Ceylon Chamber's view of the struggling rupee

The Sri Lankan currency ( LKR) has weakened against the US dollar in 2018 (9.4 per cent as at September 26) with close to 4 per cent of the depreciation being recorded in the last two weeks. Currencies like the Indian rupee, Indonesian rupiah and Philippines peso have also seen steep depreciation so far in 2018. The weakness is in the backdrop of adverse global and local factors, the Ceylon Chamber of Commerce ( CCC) said in a media release analysing recent trends vis-à-vis the rupee deprecation.

These factors were:

1. Stronger U.S. dollar – The US dollar is the reserve currency of the world and domestic currencies are referenced against it. When the US dollar strengthens, there is an opposite depreciatory pressure on local currency. In 2017, the US dollar weakened about 10 per cent against a basket of currencies. As a result, most currencies were either stable or appreciated against the US dollar. The rupee ( LKR) only weakened 2 per cent. However, this year it is quite the opposite with the strengthening of the US dollar with money flowing back to markets like the US which are termed to be haven investments when there is a high level of uncertainty and risk in global markets.

2. Impact of tight monetary policy in the US – The US Federal Reserve has increased interest rates eight times since December 2015 bringing to a gradual close a period of easy money flowing into emerging and frontier markets like Sri Lanka. Most of the other central banks globally have signalled a similar direction in terms of monetary policy. This has led to most emerging economies recording capital outflows from bond and equity markets. Sri Lanka has seen a foreign outflow of Rs. 64 billion from the local Treasury Bill and Bond market since the last week of April. In the first three weeks of September alone, there were outflows of Rs. 18 billion.

3. Impact of trade war – The trade war between the US and China has increased trade and geo- political tensions with both countries engaging in imposing higher tariff on imported bilateral goods. This has derailed the positive trade growth momentum that was expected to continue into 2018 and benefit economies like Sri Lanka. As a result of this geo-political tension, global investors have tended to invest in less risk assets adding to the portfolio outflows from markets like Sri Lanka. 4.Higher oil prices and widening trade deficit – The rise in oil prices has exposed the sensitivity that net oil importing countries like Sri Lanka face. This coupled with higher imports in items like gold and consumer goods has seen Sri Lanka’s imports widening by 12.7 per cent in the first half of 2018. 5.Current account deficit countries most vulnerable – Countries with current account deficits like India and Sri Lanka are most vulnerable during times of global volatility. The exposure to capital inflows to balance the deficits is highlighted in period such as this.

The CCC invited the Senior Deputy Governor of the Central Bank of Sri Lanka (CB), Dr. Nandalal Weerasinghe to address the monthly Chamber Committee meeting in September. In his address he covered the following areas:

1. Don’t panic- while explaining the reasoning for the recent weakness in the currency, he urged the private sector to be more rationale in their thinking of the future movement of the currency and not take panic decisions.

2. Measures to arrest LKR weakness - he explained the measures taken by the CB during the year to address the pressure on the currency. Some of these were the imposition of the 15 per cent custom duty on global imports from April 18, imposition of a 100 per cent margin deposit requirement against the Letters of Credit opened with commercial bank in importing motor vehicles from the September 19.

3. Expect limited intervention - Dr. Weerasinghe also explained that the CB will only conduct limited interventions to prevent sharp volatility of the Sri Lanka rupee and will not intervene given the learnings from the past where reserves were unsuccessfully used to defend the currency which then eventually depreciated sharply (during 2011/12 and 2015). He explained that they would also look at strongly enforcing the exporter repatriation rules to help ease the pressure on the currency.

4. Hedge currency exposure- Dr. Weerasinghe also advised the private sector to use the available forward market instruments to create hedges against possible exposure to currency risks.

What next?

The economy is in a difficult period given the external factors that are weighing in. A reversal of some of the factors mentioned above will ease some of the pressure. In the near-term a reversal looks unlikely. Here are a few steps that can be taken to ensure that a slide does not continue:

1. Rebuild confidence in the economy- a key factor in mitigating a further weakness of the currency is for policymakers and government to restore confidence in the economy and the future trajectory of the LKR. This can be ensured through credible policies that will ensure policy predictability and an improvement in overall economic sentiment.

2. Keep indicators in check- The LKR weakness underscores the need to ensure that Sri Lanka keeps indicators like the budget deficit and current account deficit in check. The CB policy decision to not use gross official reserves excessive- ly to temporarily defend the currency is a sound move given the need to have a strong enough buffer to meet the debt refinancing challenges the economy will face in the next few years. Indonesia has used up over US$13 billion in foreign-currency reserves in the first eight months of 2018 but has seen the currency losing almost 10 per cent highlighting that such measures may not always avert a currency slide.

3. Avoid disruptive short-term measurespolicymakers should not look to curtail imports unless where deemed necessary. Short-term measures to curtail imports will distort business activity. Ad- hoc raising of para-tariffs will not be in line with proposed tariff liberalisation programme that the Ministry of Finance has announced. Policymakers should look at curbing unnecessary government expenditure rather than imports which will have an impact on businesses and economic activity.

Overall, the recent LKR weakness emphasises the need for the government to improve the economy’s resilience to external shocks by pushing forward reforms that will benefit the economy through higher level of dollar income from exports, services and investment. The emerging global financial markets paradigm with higher interest rates globally will see future spells of currency pressure to which the Sri Lankan economy will need to be prepared for.