The Economic Impact of Exchange Controls

By Asia Wealth Management

Government’s recent measure to impose new exchange controls by raising taxes on vehicle imports may further moderate the excessive credit expansion in the economy.

The fact that nearly 80 percent of Sri Lanka’s vehicle purchases are financed through domestic borrowings indicates that newly imposed exchange controls may considerably curb consumer demand for domestic credit and further ward off any prospects of balance of payments issues.

Consequently, we expect the downward trend of rate of exchange against major trading currencies to reverse and interest rates to fall from current levels once vehicle purchases made prior to the raising of taxes are completely realised. It is important to clarify in this regard that increase in taxes are not mainly aimed at raising government revenue but instead is intended to curb excessive demand for vehicle imports which may not be entirely moderated by the market determination of exchange rate, demonstrating the high degree of price inelasticity of demand accompanying Sri Lanka’s vehicle imports.

Hence, the ensuing appreciation of the LKR would in turn transmit many positive developments to all sectors of the economy as it would further narrow the savings to investment gap in the financial sector. Cost of living pressures will ease to a certain extent owing to the fall in rupee price of imported essentials on the back of appreciating rate of exchange, hence, easing inflation and pressure on nominal wages to rise.

Further, the strengthening of currency may also reduce rupee expenditure of financing government and private sector borrowings from external sources. In contrast to the increase in fuel and electricity prices, which bear cascading effects on internal price level of the economy, the rise in cost of vehicle imports would in turn reduce the costs incurred in importing essentials and investment related material. The point is if the country chooses to import more of less important consumer durables the fact that it has to pay higher prices for essential imports in local terms is unavoidable. This is to say that recently imposed exchange control measures bear a strong tendency to transfer scarce foreign resources from supporting the growth of consumption led credit to the more productive spheres of the economy.

For instance, foreign private investors would find it more profitable to produce certain categories of vehicles within Sri Lanka which are subjected to increased import taxes;certain categories of petrol and diesel motor cars, motor bikes, spare parts, may now possess potential to attract foreign investment into the economy given that there is domestic consumer demand for these products that is sufficient to mitigate indivisibilities.

Hence, the measure may prove to enhance the attractiveness of Sri Lanka’s domestic market for FDIs as well as for local investors towards technologically progressive industrial operations, which unlike non-tradables, transmit development nodes to the economy of domicile. Hence, the rise in vehicle taxes may prove to increase the relative profitability of industrial sector over services.

On the other hand, middle and upper middle class savings will tend to rise as a result of their curtailed spending on potenti al vehicle purchases, which may account for approximately LKR 100 billion worth of additional savings to the economy.

Consequently, rupee liquidity in the financial system may rise causing the market interest rates to dip from current levels increasing the marginal efficiency of capital. This in our view would cause a shift in the structure of banking sector lending portfolio from consumer driven lending to a more investment oriented lending portfolio. Hence, it is our view that stability of country’s prevailing economic arrangement is further restored by imposing exchange controls on luxuries and semi luxury imports and hence, possibility of imposing further tax increases on low priority imports cannot be entirely ruled out.