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Wednesday, September 28, 2011

Six popular fallacies of currency appreciation – Part 2


Last week’s My View talked about six popular fallacies of currency or exchange rate appreciation which both the authorities and the public have tended to harbour in themselves. Of them, the following three were discussed in detail:
Fallacy One: The government can fix the external value of a currency at any level it wishes.
Fallacy Two: An appreciated currency is a sign of the strength or the preserved dignity of a country.
Fallacy Three: A currency appreciation is helpful for the government to fight inflation since the depreciation of a currency is a cause of inflation.
Today’s My View will discuss in detail the first two of the remaining three fallacies, namely,
Fallacy Four: The currency appreciation is a boon for the government budget since it helps the government to keep the foreign debt repayments under control.
Fallacy Five: It is only the exporters who hate currency appreciation and everyone else loves it.
Fallacy Six: By allowing a currency to appreciate or preventing its depreciation, a country can increase its per capita income or income per citizen in US Dollar terms.
Fallacy Four: A currency appreciation reduces government’s external debt obligations
Many, including some of the mainstream economists, appear to believe that currency appreciation is a boon for the government budget because it reduces its foreign debt repayment obligations in rupee terms. For instance, if the rupee depreciates against the dollar by one rupee, it increases the burden on the budget by the dollar denominated external debt repayment multiplied by one rupee.
In 2010, according to Table 6.8 of the Central Bank Annual Report 2010, Sri Lanka Government’s foreign debt servicing had amounted to Rs. 133.6 billion or, when converted to dollars, $ 1,182 million. Hence, if the rupee had depreciated by one rupee, it would have meant that the Government budget should have spent an additional debt service payment of Rs. 1,182 million. Had the rupee depreciated by Rs 5, it would have entailed another Rs. 5,910 million and by Rs. 10, another Rs. 11,820 million and so on.
Obviously, the depreciation of the rupee increases the rupee value of foreign debt repayments and, given the high value of foreign debt repayments by the Government in the present times, it involves a huge amount of money. Naturally, anyone who looks at the rupee depreciation from this angle should view currency appreciation as a boon for the Government budget.
Government should look at both payments and receipts sides
However, this is so only when one looks at depreciation from the debt repayment side. Depreciation affects both the debt repayment and the revenue sides of the Government budget. On the receipt side, the Government generates rupee funds out of its import duties and the inflow of foreign borrowings. When this side of depreciation is added, it would appear that the Government is a net gainer out of currency depreciation.
For instance, in 2010, Sri Lanka’s imports amounted to $ 13,512 million. At the average import duty rate of 5% which Sri Lanka has maintained in the recent times, this should have generated $ 675 million by way of import duties. In the same year, the foreign funds which the government had generated for financing the budget deficit had amounted to $ 2,157 million. Thus, the total receipts of the Government from these two sources had amounted to $ 2,832 million. So, if the rupee had depreciated against the dollar by one rupee, it would have generated additional rupee funds of Rs. 2,832 million.
Now, when the two sides are amalgamated, the arithmetic shows a different picture. Under this amalgamation, the Government would have spent an additional Rs. 1,182 million to service its foreign debt and generated an additional amount of Rs. 2,832 million, making the Government a net gainer of Rs. 1,650 million.
In 2010, Sri Lanka had a deficit in the current account of its balance of payments amounting to $ 1,419 million to be financed by way of private foreign direct investments and foreign borrowings. Since the non-debt private foreign investments amounted only to $ 435 million, the surge of dollars in the market in the year was mainly due to borrowed funds.
In response to these borrowed funds, the rupee was allowed to appreciate from Rs. 114.38 to a dollar as at the end of the previous year to Rs. 110.95 to a dollar as at the end of 2010. On average, the appreciation amounted to Rs. 1.88 from Rs. 114.94 in 2009 to Rs. 113.06 in 2010. Accordingly, the Government saved Rs. 2,222 million by way of debt repayments and lost Rs. 5,324 million on account of import duties and foreign borrowings. Thus the Government was a net loser of Rs. 3,102 million due to the appreciation of the rupee, on average, by Rs. 1.88 in 2010.
Static versus dynamic analyses
What is presented above is an analysis done on the basis of the existing situation without considering what would happen over the time. Economists call this a ‘static analysis’. However, when the time changes, the existing situation too may change and the analysis done without allowing the time to change may not be valid. For instance, if the Government’s foreign debt servicing exceeds the combined value of its import duty collections and foreign borrowings, then, the government becomes a net loser. Given the Government’s propensity to go for high foreign borrowings, especially from commercial sources, in the recent past, this possibility cannot be ruled out in the future. For instance, with the full repayment of the first sovereign bond of the Government amounting to $ 500 million in 2012, the Ministry of Finance has forecast the Government’s debt servicing to shoot up to $ 1,539 million in that year. But along with the increases in the country’s debt servicing, its imports and new borrowings are also to rise, making the Government’s receipt side on account of import duties and foreign borrowings higher than its annual debt servicing payments.  However, to overcome this specific issue brought about by the static analysis, economists normally make a different analysis called the ‘dynamic analysis’ in which time is allowed to change. An anonymous reader of My View has written to me that even in a dynamic analysis, the Government stands to lose if a currency is forced-appreciated.
A dynamic view
His analysis is as follows: If a currency is appreciated by deliberate action of authorities when the domestic inflation is high and productivity is low, it is like imposing a tax on the export sector because exports become more expensive and providing a subsidy to the import sector because imports become cheaper. The more expensive exports will reduce the country’s export competitiveness as against the exports of other competitors. As a result of the loss of the export competitiveness, the growth in the sector gets stunted.
At the same time, imports which now become cheaper due to the appreciated currency, record a higher growth. The former reduces the domestic economic growth, while the latter promotes economic growth in foreign countries. The combined effect of both forces is a low growth in output and income over the time. The low economic growth will reduce the Government’s tax potential in the long run, making it a victim of its own short-sighted action. This would not happen if the currency is allowed to depreciate in accordance with the emerging macroeconomic fundamentals: a higher inflation created by authorities than competitors and the existence of a sizeable deficit in the current account of the balance of payments. This is because it incentivises the exporters to export more by raising their rupee income to compensate for domestic inflation. Economists call this ‘indexing the income of exporters to domestic inflation’. At the same time, it makes imports more expensive like a tax imposed on imports. The combined effect of both forces is to raise the growth potential over the time and thereby raising the Government’s tax potential too.
Therefore, from both a static and a dynamic view, the Government stands to lose if a currency is forced-appreciated or not allowed to depreciate as required by emerging macroeconomic factors.
Appreciation no solution to foreign debt issues
One fact should be made clear at this point. That is, the Government’s foreign debt problems cannot be sorted by currency appreciation. To service its foreign debts, a Government needs dollars, euros, yens and sterling pounds. It does not produce these hard currencies and has to acquire them either through the export of goods and services or through foreign borrowings or through a combination of both.
If the exchange rate is allowed to appreciate despite the compelling domestic reasons for it to depreciate, both sources of foreign currencies would get adversely affected driving the country to a very vulnerable situation. This is the classic case of having to borrow more and more for acquiring hard currencies for debt repayment which the economists have termed ‘the running of a huge pyramid scheme by the Government’ to service its foreign debt. A pyramid scheme becomes unviable at one stage when the old participants cannot be paid out of the monies raised from the new participants of the scheme. Economists have warned that a government should not go into this type of risky business.
Fallacy Five: Only exporters hate appreciation and love depreciation
Some of the free thinkers appear to be firmly in belief that it is exporters who have clamoured for currency depreciation because it is in their personal interest. They further add that the global policy watchdogs like the International Monetary Fund too advocate the case of the exporters without considering the adverse effects which such currency depreciation would bring to the rest of the economy, especially the cost of living of the poor, burden on the government budget and erosion of the national honour and prestige. They cannot, therefore, understand why local economists too argue for currency depreciation.
Economists’ arguments based on macro fundamentals
It should be made clear that economists do not argue for currency appreciation or currency depreciation. All what they say is that a currency should have an appropriate value vis-à-vis its foreign counterparts to preserve a country’s competitiveness and resolve a chronic ailment involving a country’s higher foreign payments than foreign receipts.
If a country’s productivity has improved raising its competitiveness as well and it has a firm foundation to earn more foreign receipts than foreign payments on a sustainable basis, then the economists point out that the particular currency should be allowed to appreciate in the market. If the conditions are in the opposite, they would argue for a depreciation of the currency.
How would they make the judgment whether it is an appreciation or a depreciation that is required by a particular economy? By looking at what has happened to the real foreign value of a currency, known as the real effective exchange rate or REER, and noting the existence of a current account deficit or a surplus in the balance of payments.
Real Effective Exchange Rates
The REER is simply looking at whether the nominal changes that have occurred in a country’s exchange rate have taken care of its inflation rate compared with the combined inflation rate of its trading partners. This could be illustrated by a simple example.
Suppose that a shirt in Sri Lanka is Rs. 500, that in USA is $ 5 and the exchange rate between the rupee and the dollar is Rs. 100 per dollar. Under these conditions, both countries have equal competitiveness since a shirt is valued at $ 5 in both places.
 If local inflation raises the price of a shirt by 50% to Rs. 750 in Sri Lanka and by 20% to $ 6 in USA, under the existing exchange rate of Rs. 100 per dollar, local shirts become more costly now at $ 7.50 a shirt compared with a shirt in USA at $ 6. Hence, Sri Lanka loses its ability to sell shirts in USA. This is because the Sri Lanka Rupee has now appreciated in real terms against the US Dollar by 25% which is arrived at by dividing 750 by 6. To keep the country’s competitiveness undiminished the Sri Lanka Rupee has to be depreciated to Rs. 125 per dollar at which rate shirts in both countries have the same price of $ 6.
Sri Lanka’s REER has appreciated
Sri Lanka’s Central Bank calculates a REER Index for 24 trading partners taking into account Sri Lanka’s consumer Price Index and the average inflation in the 24 trading partner countries. The index numbers have been produced in Table 5.13 of the CB Annual Report for 2010. According to these numbers, the Sri Lanka Rupee in real terms has depreciated by 1.8% in 2009 and appreciated by 5.3% in 2010.
If a correction is made in the rate in 2010 based on the real rate in end 2008, the rupee should have been allowed to depreciate by 3.5% in 2010. This means that the end of the year rupee to dollar rate should have been Rs. 118.38 per dollar instead of the actual rate of Rs. 110.95 per dollar that was recorded, if the country were to preserve its export competitiveness at 2008 level.
Surely, the exporters would have felt this anomaly and the loss of the rupee income most. Given a level of exports amounting to $ 8,307 million in 2010 and a nominal appreciation of the rupee against the dollar by Rs. 3.43 during the year, they would have felt a loss of income amounting to Rs. 28.5 billion by not keeping the exchange rate at the level it had been as at the end of 2009.
There are other losers too
It is not only the exporters who have lost. Anyone who sells services to foreigners or anyone who sends remittances to their relatives back home would have similarly lost. Accordingly, in 2010, the tourism sector would have lost Rs. 1,082 million, port and airport services Rs. 1,094 million, computer services Rs. 498 million and migrant workers Rs. 7,738 million.
They have lost these amounts because they have to face the higher domestic inflation for which they have not been adequately compensated. Economists call this type of losses ‘deadweight losses’ because it causes one party to lose but there is no any other party in the system who gains as a result of that loss. So, they are losses by the system just like the loss of power generated by the Electricity Board in its transmission to consumers as a result of faulty equipment.
While the exporters are organised and have capability of lobbying for their cause with authorities, their voices are often heard in the media. That may be the reason for the free thinkers to make the judgment that it is the exporters who clamour for currency depreciation supported by the IMF.   The case of the low income migrant workers is pathetic because they have been a silent group who has no voice.
But they remit to their relatives more than $ 4 billion annually to enable the nation to cover a part of its ballooning trade deficits. But they also appear to be aware of their plight; that is the reason for them to patronise in increasing volumes the illegal money transfer systems that offer a few rupees more per dollar when they send money back to Sri Lanka.
The last popular fallacy, namely, appreciating the currency to raise the per capita GDP in US Dollars, will be dealt with in the next My View.
(W.A. Wijewardena can be reached at

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