As I write this in mid-March, the big news is the Sri Lanka rupee’s appreciation against the US dollar (and many other currencies). At this point, I presume, it would have continued till the moment you read this, and by now, the country may have also received the first component of the IMF assistance, the stock market may be doing far better, and all looks good.
However, the rupee appreciation raises a series of questions. Why and how could the rupee appreciate while we are in the middle of a crisis? Are the bad times over? Are we back on track? Will the lull last for long? Or on the contrary, is it more of a tea break in hell?
The answers to these questions largely depend on where you stand. One school of thought has already suggested that there is no rupee appreciation; they posit that the US dollar has depreciated instead (but they would have to explain how the rupee appreciated against many other major currencies too). Another group argues that the Central Bank of Sri Lanka manipulated the exchange rate (and I would be surprised that the CBSL has that kind of power). On the other hand, the pro-government club is all optimistic. A state-owned newspaper – on the day of writing this – reported people gathering at banks and other currency exchanges to convert their US dollars for rupees anticipating the greenback’s further decline (Wow! Good for them!). Meanwhile, Fitch has predicted that the rupee would reverse its gains and lose 20% of its value by the end of the year. Most of these stances or points of view oscillate between reality and sheer imagination. To discover what really happens behind the screen, we need to do a thorough evidence-based analysis. This is an attempt to do that.
Understanding the anatomy of a crisis is paramount in analyzing it. Instead of dissecting Sri Lanka’s crisis, I will first try to dissect another one that looks similar. If it offers any consolation, Sri Lanka is not the only country that did nothing as it was pushed closer to the edge of an abyss. Russia’s 1998 economic crisis began with the collapse of the ruble, which caused a severe recession and financial instability. The Russian government had been running large budget deficits for years, leading to an unsustainable level of debt that could not be repaid without major reforms or external assistance. This created a situation where foreign investors were unwilling to invest in Russia due to its high risk and lack of stability. When global oil prices dropped sharply, it put further strain on already weak public finances and caused an even greater decline in investor confidence.
Sounds familiar? Wait, there is more to come. The effects were devastating for ordinary Russians as they saw their savings wiped out overnight by hyperinflation while wages stagnated or declined significantly from one year to another due to currency devaluation against the US dollar and foreign currencies. Even though some recovery did occur during the 2000s, the crisis left long-lasting negative impacts on the economy including a widening inequality gap, rising unemployment and poverty. In addition, this period also witnessed widespread corruption within state-owned enterprises that led to the misallocation of resources and heightened rent-seeking activities that dampened productive investment opportunities and hindered growth prospects.
The fate of the ruble was catastrophic during this period. The old ruble was so badly devalued that even the notes of RUR 50,000 or 100,000 were quite common. In 1998 a new ruble (or RUB) was defined. It was equivalent to 1,000 old rubles. In other words, old ruble 1,000 notes were exchanged with RUB coins. This is what is called a true drop in currency value. Even after the approval of a $22.6 billion IMF and World Bank assistance package, things didn’t immediately get better. Russia’s Central Bank had to frequently intervene to prevent the RUB from devaluing outside the “floating peg” range. The failure to implement a coherent set of economic reforms led to a severe erosion in investor confidence and a chain reaction that was similar to a run on the Central Bank. Investors fled the market by selling RUB and Russian assets (such as securities), which further put downward pressure on the RUB. This forced the Russian Central Bank to spend its foreign reserves to defend the currency. Within a year, the Central Bank had expended over $27 billion of its reserves to maintain the floating peg.
The recent “appreciation” of the rupee (if we can call it that) is a good indication that Sri Lanka has never journeyed along the calamitous path of Russia. Sri Lanka’s economic crisis was more like a breeze, compared to the Russian storm. In fact, we could have easily avoided not just the default, but even the crisis. By 2016, the crisis in waiting was apparent. That was the exact timing for the commencement of debt restructuring. Sadly, the government at the time and Dr Indrajit Coomaraswamy, then Governor of the Central Bank, circumvented any preventive measures. They were just sweeping the dust under the carpet, presuming things would get better by themselves. By 2020, it was too late. On the other hand, the Russian default was not something that could have been avoided, unlike the Sri Lankan crisis.
Back to 2023. So what does this unexpected rupee “appreciation” mean? To answer that question, we must understand why it happened. It is so unusual in the middle of a crisis (for example, no such thing happened in Russia). Local pundits have offered many reasons but there is no consensus among them; the reason is that vague. Let me try to get it by the process of elimination. “When you have eliminated the impossible, whatever remains, however improbable, must be the truth,” avers Arthur Conan Doyle’s Sherlock Holmes.
It took Sri Lanka a relatively long time to bring back the lost international confidence. Now only it is approaching the target
So, to begin with, did the rupee appreciate because the US dollar depreciated? No, that happens extremely rarely and there are no signs the greenback depreciated. It is as healthy as it can be. This line is a cul-de-sac. If still in doubt, one can check the US dollar’s movement against other currencies during the last three months. So, was it the opposite? Was the rupee truly appreciating against the US dollar because the Sri Lankan economy is seeing a reversal? Sadly, no. For a true and long-term appreciation of the rupee, so many other things need to happen. This change comes without any meaningful reforms or a substantial rise in exports.
So what has happened? In one word, the explanation is Speculation. This is the only way the movement of the rupee over the past twelve months could be explained.
There was a time the market value of the US dollar was around Rs200. One year back, by this time of the year, it was also clear Sri Lanka was in for a nasty mess. The international media were full of negative stories about Sri Lanka. To make things worse, the government had absolutely no plans to address the incoming economic catastrophe. Instead, they continued to push their incorrect policies forward. With the decision of the Central Bank of Sri Lanka to move away from the market, speculation started playing a substantial role. With continuous protests that commenced at Galle Face grounds and fuel queues appearing, the Undial and Hawala FX traders had a field day. It was they who decided the true exchange rate. As the economic environment deteriorated, hardly anyone was willing to buy rupees for US dollars, So when the reins were eventually released by the Central Bank, the rupee hit rock bottom.
This fall was akin to throwing a heavy wooden ball into the water. It will start floating ultimately, but not before sinking further. This was exactly what happened to the rupee. It went far below its true market value. For example, the rupee was maintaining a long-term exchange rate of 1:2.5 with the Indian rupee since the 1980s. It was disturbed a bit around 1992, with market liberalization in India, but returned to the same levels fast. This rate was disturbed again in 2022 when the Indian rupee increased to 4.25 Sri Lankan rupees. As the conditions are too bad now it would be too optimistic to expect the Sri Lankan rupee to rise to the previous exchange rate with its Indian counterpart, but that will not surely continue at 1:4.25.
The next question is why the reversal of the rate took so long. Again, the answer in one word: Speculation. It took Sri Lanka a relatively long time to bring back the lost international confidence. Now only it is approaching the target. Wickremasinghe government has taken many measures to ensure a healthier economy. Board-level agreement for IMF assistance is almost achieved. High taxes were introduced to improve government revenue. (That would not be enough, but something is better than nothing.) Utility charges have been increased to reflect their true costs. All major government projects have temporarily ceased. Severe cost-cutting measures have been introduced by the state sector. While many other reforms are to be made, this is great for an island nation that had little control over economic activities just a few years back.
Does this mean the bad times are over and we are back on track? Oh, no. Not necessarily. We are not that fortunate. On the other hand, we are not ill-fated either. At least we now know that things are in our hands. We can bring things back on track. This is one lesson many of us still have not realized.
What should ideally happen following the IMF bailout? Let me quote two sensible and realistic proposals I saw on the web. The first one is by Prof. Howard Nicholas. He says Sri Lanka must focus on creating the right business environment to attract foreign investors and expand its export basket and not rely on new borrowings from global financial markets using sovereign bonds. His opinion is to address the 40-year-old trade imbalance through export-oriented industrialization. The other is by Panchama Pannilarathne, a Finance Manager in a well-known private company. In a LinkedIn article titled ‘The Tide Has Turned?’ he suggests these reforms: SOE restructuring; fiscal deficit improvements; anti-corruption regulations; a business-friendly environment; investor-friendly policies; external trade liberalization and a safety net for vulnerable communities. I think both of them aim, more or less, for the same thing. Just being complacent about the current favourable situation is the worst trap we could fall into. That must be avoided at any cost.
Sri Lanka must focus on creating the right business environment to attract foreign investors and expand its export basket and not rely on new borrowings from global financial markets using sovereign bonds.