Quo Vadis Exchange Rate?

The exchange rate (ER) last week had the dubious distinction of making a steep dive to hit Rs. 130 by being depreciated by nearly Rs. 5 against the US dollar ($) in a week in interbank trading on the back of import demand, but since then has seemingly been tenuously holding on to those levels (namely Rs. 130) throughout the rest of last week, despite Thursday’s UN resolution against Sri Lanka for alleged human rights abuse.
A reason attributed by a market source as to why the ER was maintaining those levels despite its sharp dip of Rs. 5 in a day on Monday, was due to exporters encashing their $s to meet their rupee commitments, thereby relieving pressure on the ER.
In the coming weeks such conversions will become more intense due to exporters having to meet their Avurudhu commitments such as paying staff their bonuses which will further relieve pressure on the ER, he said (see also page 41). But the source was however unable to predict where the ER will end by the year’s end, when asked to by this reporter.
But the need is sustainability to assure that the ER will not come under further shock, because a weak ER tends to make prices, beginning from imported fossil fuels needed to power transport and industry, provide electricity to the people, to go up, hitting the poor and the fixed wage earner the hardest, due not only on their direct impact on the purse, but also due to the cascading effects of such increases on the rest of the economy as well.
Sustainability of the ER may be assured if there are commensurate inflows coming into the economy on a regular basis, inflows sufficient to beat the outflows.
However that may be, Sri Lanka ran a trade deficit of $ 10 billion last year. Remittances, grant aid if there were any (!), foreign direct investments (FDI) and tourism receipts were not sufficient to plug that hole completely. That is the reality.
As it is, before President Mahinda Rajapaksa devalued the rupee by 3% when presenting Budget 2012 in Parliament on November 21 of last year, in the interim period, ie in the four month period to now, the rupee has depreciated by 17.8% in interbank trading.
In the past, the rupee used to depreciate by 4% annually on an average, the source said. But this tradition was broken in 2009 and 2010 after IMF money started to come into the economy by the middle of 2009, followed by foreign investments into the Government securities market due to higher yields offered. The rupee actually gained during this period, reversing its depreciating trend of the past.
But last year with the increase in imports coupled with rising oil prices, made worse by diminishing aid and a slow pick up on FDI, the rupee came under severe stress again. However Central Bank of Sri Lanka (CBSL) refused to accept the signals given by the market, but continued to defend the ER at administered prices at the expense of contracting its foreign exchange (forex) reserves.
Then came Rajapaksa’s thunderbolt of November 21, where he devalued the rupee by 3% in an administered move, followed by its free float three months later.
However that maybe, another seeming new crisis facing the economy is the sanctions on Iran over its nuclear programme, hitting Ceylon Tea the hardest, as Iran is its biggest market. The other is the import of crude oil from that market, Sri Lanka’s largest supplier of that commodity.
Sanctions on Sri Lanka as well, like the Sword of Damocles, hangs tenuously over the future of this island after the US backed resolution against Sri Lanka on alleged human rights (HR) violations, especially in the closing stages of the war was passed by the UN Human Rights Council on Thursday, despite assurances by US Assistant Secretary of State Robert O Blake, that the imposition of sanctions was not the purpose of that resolution.
All of these actions if materialised would tend to cause further pressure on the rupee, hitting the poor, the weak, the vulnerable and the fixed wage earner the hardest.
Nevertheless, due to the recent upward adjustment in prices, such as that which has been caused by a depreciating ER and the increase in fuel and electricity rates and the knock on effects caused by such, like price increases on other goods and services due to the cascading effects of those hikes, that may cause demand to slacken for certain imported commodities which may ease pressure on the ER. But the danger is if such fallover effects impinge in the import of intermediate and investment goods, vital to keep the wheels of the economy turning.
Markets move on the basis of demand and supply. If high supply side prices keep consumers away from such commodities and services, that would help to ease pressure on the ER, but at what cost?
Another panacea that may help to contain prices and manage the budget deficit is by cutting down on extravagance, waste and corruption which will help Sri Lanka to tide over these difficult times.
Austerity beginning at the top will not be a bad thing to practise. But at the same time consumption cannot be considered an evil. If people stop consuming how then could trade survive and thrive?
Sri Lanka’s economy is essentially a trade driven economy, so if trade slows down, it will impede on growth. What then therefore will have to be done to ensure that growth is sustained in these difficult times?
Checks and balances will however have to be imposed to cut down on inefficiency, waste and corruption, while at the same time increasing the efficacy of public sector institutions and enterprises. That may be a solution. This will help to cut down on waste and corruption and thereby help narrow the budget deficit.
On the other hand there are demands for salary hikes due to the ever increasing cost of living. Under the circumstances balancing the national budget becomes a no mean exercise. For that matter Sri Lanka has been running budget deficits year in year out. And salary hikes will cause further inflationary pressure on the economy.
Previously there was the sustenance of foreign aid, but now, due to various reasons such aid has been curtailed, so Sri Lanka has to either sink or swim on its own steam.
Ironically all of these problems have come to a head after the end of Sri Lanka’s 26 year old terrorist war three years ago.
Previously, this war was thought to have had been the root of all of Sri Lanka’s evils, not least economic, but now with the war behind, those problems appear to be getting worse and not diminishing, contrary to expectations.
Blame it on oil, blame it on the euro zone debt crisis, but are those the only reasons?
Let the Government of Sri Lanka (GoSL) turn the searchlight inwards and see whether there are any policy constraints, both economic and political, which is hindering the island’s progress.
As one corporate told this newspaper, the country is burning. His comments were from an economic standpoint.
However that may be, last week, the business pages of this newspaper, quoting a market source ran an article which said that the equivalent of a US$ ($) 115 million inflow was received by the Colombo stock market on a single transaction.
This was namely through the purchase of an 8.8% stake in blue chip John Keells Holdings plc (JKH) by a Malaysian fund on March 16.
That article quoting a market source said that this inflow would ease pressure on call money market rates, ie on interbank borrowing rates, but whether that would ease pressure on the ER, the source was not so sure.
The source’s trepidations as to whether this inflow would be sufficient to ease pressure on the ER may be justifiable when considering the fact that in the week ended March 16, the average daily turnover in interbank trading was $ 59.35 million, a little over half the $ 115 million made in the March 16 stock market transaction, according to CBSL statistics.
So one may infer that the $ 115 million inflow made through the stock market may be swallowed up in only two days of interbank trading, after which it would be again back to square one, meaning that for a brief respite of a mere two days this inflow would ease pressure on the ER, after which this pressure would once again return.
Probably if the value of the inflow was $ 1,150 million (ie 10 times $ 115 million) and not $ 115 million, then the equation, vis-à-vis the easing of pressure on the ER may have had been a reality. But then the value of the Colombo stockmarket is a mere Rs. 1,961.7 billion* or $ 15.1 billion**!
As such a $ 1,150 million ($ 1.15 billion) inflow would constitute 7.2% of the total size of the Colombo stock market. Now to attract that amount of foreign inflows in to the local bourse, begs the answer to two questions: Does the bourse have good stocks such as JKH to attract such inflows and if that be so, are those stocks liquid enough to provide space for such foreign portfolio investments similar to that of JKH?
As it’s the stock market was in the doldrums last week, which made a stockbroker to comment that that which drives the market if and when such things do take place is JKH. In other words when there is no activity in JKH then the market is dead.
Over 200 stocks are listed in the Colombo Stock Exchange, but the only low hanging fruit appears to be JKH, when that is plucked, the bourse is hungry, literally starving, a possible reflection of the overall state of the economy.
But as UNP politico Dr. Harsha de Silva, talking about this investment to a local newspaper recently said that the danger of foreign portfolio investments is that it can easily go out, in as much as it easily came in, thereby again causing pressure on the ER.
That may happen if such investments have had been made for the purpose of trading and not for the long term. So it’s left to be seen whether this Malaysian fund which invested in JKH is here for the long term, or whether it made such an investment, ie $ 115 million or Rs. 14.4 billion for the purpose of trading only.
If this investment was made for the purpose of trading, it may require this Malaysian fund quite an effort to find a buyer to which it could dump this share portfolio of such a magnitude. The largest buyer of such a magnitude in recent times as far as this reporter could remember was Maxis of Malaysia which bought NTT of Japan’s stake of 35.2% in Sri Lanka Telecom for $ 297 million or Rs. 32 billion in 2008, ie four years ago. That was a “foreign to foreign” transaction and entailed no $ inflows into the local economy as such, though subsequently on its mandatory offer, with some local shareholders acceding to the same, resulted in some foreign inflows coming into the economy as well.
So de Silva’s inference, that the Malaysian investment on JKH may be short term, might not be quite right. But the issue is to bring sustainability to the ER, not least the bourse, the market will need several more JKH type of investments.
But considering the smallness of the bourse, that may be but a pipe dream. Then there are other avenues that then may have to be explored to attract such large number of inflows such as FDI.
However that may be, call money market rates which hit a high of 10% due to a liquidity crisis facing the economy on March 9, has since marginally come down (its weighted average rate (WAR) to 9.33% by Thursday according to CBSL, not necessarily due to a sudden surge in liquidity in the market, but due to various steps taken by the regulator, namely CBSL, after WAR call money rates hit 10.1% (a record in recent times) on March 9.
CBSL had, thereafter been speaking to banks, asking them not to borrow “high” in interbank trades, and, as a further measure, consequentially imposed limits on how much of excess liquidity banks may park in CBSL’s repo window as an inducement for them to lend to each other (see also the last week edition of this newspaper’s business pages) in order to ease pressure on rates.
The restrictions placed by CBSL were a maximum of Rs. 100 million per bank, being allowed to park in CBSL’s overnight (o/n) repo window in the event CBSL had to conduct a reverse repo auction on that particular day to meet a shortfall in the market.
This threat by the regulator appears to have had worked well, in the sense that since March 12, ie the first working day after March 9 when call money rates passed the 10% threshold, there had been no reverse repo auction at least up to March 21 and interbank borrowing rates have had started to come down to be under 10%, a possible indication that banks, notwithstanding interbank lending limits, have begun to lend to each other with more vigour.
And on the contrary CBSL since Monday (March 19) has had been holding repo auctions to drain away excess liquidity from the market, which is attributed in part to the March 16 foreign purchase of a stake in JKH as aforementioned, coupled with the purchase of a 5% stake in Aitken Spence also by foreign funds on Monday. However that may be, regulations, not impeding on natural market interplay may well indeed be a thin line. Sometimes they may have the opposite reaction contrary to what the regulator wanted, nullifying the very purpose why such regulations were instituted in the first place. For instance CBSL recently cutting banks net open positions in forex to a third has resulted in banks on the borderlines of those margins not wanting to take a risk. For instance if a bank wants to dump $s to the market, it may fear doing so, thinking it may go below its prescribed net open position. The result, an opportunity to ease pressure on the ER may have had been missed!
*Market capitalization as at Thursday
**Calculated on the basis that the $, on Thursday, in spot, interbank trading fetched a price of Rs. 130.