Forex crisis: Time to face facts

Not so long ago, President Gotabaya Rajapaksa, who was riding a populist wave, decreed maximum retail prices for commodities like dhal and canned fish. Making a special statement on national television in March 2020, he announced that a kilo of dhal would be sold at Rs. 65, while a tin of canned fish would be sold at Rs. 100.

Looking back at these ‘Head of State mandated’ prices, even those with rudimentary knowledge of economics would have realised the absurdity of the effort to control prices of essential food items. After months of struggle and scarcity, the Government has finally understood that it cannot artificially control the prices of commodities, except at huge State expense. The policy has now been reversed, after substantial losses were incurred to maintain subsidies on these items. Ironically, the Government seems determined to head down a similarly destructive path with the foreign exchange rate.

The exchange for the US Dollar is set by the Central Bank of Sri Lanka (CBSL) today in the range of Rs. 200. Meanwhile, the buying rate of the greenback outside the official banking system is at least Rs. 40 more. At the same time there are numerous restrictions on importers and the general public cannot purchase foreign currency except under very strict conditions at designated bank rates. Obviously, this created an informal market, where speculation by informal currency traders would determine the ‘true’ exchange rate.

The consequences of this policy are hugely detrimental to the economic health of the country, and its effects are already manifest. The CBSL has admitted that remittances through mainstream channels had dropped 50% to $ 353.2 million in the month of September, from $ 702.7 million a year earlier. Meanwhile total remittances for the first nine months of 2021 had fallen nearly 10% year-on-year. Sri Lanka’s migrant workforce is either saving currency earned overseas, without remitting to the island’s banking system, or more likely using informal channels that offer more attractive exchange rates to send hard-earned money back home.

Instead of addressing its policies that have created an artificial disparity, the CBSL has adopted a carrot and stick approach as a remedy.

The Central Bank recently announced incentives for expatriates remitting foreign currency in the month of December by offering an additional Rs. 10 to the official exchange rate – i.e., the carrot. The stick was a threat to freeze bank accounts of those who distribute and receive money through what the Central Bank calls “unlawful money transmission methods”.

Common sense would dictate that neither the carrot nor stick will work in this case. The Rs. 10 ‘incentive’ is far lower than the rate offered for foreign currency exchanged in the informal sector, and the threat to freeze bank accounts will spell doom for confidence in the country’s financial system. Furthermore, transactions taking place outside the formal banking sector makes them virtually impossible to detect. In the ‘hawala’ system for instance, which is not illegal in most countries, there is no actual movement of money and no paper trail to be detected. This is especially true in the case of the small amounts of cash that usually make up the monthly remittances of expatriate workers.

Politicians have placed undue emphasis and importance on the exchange rate, particularly because the issue was weaponised by the current ruling party during their time in the Opposition. The falling value of the rupee, especially after the Easter Sunday attacks in 2019, was presented as being emblematic of the state of the economy. News channels affiliated to the SLPP dispatched hourly news alerts to their subscribers, each time the rupee lost value against the dollar, sometimes by a few cents. These narratives have come back to haunt the SLPP in government, as they become victims of their own propaganda.

Sri Lanka’s foreign reserves are desperately depleted. The Government cannot spend these final hours on the cusp of a major economic collapse making irrational decisions for political expediency. There is no doubt that the artificially propped up rupee will have to eventually be let go, just like the price control policy. There is little sense in spending what is left of the country’s reserves defending the rupee against the US Dollar. Unlike with dhal and canned fish, maintaining an artificial exchange rate will have devastating effects on the economy and might portend the free fall of the currency if the exchange rate is left to be determined by informal money changers in Pettah. The Central Bank must course correct now, before all is lost.