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Falling rupee signals Sri Lanka is close to economic crisis

By Paul Golden


Updated

Shop in Sri Lanka’s capital Colombo
Shop in Sri Lanka’s capital Colombo - Photo: Shutterstock

In August, Sri Lanka became the first Asian country to raise interest since the start of the pandemic. While other lenders, such as the Bank of Korea, are looking to tighten monetary policy to cool booming economies, the Central Bank of Sri Lanka (CBSL) was attempting to prop-up its ever-weakening rupee. 

On October 27 the Sri Lankan rupee (LKR) stood at 201.4 versus the dollar - a 9.1% fall from its value 12 months earlier, according to data from Morningstar.

The country’s foreign exchange reserves have also plummeted. By September they stood a smidge over $2bn down from $3.6bn in June and roughly a quarter of their all-time high of $9bn in April 2018, according to figures from data provider CEIC. 

Tourism industry ravaged by Covid

The teardrop shaped island in the Indian Ocean has long been a magnet for tourism. In 2019, the tourism sector contributed 12.6% to the country’s gross domestic product, and its unsurprising that Covid-19 travel bans have hit its economy hard. 

But an even bigger issue is economic mismanagement by the country’s government. 

According to Nikkei Asia the CBSL printed over LKR130bn ($640m) in October alone, and that between December 2019 and August 2021, the country's money supply increased by LKR2.8trn, a staggering 42% rise. 

Photo of Rehana Thowfeek, an independent economic analystRehana Thowfeek, independent economic analyst - Photo: Rehana Thowfeek

Food price inflation 

Rehana Thowfeek, an independent economic analyst and respected commentator on Sri Lanka’s financial markets, says that creating new money on this scale has been a key driver of the downward pressure on the rupee over the last 12 months. 

Unsurprisingly this bout of money creation has driven inflation. According to the CBSL, the headline inflation rate currently stands at 5.7%. But the impact on food prices has been even greater - on 31 August, President Gotabaya Rajapaksa imposed a state of emergency giving the government powers to seize food supplies and sell them to the public at reduced prices. 

According to Thowfeek the inflationary pressures which drove this move are set to worsen. 

Incoherent policy response

“There are several import bans in place and once the country opens up fully, demand for imports will need to be met and this will put more pressure on the currency,” she says. “Headline inflation is at mid-digit levels, but food inflation is closer to double digits. Increasing global market prices coupled with the domestic situation will erode the value of the rupee further for domestic consumers.”

Emeritus professor of economics at the Crawford School of Public Policy, Prema-chandra Athukorala, also refers to the absence of a coherent policy response to the country’s economic crisis.

“Almost all foreign investment in treasury bills and the share market has left the country because of the massive reduction in interest rates and economic uncertainty,” he says, adding that: “Monetary expansion coupled with import restrictions has fuelled inflation which together with the central bank’s attempt to maintain the exchange rate at LKR200 to the USD has pushed up the real exchange rate.”

Managed-float regime 

The CBSL follows a managed float exchange rate regime - sometimes referred to as a “dirty float”. A managed float is one where the currency’s value is neither entirely free nor fixed but instead kept in a range. The most high profile example of this strategy is the Chinese yuan. 

The problem for Sri Lanka’s central bank is that a managed float requires foreign currency reserves in order to manage it and as a result the official exchange rate only exists on paper, says Thowfeek.

“For the last few months, importers and others have been buying the dollars they need on the black market, where it is going for 15-20% more than the official rate. Following this ‘sort of’ fixed rate regime, along with money creation, has led to the rupee weakening more than it would have otherwise.”

Policies just postponing crisis 

Sri Lanka did manage to repay a $1bn bond by the end of July, but three further payments totalling $500m, $1.5bn and $1.25bn are due next year and in 2023. Rather than seeking assistance from the IMF, the government decided to introduce capital controls to limit outflows of foreign currency and secured foreign exchange swaps with South Korea, Bangladesh, India, and China.

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Dhananath Fernando, chief operating officer at independent policy think tank Advocata describes this strategy as simply transferring government debt to the central bank, buying time while indebting the monetary authority.

Tellimer Research senior economist, Patrick Curran, agrees that without a foreign exchange (FX) devaluation, bilateral financing and swaps are only postponing an inevitable crisis. 

Sigiriya Lion's Rock of Fortress in Sri LankaSigiriya Lion's Rock of Fortress in Sri Lanka – Photo: Shutterstock

Massive capital outflows

“While the proposed pipeline of bilateral loans and swaps can delay the crisis, many of the identified facilities are unlikely to materialise in full, meaning Sri Lanka will likely run out of road by the middle of next year,” he says.

Athukorala says there is massive capital outflow occurring through informal channels, in particular exporters bringing export proceeds home, over invoicing by importers, and smuggling of foreign currency. Athukorala refers to a vibrant network of currency dealers in Colombo and the main cities facilitating informal transfers.

Advocata’s Fernando, however, says the real issue is that there is no complementary monetary policy to make the peg credible.

Large budget deficit  

“The core problem is the 'fixing' of interest rates, not just through overnight rates but across the yield curve,” he explains. “However, since the budget deficit is large; bond markets have been crippled by the earlier fixing of interest rates; and investors are still not actively buying bonds at current rates; a float of the currency would be most likely to fail if bond auctions continue to be only partially successful.”

Attempts to peg the rupee at an overvalued exchange rate alongside import and capital controls have exacerbated FX shortages and pushed more and more activity into unofficial channels. Curran suggests that until Sri Lanka consolidates its budget and allows the rupee to depreciate, FX shortages and parallel market depreciation will persist.

But not everyone is convinced a crisis is inevitable. Adam Lemon, chief analyst at Daily Forex says interest rates that are broadly in line with the rate of inflation are preventing a stronger decline in the value of the rupee and that having lines of coverage with major trading partners lessens the scope for currency volatility.

Tourism returns?

One bright spot is tourism. Sri Lanka reopened its borders at the start of 2021 but with onerous quarantine rules for returning travellers numbers of visitors have been muted. However this is slowly beginning to change; since 4 October the UK’s “Red list” of countries - which require returnees to endure a expensive 14-day quarantine - has been reduced to just seven countries in South America and the Caribbean. 

The Sri Lankan government has responded to this more relaxed approach by launching a tourism campaign targeting five countries, including the UK and Germany. 

Timothy Peng, head of trading Asia-Pacific for StoneX Global Payments also says that if tourism could be opened up relatively soon the government might be able to avoid the loss of fiscal autonomy and various restrictions that would come with a full-blown bailout by the International Monetary Fund (IMF).

Fear of a disorderly default

However, Thowfeek says that an IMF assistance programme is not necessarily a bad outcome. She says it would give Sri Lanka more bargaining power to restructure its debts.

“The fear now is that, instead of an orderly default, Sri Lanka will go into a disorderly one which will be bad for everyone.”

A default now seems likely, emerging market specialists Klieman International, tweeted in response to Capital.com's story that both local and international investor's interest in Sri Lanka's government debt was nearly extince. The outlook is ominous. 
 

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