Sri Lanka’s devaluationist REER targeting is a tiger’s tail

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With the rupee hitting new lows against the US Dollar, driven by a REER-targeting devaluationist policy to hurt wage earners, there seems to be little preventing Sri Lanka from being shunted to greater political instability and discontent.

It is not fair to blame the Central Bank only for the current problems. It was the 100-day profligate budget under then Finance Minister Ravi Karunanayake, assisted by Central Bank Governor Arjuna Mahendran’s unprecedented money printing, that lit the fuse under the economy. The last year has seen many difficult corrections under Finance Minister Mangala Samaraweera. Small businesses – a mainstay of the United National Party – have been alienated by VAT and other taxes charged to pay the salary hikes of state workers and ad hoc policies of the first two years. Governor Indrajit Coomaraswamy, a man of integrity, has done much to restore confidence in the Central Bank, slow credit expansion and stop money printing, bringing back some stability. But, he has also maintained one policy championed by Arjuna Mahendran – that the rupee is ‘overvalued’ and has to be devalued along with the salaries of little people and savings of all. With energy to be market priced, the true effects of the 2015-2017 devaluations will be felt politically.

SRI LANKA’S CENTRAL BANK AND TRUMP
Of late, Sri Lanka has started to echo a false Donald Trump claim – cooked up by US mercantilists long before Trump and amplified by the Western financial press – that East Asian export powerhouses depreciated and ‘undervalued’ their currencies. These are the same people who said that an ‘Asian Savings Glut’ caused the 2008 credit bubble, and not the mother of all liquidity bubbles by the Fed. This column has previously shown that other than countries like Indonesia and the Philippines, which export labour to the Middle East (and to other East Asian nations with sound money), have strengthened their currencies in nominal terms and many in fact had REER index numbers far above 100. Like Governor Mahendran, Governor Coomaraswamy says that a currency is ‘overvalued’ if a Real Effective Exchange Rate index goes above 100 (ignore the fact that many export powerhouses have REER indices in the 120s to 130s), and it harms exports.

Instead of measuring an exchange rate against a single currency (the US Dollar in Sri Lanka’s case, which is also the anchor or peg), an effective exchange rate index measures it against several or a basket. This is called a Nominal Effective Exchange Rate index. A Real Effective Exchange Rate will adjust it for inflation. The index will also change based on the inflation number that is used. In Sri Lanka, the REER went up after the inflation index was re-based. So what is the correct REER? (Graph 1)

According to the REER index published by the Central Bank now (which has been changed since 2015), the index went up from 100 in July 2013. The index fell to about 92 when the rupee collapsed in 2012 and went up as inflation spiked after the currency collapse. By April 2014 it was 102 and fell as low as 101.5 in May. But, by February 2015 the index had rapidly gone up to 112.

WEAKENING EAST ASIAN CURRENCIES
This was not because the Central Bank was generating much inflation in that year, but because many currencies were weakening against the US Dollar. At the time, a strengthening US Dollar was also pushing down prices of commodities, including oil.

The Chinese Renminbi peaked at 6.0 yuan around January 2014 and fell to around 6.25 by February 25, and went on to weaken to 6.8 yuan till April 2017. The Malaysian Ringgit which had also peaked around 3.04 in January 2013 had weakened to 3.6 by February 2015. Both countries tried to intervene and injected liquidity to keep rates down, and lost reserves, which made matters worse, until they gave up. (Graph 2)

The Singapore Dollar had started weakening from mid-2013, around the time oil prices peaked. Singapore practices sophisticated monetary policy – not found anywhere else in the world – without a targeted policy rate. The Singapore Dollar fell from 1.2 to around 1.35 by February 2015. It eventually weakened below 1.44 to the US Dollar by January 2017. The Thai Baht had peaked at 29.0 around April 2013 and weakened to 32.5 by February 2015. The India Rupee had also weakened. The Sri Lanka Rupee was around 130 at the time. The rupee collapsed under the weight of massive money printing and sterilized forex sales in 2015 and 2016 to around 150 to the US Dollar. In 2017, though money was no longer printed, the rupee continued to fall. It continued to do so in 2018, unlike better managed East Asian nations, because the rupee has once again become a depreciating crawling peg.

SOUND MONEY
The currencies of better managed East Asian countries started to appreciate in 2017 as the dollar weakened and commodity prices rose. Oil prices are rising, but its effect is somewhat mitigated with rising currencies in better managed East Asian nations, where poverty is lower. The ringgit originally fell from 3.0 to 4.2 to the US Dollar, which means it inflated about 39% compared to the US Dollar. It is no surprise that there is political unrest in Malaysia with a steep fall like that. Singapore and China fell the least. (Graph 3)

The inflation of the Singapore Dollar against the US Dollar was only about 14.7% around the same period. It is now reversing. In better managed East Asian nations – including Singapore, China, Malaysia and Thailand – the currency is appreciating. Hong Kong has a currency board, so the exchange rate does not move.Sri Lanka is diverging and moving towards the badly managed countries. When the rupee fell in 2015 and 2016, the effects on domestic prices were muted because global commodity prices were falling. However, it worsened the effects of a drought. But now, with global commodity prices rising, its full effects will be felt, particularly with oil.

In most countries, currency depreciation, which pushes up the price of traded goods, only gives extra profits to exporters by destroying real wages. But in Sri Lanka, exporters get a double benefit because energy prices are not hiked immediately or monthly. As a result, there is a clamour for currency depreciation. In the last few years, Sri Lanka’s currency has kept pace with countries like Mongolia and Indonesia. Vietnam avoided a BOP crisis for almost a decade. However, credit growth is zooming and the central bank is encouraging low interest rates. Indonesia’s currency has stabilized after a sharp fall. (Graph 4) Mongolia reported 7.5% inflation in 2017 – higher than the 7.1% created by Sri Lanka’s Central Bank. (Graph 5) It had two sharp devaluations in recent years and the peg crawled down between them (like Sri Lanka is doing now) before stabilizing and starting to appreciate. It also has an International Monetary Fund backed EFF programme. Even the Philippines is doing better, though the currency is still weakening steadily in the latest round. Its central bank – created under US State Department pressure to make the country join the Bretton Woods – once went bankrupt.

UNSOUND MONEY
The danger of inflation and a currency that permanently weakens cannot be overemphasized. It is no accident that the Philippines has high levels of crime and ended up with a president like Rodrigo Duterte who has scant respect for rule of law or justice or the life of citizens.

Unsound money breeds corruption everywhere, especially in the public sector. No private agency can destroy a society comprehensively like a central bank that supplies unsound money. In fact, Venezuela’s doctors and teachers are crossing the border and turning to commercial sex to make ends meet. It is not necessary for central banks to create hyperinflation like in Zimbabwe or Venezuela, and force mothers and sisters to sell their bodies to save their children, and little siblings from starvation to feel the bad effects of currency depreciation and inflation.

In the 1970s, when exchange, trade and price controls were used to counter the effects of Central Bank money printing in Sri Lanka, previously law-abiding people were made into law-breaking black marketers, their customers and ‘hoarders’ of all kinds. The public sector was able to collect bribes for permits and turn a blind eye. In Russia, during Soviet rule, money printing, trade and price controls created one big private enterprise – smugglers and black marketers. When the country opened, this mafia was the only private enterprise available to take the reins of the economy.

Sri Lanka’s jewellers are now asking for permits following an import tax hike on gold in April, after imports soared. This would not have happened if the rupee was stable. If permits are given, there will be ‘leaks’. Even if permits are not given, gold will be smuggled.

In the 1980s, when the rupee was allowed to fall in line with money printing in a crawling peg, a construction worker could barely save money to buy an Indian-made Hero bicycle when he found that the price had doubled. Buying a motorcycle was a joke.

If someone could buy a motorcycle or a car, he could sell it for twice the price a few years later. People who got a loan to build a house found that, in the two years it takes to complete a house, construction costs had gone up by 400%.

Factory workers were striking all over the place as the Central Bank busted the currency and stole their wages, not once every four years in a BOP crisis but every month, with a deadly crawling peg that relentlessly ate away at their salaries and what meagre savings they had, without giving a chance for wages to catch up. The JR Jayawardene administration had to rig elections and carry out one of the most brutal suppressions to remain in power during the time, while high inflation and a currency collapse created fertile ground for armed uprising.

A TIGER’S TAIL
This column has said earlier that the REER can fall when monetary policy improves in competitor countries/trading partners, and it is not always necessary to depreciate one’s own currency. If every country had good policy, Sri Lanka’s REER may fall below 100 and maybe the rupee will be allowed to appreciate – if credit expansion is still moderate.

If the country is open to foreign investors – which should increase the supply of credit and bring down or equalize rates with the rest of the world – they will also demand a higher return from the country with the weaker currency. This can be clearly seen in the case of Singapore and Hong Kong

However, that makes the REER hostage to the monetary policy of other countries, particularly India’s, which is hardly an example to follow. This is infinitely more dangerous than making a country hostage to the US Dollar though a peg, whatever the problems the Fed has. The rupee was even forced down in 2017 when foreign reserves were being collected and purchases were sterilized.

One major problem with that strategy is that prices of traded goods will continue to rise even if domestic credit has moderated and the Central Bank is no longer firing excess demand at home. The prices of domestic non-traded goods will fall as demand reduces, but overall traded goods will continue to rise, keeping the index up. As a result, interest rates will have to be high for longer than necessary; delaying a recovery, though it may help collect more reserves at the expense of growth. In general, a country with a permanently downward crawling peg – due to REER targeting or otherwise – will tend to have higher interest rates than otherwise.

If the country is open to foreign investors – which should increase the supply of credit and bring down or equalize rates with the rest of the world – they will also demand a higher return from the country with the weaker currency. This can be clearly seen in the case of Singapore and Hong Kong, both of which run surplus budgets.

What a crawling peg also shows is that even if people paid higher taxes and budgets improve, the rupee will still fall. If fuel prices are raised, reducing borrowings and improving public sector finances, it can also push the REER up and the rupee will have to weaken further.

A crawling REER targeting peg is like holding a tiger by the tail. All this means there is no hope for the wage earner. And that is dangerous.