Appreciating exchange rates: Not a boon always

Last week, media were abuzz with two reports on how undesired exchange rate movements could worry governments. One was a currency under pressure for appreciation in the market and the other was a currency moving in the opposite.

Swiss Franc: One way Journey to Appreciation

The first was the case of the Swiss Franc which had been under pressure for appreciation quite for some time. The Swiss Franc started its one way journey from around the end of 2000 at a rate of one US Dollar equal to 1.68 Francs. By early September 2011, it had reached a record high level of 0.75 Francs per US Dollar. Since the appreciation was continuing unabated, Swiss National Bank, Switzerland’s Central Bank, made a sudden announcement last week that it would take every measure to halt the appreciation of the Swiss Franc in the market because it hurt the Swiss economy by bringing the ‘risk of deflationary development’ to the country. What it meant by deflationary development is a situation where the continuing appreciation of the Franc leading to an increase in export prices making its exports uncompetitive in the world markets. A loss of export business by Switzerland is a loss of income and employment back at home since exports accounted for more than a half of its total output. It, therefore, invariably meant bringing the country to the doorstep of a deep – rooted economic recession. The Swiss National Bank did not want to take this risk and, hence, took early action to prevent the occurrence of a deflationary development in the country.

Sri Lanka Rupee: One way Journey to Depreciation

The second was the reported warning by the IMF’s Chief of Mission to Sri Lanka, Brian Aitken, that Sri Lanka should refrain from intervening in the market to prevent a depreciation of the Sri Lanka Rupee, another one way journey but in the opposite direction to depreciation which the Rupee had started since late 1960s. Sri Lanka had used during this period every trick in the book to prevent this one way journey: strict exchange and import controls, delaying the adjustment to the rate as much as possible and then permitting a massive depreciation eventually when it could no longer be possible to hold onto rates and borrowing Dollars and then selling them in the market. This latest warning, it appears, had come after Sri Lanka had reportedly sold US $ 416 million in the foreign exchange markets in July followed by another sale of some $ 300 million in August to prevent the Rupee from falling against the US Dollar in the country’s thin foreign exchange markets. Since Sri Lanka has been accumulating foreign exchange reserves by borrowing from the IMF under its special stand-by arrangement extended to the country in early 2009 and raising commercial loans abroad, apparently, IMF’s warning would have been that the country should not waste its borrowed Dollars unnecessarily to pursue an elusive goal of sustaining a high value for Sri Lanka Rupee when the pressure is for it to fall in the market.

Switzerland: A Strong Export Economy

Switzerland has been a stable and a very strong export based economy in Europe. Its average income per head at $ 67,000 in 2010 made it number four in the world’s per head income ranking for its relatively small population of some 7.6 million people. Its exports consisting mainly of sophisticated machinery, chemicals, metals, watches and agricultural products have been sold principally to other Europeans and Americans. It has been one country in Europe which has run a surplus in its trade account continuously: in 2010, it exported $ 233 billion worth of goods while it imported only $ 226 billion worth of imports. In addition to the visible trades, it has been a prominent seller of invisible services such as tourism and banking services. It, therefore, has a high exposure to foreign trade accounting for about 84% of its total output. At the same time, Switzerland has maintained a good scorecard on its public finance too. Its government revenue of $ 190 billion has been above its expenditure of $ 185 billion in 2010. Its public debt has been at an affordable level of 38% of its total output.

Thus, Switzerland had all the reasons for its currency to see a one way journey toward appreciation in the market. However, what worried the Swiss authorities was that that appreciation was pretty fast in the recent few months not because of any supportive improvement in the productivity in the Swiss economy but because other nations losing confidence in the two traditional reserve currencies, namely, the US Dollar and Euro, and choosing Swiss Franc as a safe haven instead.

Like the US economy or the economy of the Euro zone, the Swiss economy is not big enough to supply reserve currencies to the rest of the world. Its total output in 2010 was just $ 546 billion compared to the mega economies of the US and the Euro zone which had produced a total output of $ 15 trillion and $ 16 trillion, respectively, in that year. Besides, the Swiss Franc is very sparsely used for settling international transactions and hence, the countries had to change Francs into Dollars or Euros when they had to make an international payment.

This meant that the sudden interest shown by the world nations in the Swiss Franc was not a permanent one but a move in search of a temporary parking facility for their reserves until the situation in the US and Euro zone improves to an acceptable level.

A Dutch Disease of a different kind

A country should worry about the appreciation of its currency due to this type of temporary foreign exchange flows because it displaces its export sector permanently or as the Swiss National Bank has termed it, it brings in the risk of deflationary development.

This situation is known as the Dutch Disease, a term coined to describe the displacement of the traditional export sector by the appreciation of the Dutch Guilder in 1970s due to the surge of sudden foreign exchange flows which the Netherlands got from its North Sea oil and gas exports. What Switzerland has been experiencing is a Dutch Disease of a different kind: its currency is demanded by other nations not because Switzerland has experienced an export boom, but because there is a festering economic recession in the US and the Euro zone making Switzerland the saviour of the nations which had trusted the US and Euro zone economies previously.

Sri Lanka is caught up in its past legacy

Sri Lanka’s case is quite different from that of Switzerland. Its exports, projected to rise to $ 10 billion in 2011, are just 15% of its $ 65 billion economy. But the majority of its workforce is employed in the export sector making it the country’s lifeline. Except a few years in early 1950s when the country had the benefit of rising rubber prices and in mid 1970s when there were strict exchange and import controls, its exports have always been far less than its imports, making a deficit in its trade account. The shortage in foreign exchange arising from the deficit in the trade account could not be filled completely by inflows from the sale of services and grants and remittances.

Hence, the gap had to be filled by borrowing from abroad, first from concessionary sources and later in the last few years, from both concessionary sources and market borrowings.

This has raised its foreign borrowings from merely a 3% of its total output at the time of independence to well over 37% today. To complicate the matters, Sri Lanka’s budgetary scorecard too has not been very impressive. Relying on Keynesian type of deficit financing for generating economic prosperity, Sri Lanka has had sizeable budget deficits in whole of its post independence period except two years in mid 1950s.

This raised the country’s public debt above its total output in early 2000s and today, it stands at around 81%. Since a major part of the deficit had been funded out of borrowing from the banking sector, the faster rise in both money and credit levels has made a double digit inflation a permanent feature of the economy in the period since 1978.

The current year, 2011, is going to be a bad year for Sri Lanka. Though its exports have been projected to rise to a record $ 10 billion level, imports are projected to rise to a still record level of $ 18 billion generating a massive trade deficit of $ 8 billion, a significant increase from the previous year’s deficit of $ 5.3 billion.

This deficit cannot be fully funded by remittances which too have been projected to come closer to $ 5 billion for the first time in Sri Lanka’s history. Hence, the country’s much boasted foreign reserves of $ 8.1 billion are in a very critical state of fast erosion, unless the country goes for a massive foreign borrowing to top up its already raised sovereign borrowing of $ 1 billion made in August.

The Double Jeopardy faced by Sri Lanka

All signs in Sri Lanka, therefore, show a brewing pressure within the system for the Rupee to depreciate. The authorities have so far averted it pumping the borrowed Dollars to the market in large amounts.

But, that kind of a strategy, though it appears to be soothing in the short run, locks a country in a ‘double jeopardy’, the escape from which becomes quite a feat.

The double jeopardy takes the following form:

To prevent a Rupee depreciation, Sri Lanka has to supply Dollars to the market, but it does not produce Dollars. It has to acquire Dollars by selling more goods and services to foreigners than its purchases from them. This is not possible since there is a massive deficit in its foreign transactions relating to goods and services.

The remittances by Sri Lankan workers abroad are a consolation but their remittances too are not sufficient to bring in adequate amounts of Dollars to the country. Hence, the only alternative available is to borrow abroad which has to be done by the country in increasing amounts in the next few years to fill the gap and repay the previous years’ borrowings. So, the country is getting into a foreign debt trap without its knowledge. This is the first jeopardy which Sri Lanka is facing today.

The use of the borrowed Dollars to prevent the depreciation of the Rupee is the second jeopardy. Once these Dollars are sold in the market, they are gone and cannot be recovered again. It causes an erosion of foreign reserves eroding the confidence which foreigners are having in Sri Lanka on the one hand and making it difficult for the country to meet its future foreign debt obligations on the other. From a historical point of view, the current level of reserves is adequate for the country to finance a moderate trade deficit which it had had in the past. But the oncoming trade deficit is as big as the reserve level and the supply of Dollars to the market to prevent the depreciation of the Rupee may look like pumping water to a sinking well. Sri Lanka, therefore, not only loses its foreign reserves; it will also have to abandon the policy of holding on to the current exchange rate sooner or later as it was forced to do in 2001.

The Double Jeopardy in action: the tragic experience of the Philippines  

The tragic experience of the Central Bank of the Philippines in early 1990s is a case in point for the working of this double jeopardy against a country.

The Central Bank of the Philippines, guided by its desire to maintain a strong domestic currency, Peso, against the mounting pressure for it to depreciate, went on a free spree of making short term foreign borrowings and supplying Dollars to the market in order to support the currency. Soon it found that it had lost all its foreign exchange holdings leaving it only with foreign exchange liabilities arising from its foreign borrowings. This made it make more interest payments on its foreign borrowings than interest earnings it made on its foreign assets. The ensuing net interest outpayments year after year caused the Bank to incur losses and those losses eroded its capital base completely thus making it bankrupt by early 1993. Fortunately for the Philippines, Japan which was the largest creditor to that country at that time stood to lose the most and therefore had a personal interest in supporting the rescue of the Philippines. Thus, with the active intervention of Japan and support from both the IMF and the US Administration, the Philippines managed to unwind the error it had been making: the Central Bank of the Philippines was liquidated in July, 1993, a period of 25 years was given to its liquidators to repay all the debt and a new central bank by the name of Bangko Sentral ng Pilipinas was established.

Policy corruption is as bad as financial corruption

What went wrong in the Central Bank of the Philippines? It was a case of ‘policy corruption’ which did not get caught in audit reports or in any other appraisal of the work of the central bank by the Filipino authorities. Policy corruption is as bad as the financial corruption which auditors or legislators are normally concerned about. In the case of a central bank, policy corruption occurs when it adopts a policy which drives the economy to a dangerously critical level thereby permitting outside creditors or interested parties to intervene in order to rescue the economy but at huge welfare costs at that time. What was the policy corruption which the Central Bank of the Philippines practised? It continued to borrow abroad to generate Dollars to support the exchange rate, but at the end, lost both borrowed Dollars and the stability in the rate.

Switzerland has no problem of preventing an appreciation of the Swiss Franc because all it has to do is to produce more Francs to support the currency. The production of Francs is within its purview. Since these newly produced Francs are held by foreign countries as reserves and not for buying goods and services from the Swiss economy, they do not pose an immediate threat of inflation back at home.

But for Sri Lanka to prevent a depreciation of the Rupee it has to supply Dollars to the market but Sri Lanka does not produce Dollars and has to acquire them through foreign borrowings. That is why IMF has warned that Sri Lanka should not use borrowed Dollars to support its currency.

(W.A. Wijewardena can be reached at [email protected] )