Increasing foreign reserves and the exchange rate

Tuesday, 25 January 2011 00:01 - - {{hitsCtrl.values.hits}}

The year 2010 witnessed a significant inflow of foreign reserves. The gross official reserve which fell to a low of USD 1272mn (which is sufficient for only 1.2 months of imports) at the beginning of year 2009 exceeded USD 7 bn by year end. The total reserve figure for November stood at the equivalent of 6.1 month of imports.

With a strong foreign reserve base that exceeds USD 7 bn, Sri Lanka was in a position to relax foreign exchange controls with the objective of further expanding the economy.

Budget 2011 implemented a more liberalised capital account injecting more foreign capital especially into the equity and debt market. The sovereign bond issue which took place in September 2010 was oversubscribed by 6 times clearly emphasising the restored foreign investor confidence bringing in a further inflow of USD 1 bn sharply increasing the foreign reserves. The rising remittances throughout the year further increased the foreign inflows to the country. Such developments and the prevailing depressed US economic conditions together with the EuroZone sovereign debt crisis has appreciated the LKR against these currencies, adding further upward pressure on the LKR. The rupee appreciated 2.2 % against the USD and 7.4% against the EURO by end September 2010.

However the appreciation of the Rupee is by and large due to the Capital account of the BOP as the Current account continues to deteriorate amounting to a trade deficit of USD 4,039 mn during the first 10 months of 2010. The Central Bank intervened and mopped up the excess volatility by way of net absorption of USD 241mn in September 2010 as a measure of retaining export competitiveness.

An appreciating rupee creates mixed macro economic consequences. On the one hand it would deteriorate the export competitiveness, and negatively affect the tourism industry as tourist interest would shift to cheaper destinations.

On the other hand currency depreciation could worsen the foreign debt burden as debt servicing cost increases with depreciation.

A stronger currency would reduce the price of essential food items and reduce the cost of living of an import dependent economy. However, the reducing cost of imports will increase the demand for foreign goods, creating upward pressure on the trade deficit. Furthermore the considerable build up of foreign reserves will increase the ability to withstand external shocks.

Therefore the currency appreciation cannot be solely viewed from the competitiveness angle and the prevention of creating imbalances to the rest of the economy should be taken into consideration.

Although Sri Lanka’s trade deficit continues to be in negative territory, it is expected that the LKR would continue on an appreciating trend gradually by 2%-3% over 2011 with the increase in foreign investor confidence which would further increase foreign inflows to the country. (Source: Asia Securities/Asia Wealth Management Ltd)