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FINANCIAL CHRONICLE™ » FINANCIAL CHRONICLE™ » Managing the Impossible Trinity

Managing the Impossible Trinity

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1Managing the Impossible Trinity Empty Managing the Impossible Trinity Sun Sep 18, 2011 11:54 pm

Quibit


Senior Vice President - Equity Analytics
Senior Vice President - Equity Analytics
Shamindra Kulamannage
LBR,Thursday 15 September 2011

Since the Sri Lankan economy was opened for trade in the late seventies governments have yielded to the temptation to drive down the currency to grab a greater share of world trade. That temptation has been greatest during periods of profligate government spending when rising inflation also increases production costs for exporters. The easy response has been to devalue the currency which Sri Lanka has done by between 5 to 10% every year.

However a few years ago Sri Lanka’s Central Bank stopped competing devaluations and a permanently undervalued currency policy and pegged the Sri Lankan rupee to the US dollar. Over the last few years the bank has been a net buyer of US dollars in the forex market as post war inflows of aid, investment and greater export revenue strengthened the Rupee.

A weaker rupee, cushions the profit margins of exporters who have to deal with rising production costs due to inflation. It has also hardened the belief in Sri Lanka that the Central Bank shouldn’t allow the market solely to determine the exchange rate.

Fragile currencies have far reaching impacts on developing countries because businesses and

international traders are far less sophisticated and struggle to deal with the volatility. In an open and small market exchange rates can veer wildly from their ideal levels.

Shifting foreign trade volumes, aid and volatile capital flows mean that floating currencies can

be a source of instability and a challenge for manufacturers. For instance exporters like ones

manufacturing readymade clothes, Sri Lanka’s largest foreign currency earner, were used to a 5 to 6% annual Rupee depreciation. “We have rarely took a forward position but that position we

continued till 2009 and then we had to relook at it because the currency,” says Ranil Pathirana,

Finance Director at the Hirdaramani Group, Sri Lanka’s third largest exporter of readymade clothes.

For readymade clothes the competition from Vietnam, Cambodia and Bangladesh, all low cost

manufacturers, is fierce. Most of Sri Lanka’s apparel exports are in dollars even when goods are shipped to Euro Zone countries. Sri Lanka is also no longer a low cost manufacturer for apparel, “we are trying to find ways to improve technology and also looking at environmentally friendly manufacturing facilities which are a buzz word in the world right now,” explains Pathirana the industry wide strategy of positioning itself as an ethical manufacturer. Hirdaramani group has been diversifying in to power generation, financial sector and hotels to mitigate the risk of their high exposure to apparel. “We have been diversifying for the last 7 to 8 years and have now increased the pace in the last two years. Going forward we will invest more in Sri Lanka,” he says. Pathirana was speaking at a joint LBR and CIMA Sri Lanka forum discussing currency fragility and its impact on developing economies in Colombo recently.

The Central Bank’s early intervention to prevent the currency from strengthening has now turned in to one of stopping its slide. In July the Central Bank sold $419 million from its reserves to defend the Rs110 peg to one US dollar. Previously the Central Bank had been buying up dollars in the foreign exchange market to prevent the rupee appreciating and then issuing bonds to mop up the extra cash it releases.

A pegged exchange rate is likely to challenge Sri Lanka in two ways. Firstly is its macro economic impact and secondly is its impact on exporters.

The Central Bank, the standard bearer and spokesman for the Sri Lankan economy, is keen to

highlight the government’s macro economic achievements since the war’s end. Indeed they are

impressive. Economic growth topped 8% last year for only the second time since independence

and is forecast to hit 8.5% this year, a record. The budget deficit is forecast at the equivalent of 6.8% of GDP this year and is expected to decline to 6.2% in 2012. Inflation is also down and so is unemployment. Overall level of government indebtedness is forecast to decline to 70% next year as a percentage of GDP, which is still very high, but much lower than the catastrophic 100% plus levels a few years ago.

The rupee strengthened 3.1% against the dollar in 2010 and has appreciated some more this

year. “The exchange rate movement is driven by the inflow of currency,” says Dharma Dheerasinghe, Deputy Governor, Central Bank speaking at the LBR and CIMA Sri Lanka Forum. Central Bank is forecasting a balance of payments surplus this year on the back of strong exports and remittances growth.

However the apparent economic serenity, of which the rupee pegged to the dollar is now part, can be deceiving. Exactly a decade ago East Asian economies boasted low inflation, balanced budgets and a remarkable record of 8% plus economic growth over three decades. Their economic strength was in sharp contrast to Latin American nations were balance of payments crises were perennial.

There were also other factors below the headlines common among Thailand, Indonesia, Malaysia and South Korea; the countries worst hit by the 1997 East Asian Financial crisis which also affected the economies of Hong Kong, the Philippines, Singapore and Taiwan. Chinks included weak financial systems, hasty opening of economies to foreign capital and pegging local currencies to the dollar. Expectations that currencies would remain fixed encouraged firms to borrow in dollars because interest rates were also low.

As cheap money became plentiful borrowings and imports soared. In July 1997 Thailand ran out of reserves trying to defend its currency from speculators who had spotted the deep flaw. When it floated, the Bhat plunged. Other East Asian tiger economies couldn’t weather the speculators for much longer and were all were forced to break their dollar pegs.

Sri Lanka’s foreign currency reserves at $8.1 billion are high. However reserves were boosted

because $2.3 billion of outstanding government debt is held by foreigners and Sri Lanka would by year end 2011 complete the drawing down of a $2.4 billion IMF standby agreement secured during the throes of its last balance of payments crisis. However the IMF loan has to be paid back and short term capital flows can be fleeting. In addition to greater demand for imports easy credit also causes bubbles in stock and property markets.

Sri Lanka has received IMF loans on seven previous occasions but the current facility is the first one that appears headed for full disbursement. All the previous loans did not go beyond the first or second tranche. Eight tranche’s of the current loan have already been received. “One of the targets with the IMF programme is the reserve position we are comfortable and very much on target,” says Central Bank’s Dheerasinghe.

E conomic textbooks also talk about the “impossible trinity” a theory expounded in the sixties by Robert Mundell and Marcus Fleming. The idea is that a country can’t simultaneously have a fixed exchange rate, be open to capital flows and operate an independent monetary policy. Any two of these can be done but not all three, the Mundell-Fleming model argues.

Sri Lanka’s monetary policy is aimed at controlling inflation and so is independent. Its exchange rate is fixed and capital movement are partially liberalised with more and more controls being lifted every year. It also makes sense for Sri Lanka, which sees the lifting of people out of poverty as one of its major challenges, to be more accepting of foreign capital. Also given the growth in trade capital controls are often evaded and few important countries impose them. For businesses borrowing foreign currency is more advantageous because interest rates are a third or less compared to rupee loans. Businesses with international connections and exporters already benefit from foreign currency loans. However for the vast majority of firms capital isn’t cheap.

Foreign investors are exploiting Sri Lanka’s fixed exchange rate and partially liberalised capital

account. “There is an arbitrage opportunity and we are mindful of the fact that our interest rates are still too high,” says Dheerasinghe referring to 7% or so Sri Lankan bonds are yielding. Foreign investors who have purchased 10% of the outstanding government debt stock investing $2.3 billion would have borrowed that money at rates as low as 2.5%. A back of the envelope sort of calculation shows their annual collective profit is around $100 million. Over three years their profits would be adequate to build the Southern Highway, the islands first toll road.

Sarath Rajapakse a director at stockbrokerage Capital Trust Securities argues that Sri Lanka should align the challenge of the “impossible trinity” with its economic priorities. “If your priority in this country is embarking on an ambitious development plan then it has be interest rates. When you cut interest rates (independent monetary policy) the rupee should fall, if it was free floated because there is no attraction in the rupee because of the low interest rate,” he points out.

Even the Central Bank, which is driving the island’s exchange rate policy, agrees that the

inconsistency lies in fixed exchange rate strategy. “Ideally we should have a free float, we are

moving towards that but we can’t have it overnight,” argues Dheerasinghe, “first we have to put our house in order, and we are working towards that.”

Rajapakse argues that the Sri Lankan rupee should be floated, “stability comes from free trading,” he points out. “Markets know what is right and markets know what is best, if a currency is freely traded its parity is correct.” Pegged exchange rates and the temporary insulation they offer also make it tempting for irresponsible behavior. “You have a temptation; whenever you are running short of money to print a little money. You are hard up for money? Lets print some. That’s been the weakness in most developing countries where currency crises have set in,” Rajapakse says.

In 1994 the then newly elected government pledged to make the Sri Lankan rupee a hard currency or one that is widely accepted. A precondition for wide acceptability globally is its free convertibility.

A few years later the rupee was floated. However the government also continued with profligate

spending which weakened the currency. “The first thing a foreign investor coming to the stock

market asks is how sure are you is the exchange rate is correct how sure are you that it will remain stable for a long time to come. Foreign investors ask what is the guarantee when I repatriate my profit your exchange rate won’t be artificial? What I gained here in my business I might lose in the exchange market because the rate would have moved in an adverse manner, wiping out my profit,”points out Rajapakse who is a director at Capital Trust, a stockbrokerage.

On top of macroeconomic challenge comes the risk of a US and the Euro zone recession. This leads us to the second impact of fragile exchange rates, the one on exporters.

Sarath Rajapakse, who has long experience at the now second largest financial center in the world: Hong Kong, argues that the rupee peg is what causes exchange rate uncertainty and risk. “Earlier the argument for not making the rupee convertible is that the rupee will collapse, now the argument is that it will shoot up,” he says “you can’t be evasive like that, you should bite the bullet and take a risk it may go up or come down but markets will determine that.”

Despite the long term implications, exporters want the Central Bank to prevent rupee

appreciation. “Central Bank has supported the currency in the short term we are glad there is

some support,” says Ranil Pathirana from the Hirdaramani Group. Since 2009 family controlled

Hirdaramani Group has been covering half its foreign currency exposure with forward contracts, “we are safeguarded and it helps us to plan,” says Pathirana.

Rajapakse disagrees: “For the exporters and importers it’s a nightmare, because you can’t plan anything, when you are importing raw material exchanging rates are at one level, when you export your produce the exchange rate is somewhere else, the whole planning process is haywire,” he says “stability should not be achieved by pegging, because it creates this moral hazard problem of insulation. When you are insulated you can do anything.”

Revenue generated from foreign tourists is an indirect export. The tourism industry which has seen higher demand for its services will have doubled hotel room rates in the two years to the Winter season this year, according to Vasantha Leelananda who also addressed the LBR and CIMA forum of Currency Fragility and its Impact on Developing Countries.

However the key Euro zone debt crisis is now sending shivers down the spine of the tourism

industry. Long haul holidays will be one of the first things that recession hit households will cut

back on. Irresponsible spending in the US, Spain, Italy and Portugal and the outright fudging of government accounts in Greece has increased the recession risk. The US and Euro zone are Sri Lanka’s largest export markets and the latter a major tourism generating area.

Many Euro zone countries are in breach of their maximum 3% of GDP deficit and debt ratio of 60% of GDP. With a downturn on the horizon some member states don’t have the ability to spend their way out of the mess. This is weighing heavy on the tourism industry here, which is still heavily dependent on long haul travelling Europeans. On top of that, higher fuel surcharges add $150 to an airline ticket out of Western Europe and $170 out of the UK, a cost that has to be borne by the holidaymaker even if they have pre booked the holiday. Some European airports have also increased their levies on passengers.

Vasantha Leelananda, who heads the Leisure sector at John Keels Holdings, one of the largest

hotel operators in Sri Lanka, says “consumers will purchase holidays on the strength of the home currency”. He says that impacts the prices for holidays quoted on brochures and general value for money are other key determinants. “In the times Euro was strong there was a lot of traffic out of the area because the dollar was weak; there was an exodus European travelers going to the US,” he says.

“Our strategy has been to move some of our exposure in Euro and Sterling to the dollar base,”

says Leelananda about John Keells. The firm billed 32% of their tourism business from foreign tour operators in Euro last year which is down to 27% so far this year. Billing in GBP is also down to 7% from 10% last year. Dollar billings are up 6% to 66% this year at JKH Leisure.

The US dollar has significantly weakened in the last few months. The Hirdaramani Group is looking as far ahead as two years because much of their business is still exposed to foreign currency fluctuation particularly to the US dollar. “For the apparel sector a weak dollar in the future could be a serious threat because the US market is one of our biggest buyers. For our group its 60% of our business and there is a better margin for exports to the US,” says Ranil Pathirana.

Some industries that have weathered the rupee appreciation have managed it’s risk not due to

improved risk management but because their fortunes have improved; like the tea industry. For decades auction prices for a kilogram of tea hovered around the $2 mark although in rupee terms they increased due to the local currency weakening. “Before 2009 the plantation sector depended on a highly devalued rupee and that’s how the sector survived,” agrees Rohan Fernando a plantation sector veteran and a Director at Aitken Spence, a listed conglomerate. The shift happened when tea prices almost doubled in dollar terms to almost $4 a kilo in 2009. “Fortunately the plantations companies have been able to work around the rupee appreciation because tea, rubber and palm oil earnings did well,” Fernando says.

Although the high prices have provided a respite for now, the sector is beset with problems including unproductive labour and lack of investment. The source of some of these challenges was the weak currency policy over the 1990s’. “In 1995 we had large investments coming from UK companies in the plantation. One company invested 10 million pounds in several plantation companies and they had a very bad experience particularly because of the devaluation of the rupee,” explains Fernando. “Somehow the international community haven’t got the confidence to plough money back in to the country and we need foreign investment and technology to the agriculture sector,” he says.

There are no standard approaches to dealing with the “impossible trinity” because each economy has its unique challenges and priorities also change often. The fixed-exchange-rate system broke down in 1971 when US President Nixon abandoned the link to Gold. That was the dawn of paper money, which has tempted government to try to print wealth in time of hardship. It also heralded the start of floating exchange rates, something Sri Lanka has been reluctant to embrace.

Sarath Rajapakse, a hard boiled neo liberal, thinks floating the currency would teach business to proactively manage their risks and more importantly force government to be responsible. “When there is a peg you know there is a government guarantee. However irresponsible we are (businesses are) the exchange rate will be maintained,” he explains the risk that firms may not focus on productivity, innovation and supply chain efficiency.

Although not obvious, there are many problems stemming from the perfectly fixed exchange rate, somewhat open capital account and monetary policy autonomy. Exporters are disadvantaged because they are not being shielded from inflation, with a commensurate weakening of the currency. A rich “carry trade” opportunity exists for the few foreign investors lucky to hold government debt and most businesses are unable to benefit from lower foreign currency loan interest rates, something a full liberalization of the capital account should bring.

The challenges of modern economic policy are interlinked. So every economy needs to figure its own priorities. Policymaker need to realize that at least some aspects need to be left to the market.

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