By Bodh Maathura
The immense volatility of the exchange rate has made it a headline for the past few months. The former Central Bank Governor’s decision to fix the Sri Lankan rupee at 202 against the US dollar has evoked polarised responses from academics and businessmen alike. In this context, currency devaluation has become a salient topic in the media.
The devaluation of a currency to promote exports is an orthodox economic theory that is embraced by orthodox economists to make a case for reaping the full benefits of “free” international trade. The International Monetary Fund (IMF) in the past has advocated for Sri Lanka to devalue its currency based on this premise. However, Sri Lanka’s trade data paints a different picture of the key variables that have enabled the expansion of exports.
What the theory says
The orthodox theory states that the devaluation of a currency of a country will be beneficial for the exports of that country. This is because once the currency is devalued, the goods produced in that country are cheaper and become more price-competitive for the rest of the world. This can best be explained through an example.
In the first scenario, we assume that the exchange rate will be USD 1 = LKR 100. The total cost of producing a given commodity will have imported inputs and local value addition costs such as labour. Assume that the imported input cost is $ 100 (Rs. 10,000) and the locally incurred cost for value-addition is Rs. 10,000 ($ 100). Therefore, the total cost of production per unit is Rs. 20,000, which is $ 200.
In the second scenario, we assume that the currency has been devalued by 100%, making USD 1 = LKR 200. The cost of imported inputs for producing a given commodity will be $ 100 (Rs. 20,000) and the local value-addition will remain at Rs. 10,000 ($ 50). Therefore, the total cost of production per unit is $ 150.
We see that in the second scenario, the good has become cheaper in dollar terms through the devaluation of the currency. Therefore, by merely devaluing the currency, the product becomes more price-competitive in the international market. In theory, as depicted above, the price competitiveness created by the devaluation of the currency would make Sri Lankan goods more attractive for the international consumer. Consumers will, therefore, demand greater volumes and the exporter is able to increase his revenue by increasing the output.
The Sri Lankan experience
The Sri Lankan rupee has depreciated against the US dollar at an annual average rate of 5% between 2010 and 2019, with double-digit depreciation of 12%, 10%, and 20% being recorded in 2012, 2015, and 2018, respectively. $ 1 at the latter part of 2010 was valued at Rs. 111, but by the end of 2019, it has reached Rs. 182. This is a 64% devaluation of the currency.
In line with the theory, Sri Lankan products have become more price-competitive in the international market due to the depreciation of the currency, which should result in the expansion of export revenues. However, the comparison of the exchange rate (USD/LKR) and the merchandise export revenue shows that export revenues have expanded at a much slower pace than currency depreciation, and has even declined in certain years.
This simple correlation analysis (see Fig 1) makes evident that the devaluation of currency in itself is not a sufficient condition for the expansion of exports. In this case, we must look at what is needed to expand exports following devaluation, and whether it is a necessary and viable factor in expanding export revenue for Sri Lanka.
Impact on the cost of living
The Sri Lankan economy is highly dependent on imports. This makes the domestic price of certain goods vulnerable to currency devaluation. Many essential goods such as sugar, dairy, wheat, and pharmaceutical products are all imported. Fuel imports account for 20% of import expenses, and another 20% is spent on consumer imports. Devaluation of the currency pushes the prices of these imported products up, causing the cost of living to rise. This would push the cost of wages and other local inputs up, resulting in the local cost component of exports to rise. In turn, the theoretical benefit of devaluation for exporters would be lost.
For example, consider the earlier scenario where the currency is devalued by 100%, assuming that in turn, local consumer prices rise by 50%. This means the local cost component that was Rs. 10,000 ($ 50) before will now be Rs. 15,000 ($ 75). This will lead to the final cost of the commodity being $ 175. The example emphasises that the extent to which currency devaluation will increase price competitiveness will be reduced if the country is also import-dependent. While a currency depreciation may result in exports being more price competitive for the foreign consumer, this comes at the expense of the cost of living rising for local consumers.
Testing the theory with tea
Ceylon Tea, venerated as the best and the purest in the world, has maintained its position as a staple export since it was introduced to Sri Lanka by the British. In 2019, tea export revenue was $ 1.3 billion, accounting for 11% of the total export revenue of that year.
But tea export revenues have been stagnant and export volumes have declined (see Fig 2) , despite devaluation of the Sri Lankan rupee. Despite price competitiveness from devaluation, the tea sector has been unable to increase yields and productivity. This highlights the role of the production process itself. The tea industry has depended on currency devaluation to stay competitive while focusing on low-value bulk tea and tea packet exports. In contrast, China’s tea exports have risen over the past 10 years, aided by the predictability of their stable exchange rate regime.
Although orthodox economic theory suggests that devaluation is ideal to expand exports, in practice, focusing on increasing the efficiency and productivity in the supply chain and developing value-added products play a much more prominent role in meeting this end.
Apparel exports: Depreciation or innovation?
Sri Lanka’s apparel and textile sector has remained the largest export earner throughout the past decade, accounting for 47% of export revenue in 2019. Apparel and textile export revenue has grown at an annual average of 6% between 2011 and 2019, despite the currency depreciating at an annual average of 5% in the same period. Theoretically, the depreciation of the currency would have increased the price competitiveness of Sri Lankan products, aiding the growth of the sector (see Fig 3).
However, apparel exporting countries such as Bangladesh, India, and Vietnam are more price-competitive compared to Sri Lanka because of their cheaper labour force, scale of production, and backward integration. The Sri Lankan apparel sector has had to rely on ethical labour practices to compete and produce high-value items. The shift from manufacturing “basic apparel” such as shirts and trousers to “fashion-basic apparel” such as lingerie, and a further move to “apparel product designs” designed, developed, and manufactured in Sri Lanka such as high-end sportswear, has enabled the sector to climb up the value chain.
The devaluation of the currency has played some role in making apparel exports more price-competitive. However, this has been accompanied by rapid investments in product development, manufacturing high-value items, and a focus on vertically integrating the supply chain, which together has helped the expansion of both export volume and revenue.
Rubber exports: Stagnant despite depreciation
Rubber-based products account for 7% of export earnings and are seen as an upcoming export sector. Sri Lanka has been vetted as one of the best industrial tyre manufacturers, inviting special mentions at the World Economic Forum (WEF) in 2016. However, the industry has remained stagnant since 2011. In 2011, rubber-based product exports grew by 59% (Year-on-Year) to $ 885 million, but recorded an annual average decline of 0.05% between 2012 and 2019 (see Fig 4).
Once again, we see that the depreciation of the rupee in itself is not a sufficient factor for production capacity to be increased. In 2020, local specialty tyre manufacturer GRI made a $ 100 million investment to expand their production capacity due to the growing global demand, while the Chinese Shandong Haohua Tire Co. invested $ 300 million to set up their manufacturing facility. The former was lured in by the tax incentives given under the Strategic Development Act while the latter has made use of state investments in the Hambantota Port. In both these cases, it was not devaluation-induced price competitiveness but specific government policies on taxation and infrastructure that incentivised expanding production.
The importance of stability and long-term investment
Our analysis of tea, apparel, and rubber, which account for 65% of export income, demonstrates that currency devaluation has rarely been a determining factor in the expansion of export revenue and volume. Rather, it is stable economic conditions and investment in key technologies and infrastructure that is decisive in increasing production capacity.
Furthermore, due to the import-dependent nature of Sri Lanka, the devaluation of the currency would result in price inflation, which would push the cost of inputs and wages higher. In this case, stable exchange rates will be a more viable condition to promote exports. Stability and predictability are also needed in monetary policy, where the Central Bank should maintain a low interest rate regime and guide lending to strategic sectors. Banks must be prepared to finance the long-term investments that manufacturers make to expand production.
Following the path taken by the export-led economies of East Asia and Southeast Asia, Sri Lanka must look towards new export products and move up the value chain of existing export products. The Asian Tigers moved from apparel to electronics, which remains an unexplored frontier for Sri Lanka despite an expanding consumer electronic market. In the 1980s, Sri Lanka missed the opportunity for this transition as an expected investment in a microchip plant by Motorola never materialised due to the war. However, it is not too late, and Sri Lanka’s highly literate and skilled workforce would enable efficient integration into the global value chain.
(The writer is an Economic Research Analyst at Econsult Asia, which is an economic research and management consultancy firm with an alternative development outlook)