Fundamental problem of the currency depreciation

P. Samarasiri-Wednesday, September 19, 2018

The currency value is a frequently discussed topic among financial media, opposition political corners and policy-makers in almost all countries without. The most in emerging market economies (EMs) raises grave concerns on the depreciation of the currency and its adverse effects on the economy and public as currency appreciation is not generally heard in many countries like Sri Lanka.
The frequently raised concerns over the currency depreciation are the increase in local currency funds required to service and repay foreign debt, increase in domestic price of imports and resulting increase in local inflation, reduction in trade-competitiveness in international trade and adverse impact of living standards. However, exporters like depreciation very much since it increases local currency proceeds of exports that will help their export industries. The countries who experience appreciation of their currencies also do not like it for long as import rises due to cheaper imports casing adverse impact on local industries and balance of payments.

In all instances of currency depreciation, the incumbent government or policy-making officials, mainly, central banks, are blamed for not being able to protect the currency. With all experts in policy management, economics and business management and availability of ample country literature of success stories on the subject, many countries have not been able to fix the problem in sustainable manner. As a result, currency stresses and turmoil happening regularly have become a routine of some EMs. In some instances, some analysts even predict collapses of such economies in few months based on various scenarios of the countries’ foreign exposures such as short-term commitments as compared to their foreign reserve buffers, but the countries survive. The authorities usually respond that those scenarios are not correct as economic fundamentals and investor sentiments are strong as they think and, therefore, there are no grounds for such currency pressures.

In Sri Lanka, the currency has depreciated from Rs. 4.76 per US$ as at end or 1950 during the fixed exchange rate period to Rs.15.56 as at end of 1977 immediately after commencing the managed float exchange rate regime, to Rs. 80.06 as at end of 2000 just before commencing the flexible exchange rate regime and to Rs. 162 at present. This shows 415% depreciation during the managed float period of 22 years (nearly 19% per year) and 102% depreciation during the flexible exchange rate system of 18 years (nearly 6% per year) so far. The total currency depreciation so far is nearly 941% in 40 years of managed and flexible float period which is nearly 23.5% per year on average. However, it is difficult to explain specific reasons for such different rates of currency depreciation as economic policy environment, exchange rate policy regime, global real and monetary shocks and bureaucracy were widely different.

During the year so far, the rupee has depreciated by about 5-6% whose economic effect is gradually being felt. Since nobody is aware of currency speculative activities and possible external shocks, it is very difficult to predict a rate of currency depreciation during the rest of the year. Further, in flexible exchange rate systems, the public has to be careful of statistics on exchange rates as there is no official exchange rate and published exchange rates are representative rates compiled from a sample of information provided by banks where issues relating to reporting and compilation could be significant, as usual in such market prices and rates.

Exchange rate is the international or external value of the currency or its purchasing power to buy goods, services and assets in foreign countries. Therefore, central banks are responsible for protecting the exchange rate of the currencies they print as same as the domestic value of the respective currencies in their monetary policies. That is the reason why central banks have monetary policy powers to regulate the exchange rates and they are blamed for any unhealthy volatility of exchange rates. In addition, there are separate state controls on foreign exchange transactions of citizens where such controls also are generally vested with central banks as agents of the government, given the primary powers of the central banks to control the exchange rate. Meanwhile, as central banks in flexible exchange rate regimes do not announce any targets of exchange rates that they plan to manage in the monetary policy, it is difficult to assess the performance of central banks on the stability of the exchange rate or the external value of the currency.

The exchange rate being the price of the country’s currency against the foreign currency, generally US Dollar being the most popular global reserve currency, is largely a macroeconomic outcome, similar to inflation, wages, interest rates and asset prices. In open economies, the exchange rate is largely determined by market forces on transactions with foreign countries that appear in the balance of payment (BOP), subject to the degree of the market control by the central bank. We have only a partly flexible exchange rate regime because of the state control through various policies. If so, if the currency is depreciating excessively, it is a lapse of the control system too.

In open economies, as countries trade, the BOP is the result of the difference of the competitiveness of the macroeconomy between the country and other countries. The competitiveness comes from the productivity which results in comparative advantages for the countries to gain from international trade.

The countries with higher productivity and competitiveness can export more goods and services, import less and attract more foreign investments which will help to generate BOP surpluses. Therefore, market forces in foreign exchange are driven by the macroeconomic competition between the country and foreign countries which is reflected in the BOP of the country, i.e., the net position in foreign receipts and payments of the country on foreign trade of goods, services, investments/capital and remittances/gifts. Therefore, the exchange rate and the BOP are the two sides of the coin.

If the BOP is a surplus, the country is a net earner of foreign exchange which appreciates the value of the currency or the exchange rate. The opposite is the BOP deficit and the currency depreciation. We can dig into class room economics on exchange rates and analyse various imbalances of the economy as factors underlying the BOP position on various economic approaches to any length we like. For example, we can blame the monetary front for not managing the country’s monetary conditions as appropriate to protect the stability of the currency as the growth of money supply or inflation higher than that of foreign peers is considered as the cause of the BOP deficits and currency depreciation.

 On another approach, we can blame the protracted budget deficits as the cause because budget deficits have to be financed by the inflow of foreign resources/savings imported through BOP current account deficit and net private domestic savings. In both approaches, there is no any practical fix to the problem in current circumstances.

In essence of analyses of all factors, the BOP surpluses or deficits are the results of the differential in the macroeconomic competitiveness between the country and other countries that comes from the productivity - lower cost and higher quality of products - to compete in international businesses/trade.

The productivity is a result of the endowment/availability of resources/factors of production, quality of resources, technological know-how, degree of the market mechanism and the state economic/market management efficiency. If we have a complete free market mechanism, people and markets will drive their economic activities competitively based on the productivity. However, the free market mechanism is still only an economic philosophy of Adam Smith, the father of Economics, and his followers as we have never had an open opportunity to practice or experience it because of the government. There is no doubt that the world has been gradually moving towards largely free markets which have helped the world to get many people and societies out of the poverty more than what the state-run/centrally-planned economic systems alone would have achieved.

In all countries with acute BOP deficits and currency problems, much of the low productivity is attributable to the inefficiency of the state economic management bureaucracy. The World Bank’s Ease of Doing Business Ranking is only a part of this story if we accept the ranking. This is why we all talk about public sector reforms, despite enormous difficulties confronted by the reformists. But there are many countries successful in reforms and significant productivity gains.

The idea here is whether we can improve Sri Lanka’s Ease of Doing Business Ranking (111) to closer to high rankings of Singapore (2), South Korea (4) and Hong-Kong (5) or Thailand (24) and Malaysia (26) who were parallel to Sri Lanka in the economic development three to four decades before. Even advanced market economies with BOP surpluses continue to take up economic reforms to improve their productivity/competitiveness further to survive in the competitive global economy. At the beginning of the year, the US also has launched a strong protectionist economic policy, America First, to promote businesses and reduce its BOP trade deficit and the US President claims that the US also is a developing country like China and many others that requires policies to protect from unfair trade and market manipulations. Therefore, the competition in productivity has now become the new world economic order.

At a Bloomberg interview on April 20, 2018, Le Marie, French Finance Minister, responding to few queries on current reforms and consequent labour strikes in France, stated that “we will keep the path of reforms and the phase of reforms because, in eminent macro, we strongly believe that we need those reforms to improve the competitiveness of French companies to improve the attractiveness and to create more jobs……..A large majority of French people wants reforms. Strikes are there because we are in democracy. In democracy, there are people against reforms and those strike. That is something normal. We have to live with that. But at the end of the game, we will keep the reforms, we will adopt the laws and we will improve the situation of French people.”

Can we fight against the strength of the US Dollar?

Meantime, we must not forget that the US Dollar is not an isolated currency like Sri Lanka rupee for us to manage its value as we wish. The US Dollar is the most popular world’s reserve currency representing nearly 63% of the central bank currency reserves in the world. The monetary policy and geopolitical and macroeconomic performances of the US have a large influence in the value of the US Dollar. The US Federal Reserve Chairman Jeromy Powel at a speech made in Zurich on May 8, 2018 accepted the existence of spill-over effects of the US monetary policy to EMs through the change in the value of the Dollar, bond yield rates, equity prices and capital flows because the Federal Reserve is the central bank of the world’s largest economy and issuer of the world’s most widely used reserve currency.

Accordingly, the on-going US monetary policy tightening since December 2015 with seven-times increases in Fed funds rate target from 0-0.25% to 1.75%-2.00% by end of August 2018(increase by 1.75% and further expected to increase to around 3-3.25%) and tapering of asset purchases of the US central bank will continue to strengthen the US Dollar and reduce the US Dollar liquidity available for investments in EMs which will have spill-over effects to depreciate currencies of all EMs until the US monetary policy change is stabilized. The current monetary policies of all emerging markets economies are largely driven by the capital flows and the value of the US dollar caused by the US monetary policy. The US President also criticized the current phase of the US monetary policy recently and openly requested the US central bank to fall within the national economic policy.

Almost all central banks in the world attempt to play games with the value of the US Dollar for maintaining and improving the competitiveness of respective countries. China has helped maintaining a high value/price of the US Dollar by keeping its currency under-valued through the huge foreign reserve of nearly US$ 3.2 trillion and continued purchases of US Dollars from the market where the US blames China as the currency manipulator.

All central banks of EMs attempt to stabilize the exchange rate of their currencies against the US Dollar by selling a part of their foreign currency reserve buffers. Speculative currency dealers in global financial markets mostly drive the value of the Dollar through having volatile capital flows causing currency depreciation in EMs. For example, currencies in these countries have depreciated by double digits by the end of August.

As a result, many EMs factor changes in capital flows in their monetary policy decisions and adjust policy interest rates to retain foreign capital in order to protect their currencies and foreign investments. In this environment, these dealers demand increase in policy interest rates to retain capital.

The major problem here is that central banks have arranged foreign investors through such dealers to invest in local treasuries in order to activate the markets and mobilise foreign reserves to fund budget deficits and BOP deficits simultaneously. As a result, many emerging market economy central banks have increased interest rates ranging from 50 basis points to 600 basis points in the last four months in line with text book monetary policy prescriptions. Further increase is expected in response to the US monetary policy tightening towards fed funds target rate of 3-3.25% in 2019-20 as projected so far. In this background, Sri Lanka’s attempt to defend the rupee against the US Dollar in the current model with brave talks without acknowledging and touching the fundamental macroeconomic problem of the low productivity and competitiveness will not be sustainable.

(The writer is a recently retired public servant as a Deputy Governor of the Central Bank and a chairman and a member of several Public Boards. He also has authored several economics and financial books and articles covering this topic)
Part II of this article will appear tomorrow.