The currency conundrum

The balance of payments crisis and difficult economic conditions have certainly had an impact on the Sri Lankan exchange rate, the rate regime, and the present situation of the currency. Significant pressures and foreign exchange liquidity in the local foreign exchange market have both negatively impacted the Lankan rupee. The Sri Lankan currency rate regime has, therefore justifiably undergone changes and flexibility measures in response to these difficulties, albeit with some calling for a completely new approach.

In early March 2022, the long-standing exchange rate regime was somewhat adjusted to account for depreciation pressure and worries about the negative effects of a significant devaluation on society. However, due to market overshooting and considerable liquidity pressures in the local foreign currency market, the additional exchange rate flexibility made possible after the initial adjustment fell short of expectations. This example emphasises the need to carefully plan the timing of actions while allowing for exchange rate flexibility during a balance of payments crisis.

Understanding the causes of such crises is necessary for managing exchange crises and their effects on the Sri Lankan economy. An exchange crisis may be brought on by long-term economic mismanagement, which includes improper economic policies, hasty judgments, a lack of competent counsel, poor execution, and financial corruption. The use of a peg or fixed system to regulate currency rates was one attempt to stabilise the local economy. For the preceding six months, the rupee was fixed at a rate of around Rs. 203 to the dollar. But keeping a pegged or constant currency rate necessitates substantial foreign reserves.

Through import pricing, the excessive depreciation of the rupee exacerbated inflation, and subsequent consequences on other commodities and services. Furthermore, the severe lack of foreign currency in the domestic market and the ongoing decline of the exchange rate slowed down the conversion of foreign money and raised pressure on the currency. Due to the likelihood of additional devaluation and hefty premiums paid, which further strain the currency, the black market for foreign exchange flourished. These led some economists and pundits to consider alternatives such as a currency board or dollarization.

A currency board is a mechanism that prints local banknotes at a set rate in return for a certain foreign currency, such as the US dollar. It guarantees that the authorities will be able to satisfy any requests for foreign money made by owners of the local currency. The severe dollar scarcity on the market may be alleviated and the exchange rate could be stabilised by the implementation of a currency board. However, the stress this throws the economy into while also taking away the ability of national institutions like the Central Bank to steer the ship is undeniably dangerous.

For example, Colombo Port City, which is supported by China, is free to pay its employees in foreign currencies, and the rupee devaluation is to blame for any violations of other workers’ constitutional rights outside of Colombo Port City. The Colombo Port City is meant to be ‘dollarized’ with numerous currencies by denominating economic operations, including salaries, in a variety of designed foreign currencies. Workers would therefore be shielded against currency collapses brought on by policy mistakes or intentional REER targeting by the Monetary Board of the central bank, which would otherwise cause real pay and savings destruction and bankrupt them.

On 8 March, Sri Lanka established a floating currency rate system in response to the economic crisis and the difficulties experienced. This choice was made because defending the rupee with depleting reserves was virtually impossible. Significant volatility was observed in the interbank exchange rate, and the US dollar rose reaching greater depreciation highs and now stabilised at Rs. 300 per USD. The country’s inflation rates too increased back then as a result of the weaker currency.