, it does not matter what the exchange rate level is right now, because there is a commitment on the part of the authorities to let that rate move to reflect market fundamentals.”
‘Overvalued’ exchange rates are believed to hurt exporters. Sri Lanka’s exports however have grown 20 percent a year for the past two years.
At its most basic form, so-called ‘real effective exchange rate indices’ can be used to make a case whether a currency is overvalued or not.
A currency with a persistent high level of inflation is considered to become progressively overvalued against a currency that inflates less. Overvaluation could be measured against a group of currencies, usually a trade basket.
The degree of ‘overvaluation’ depends on the currencies chosen. Critics say advanced nations, with floating exchange rates, such as the United States use sophisticated tricks to understate inflation, while many developing nations do not.
They point out that say by changing the inflation index itself or even by changing the basket of currencies that one country is measured against, or by changing the base year, real effective exchange rates indices could be manipulated at will.
Accusations of ‘overvaluation’ are most often hurled against soft-pegged countries, where central banks intervene in forex markets periodically, while floating rate countries do not usually attract that much criticism.
Analysts say one of the biggest ironies of modern economics or international politics is the situation in mainland China and Hong Kong.
China has been frequently accused of ‘undervaluing’ its currency by the some US critics, because the Bank of China buys foreign exchange, despite it steadily appreciating its currency in recent years.
But the Chinese province of Hong Kong, which has a hard peg, that also buys foreign exchange in the market and has kept the exchange rate absolutely fixed since 1982 has not attracted such criticism.
The Hong Kong monetary authority is legally barred from making sterilized foreign exchange sales, and has no power to depreciate its currency.
Economists who have studied pegs have also found that, the inflation indices of a pegged country tends to grow faster than the anchor currency over time as wages gradually equalize and prices of non-traded goods and services go up.
Even higher labour productivity in export industries can push overall wages up.
Depreciating a currency however has the effect of cutting real wages of workers, helping both businesses and the state. It can also destroy the real debt, effectively imposing a default if the depreciation is permanent.
Cutting real wages can help boost exports, which increase economic activity through an export revival.
Sri Lanka’s exchange rate is now appreciating with some capital inflows also coming in.
Mathai says in a flexible exchange rate framework capital flows are also a factor in determining the rate, either way and that is not a problem.
“So if the market is judging that there is a higher demand for imports than expected, or weaker inflows of capital or stronger inflows of capital – whatever the reason – if the market judges the rupee needs to be stronger or weaker, now we have policy framework that allows it to happen.”