The present sharp depreciation of the rupee is not something unexpected but an inevitable outcome of the volatile balance of payments situation experienced for some time. The widening balance of payments deficits emanated from the excessive foreign trade gaps have been comfortably cushioned by the inward remittances and foreign borrowings. These two factors alone helped to maintain a stable exchange rate as well. In addition, the Central Bank came forward from time to time to defend the rupee by releasing foreign exchange to the market so as to ease demand pressures. The Central Bank has reportedly sold foreign exchange to the tune of US$ 2.5 billion since June 2011 to defend the exchange rate in the midst of increasing import demand.
Widening trade deficit
The exchange rate which was around Rs. 114 a dollar in the beginning of 2010 began to appreciate since the second quarter of that year. By mid-2011 it reached around Rs. 110 a dollar. Reversing this trend, the rupee has shown signs of depreciation since the end of 2011, and reached record levels of around Rs. 120 a dollar last week. The monetary authorities should have allowed the rupee to depreciate much earlier through market forces in response to the widening trade deficits, instead of defending an overvalued exchange rate. The trade deficit almost doubled from $4.9 billion in 2010 to nearly $9 billion in 2011. Around 50 % of this large deficit was covered by the inflows of workers’ remittances which amounted to $4.6 billion in 2011. These inflows coupled with continuous foreign borrowings helped to build up foreign reserves by the end of 2011. With the comfort of these reserves, the monetary authorities were able to maintain a strong rupee ignoring the fundamental weaknesses in the foreign exchange front, particularly in the export sector. Thus, the overvalued exchange rate did not in any way reflect the actual demand for and supply of foreign exchange in the market.
“Dutch disease’: symptoms and effects
Eventually, the real exchange rate, which is the nominal exchange rate adjusted for the differences in domestic and foreign inflation, tended to appreciate against the dollar and other foreign currencies. According to the Central Bank figures, the Real Efective Exchange Rate (REER) index (2010=100) rose from 77 in the beginning of 2005 to 103 by the end of 2011 reflecting a real appreciation of rupee. As a result, the relative prices of non-tradable goods (which are produced and consumed domestically) rose against the tradable goods (which have export or import potential). This leads to a shift of resources from the tradable sector to the non-tradable sector leading to an erosion of the country's export competitiveness. This phenomenon is usually known as the ‘Dutch disease’. Interestingly, the term ‘Dutch disease’ has its origins in the Netherlands when the country’s export competitiveness eroded following the discovery of natural gas during the 1960s. In consequence, the services sector flourished at the expense of the export-oriented industrial sector in that country.
Sri Lanka also experienced a similar kind of Dutch disease, as the appreciation of the real exchange backed by a buildup of foreign reserves through exogenous factors such as workers’ remittances and foreign borrowings led to a decline in the relative prices of tradable goods against non-tradable goods. It resulted in a shift of resources from the production of tradable goods to production of non-tradable goods and services. This chain of events encouraged imports and discouraged exports. The thriving import trading in recent years proves this point. The injection of foreign currency to the market by the Central Bank at an overvalued exchange rate at regular intervals aggravated the situation. Further, importers were able to borrow from banks at artificially-kept low interest rates exerting further pressures on the foreign exchange market. The market interest rates, which remained low, did not seem to have responded to the growing borrowing requirements of the private sector and the government until recently.
Overdue policy actions
The recent volatility in the foreign exchange and money markets is a reflection of the delayed attempts taken by the authorities to correct the macroeconomic fundamentals which were in disarray. These disarrays cannot be suppressed for long, as they are bound to be visible sooner or later. Unless these disorders are rectified appropriately at the right time, the economy is likely to settle down at a low equilibrium level with a low growth path. These well-tested economic realities cannot be ignored.
Reluctance on the part of the policy makers to allow the market to determine the equilibrium level of exchange rate causes severe economic setbacks. A market-determined exchange rate regime could have arrested the widening of the trade deficit and the resulting sharp fall of the rupee. The impact of the sharp rupee depreciation on inflation is unavoidable. Attempts to provide relief to the affected parties by way of subsidies, as in the case of providing the proposed fuel subsidies to the transport and fisheries sectors to ease the impact of the recent fuel price hike, are futile. Such policy measures will only lead to create market distortions and abuse of the facilities, as repeatedly proved in the past.
A coherent macroeconomic policy framework is needed to navigate the economy to a high growth trajectory supported by a vibrant export sector. Overdependence on a few export categories, mainly on garment products, after so many years of liberalization is a major hindrance to economic growth and to overcome the balance of payments constraint. At least by now, attempts need to be made to improve the macroeconomic fundamentals particularly to attract the much needed foreign direct investment, which are a relatively stable source of foreign exchange, to materialize export-led growth that was envisaged more than three decades ago when the country opted to go along the liberalization path. (The writer is an academic, an economist and a former senior Central Bank official).