Sri Lanka’s economic recovery has seen a notable appreciation of the Sri Lankan Rupee, highlighting a shift in the country’s financial trajectory. After enduring a challenging period of currency depreciation in 2022, where the rupee fell by 44.8% against the US Dollar, the currency rebounded in 2023, appreciating by over 12%.
This improvement is driven by a number of factors such as current account surplus, rising tourism earnings, and robust worker remittances. However, as Sri Lanka moves forward as a crisis-hit country with slow recovery, the challenge lies in sustaining these gains without compromising long-term economic stability.
According to Central Bank of Sri Lanka (CBSL) reports, the Sri Lankan Rupee appreciated by 12.1% in 2023 following the sharp depreciation of 44.8% in 2022, driven by a market-based exchange rate policy implemented by the CBSL.
Key factors contributing to this appreciation included enhanced forex liquidity, policy measures such as the relaxation of mandatory sales of foreign exchange, and improved market sentiment following Sri Lanka’s agreement with the International Monetary Fund (IMF) in March 2023.
Additional inflows from export proceeds, worker remittances, and foreign investments, along with loans from the Asian Development Bank (ADB) and the World Bank also supported the rupee’s recovery. As of March, the rupee further appreciated by 7.6% due to continued inflows from tourism, remittances, and reduced import expenditure.
In 2023, the Sri Lankan Rupee appreciated significantly against major global currencies, including the euro by 7.9%, pound sterling by 6%, Japanese Yen by 19.5%, and the Indian Rupee by 12.6%, reflecting broader movements in cross-currency exchange rates against the US Dollar. The rupee also appreciated by 11.2% against the Special Drawing Rights (SDRs), indicating continued competitiveness for the rupee despite its nominal appreciation.
Sri Lanka has faced persistent current account deficits due to large trade deficits. However, according to reports, the current surplus reflects the country’s adjustment to external shocks, including the balance of payments crisis and debt default.
A key outcome of this adjustment was the stabilisation of the exchange rate, which played a role in boosting export competitiveness. However, while the current surplus is seen as favourable for building up reserves, it may also necessitate CBSL interventions to prevent excessive currency appreciation, which could impact trade competitiveness.
Moreover, reports suggest that moving forward, maintaining a flexible exchange rate policy and focusing on low inflation, export promotion, and economic diversification will be critical to sustaining a balanced current account.
While surpluses are beneficial in stabilising the economy post-crisis, they must be managed carefully to avoid the economic pitfalls associated with excessive currency appreciation and reduced domestic demand.
Accordingly, in order to achieve a sustainable current account balance as a country still positioned in the aftermath of an economic crisis, it is crucial to implement a suitable policy mix that avoids disruptive adjustments.
This involves adopting a flexible exchange rate policy, where the rate is set by supply and demand in the domestic foreign exchange market. Additionally, maintaining low and stable inflation and concentrating on promoting and diversifying exports are essential measures.
‘Confidence in the economy is crucial’
State Minister of Finance Shehan Semasinghe told The Sunday Morning Business that maintaining a market-driven exchange rate was important for the country. “The exchange rate should be market driven. We don’t intervene; we only ensure that there is a market-driven exchange rate in Sri Lanka,” Semasinghe stated, emphasising that there would be no pegging.
Further, he noted that the flexible exchange rate approach was functioning well under IMF guidance. “The IMF will not oppose it. We need the continuation of the IMF programme without any deviations,” he said, stressing the importance of maintaining a 2.3% GDP primary balance surplus by 2025.
“Confidence in the economy is crucial. The moment confidence is lost, the rupee will depreciate,” he said, adding that the completion of debt restructuring, particularly with bondholders, would boost confidence and drive economic recovery.
“Currently, the key factors are inflows and investor confidence in the economy’s growth and stability. The strength of the stabilisation programme and how it is perceived play a significant role in maintaining this confidence.”
CBSL’s monetary policy framework
Speaking to The Sunday Morning Business, Open University of Sri Lanka (OUSL) Faculty of Humanities and Social Sciences Emeritus Professor Sirimevan Colombage explained that Sri Lanka was in a recovery phase, with the CBSL now following the Flexible Inflation Targeting (FIT) monetary policy framework.
“One of the objectives of this framework is to make the CBSL an independent body, free from fiscal policy and political pressure. It is tied to a flexible exchange rate mechanism as well,” he noted.
He highlighted that between 2019 and 2022, the CBSL had attempted to control both the interest rate and the exchange rate, fixing the latter at around Rs. 180 per USD. “The CBSL maintained a very low interest rate policy and tried to peg the exchange rate, but that was a failed mechanism,” he explained, emphasising that such manipulation of both rates led to capital outflows.
“Manipulating both the interest rate and the exchange rate will lead to capital outflow. There are three options: a free capital flow, an independent monetary policy, and a fixed exchange rate. Fixing both the exchange rate and the interest rate will lead to capital outflow. This concept is called the impossible trinity or the policy trilemma.”
Accordingly, the CBSL must choose between controlling either interest rates or exchange rates, not both. “When lowering interest rates, the CBSL should allow the exchange rate to depreciate to avoid capital outflow,” he said.
Prof. Colombage also underscored the risks of allowing the exchange rate to depreciate. “The main challenge of depreciation is that it leads to inflation, increasing import costs,” he said.
However, maintaining a fixed exchange rate could be sustained given the current lower inflation rate and the CBSL can allow the exchange rate to appreciate, which can impact the export sector. Furthermore, allowing the exchange rate to depreciate significantly can increase the debt servicing burden as it will lead to a rise in interest payments on foreign loans and worsen the debt burden.
“Although the Government does not service external debt, interest rates will accumulate over time, increasing the debt burden. Allowing interest rates to rise could also worsen the Government’s debt service obligations. The CBSL issues over Rs. 100 billion worth of Treasury bills weekly and higher interest rates could significantly strain fiscal operations, escalate the foreign debt burden, and increase the domestic debt load,” Prof. Colombage said.
He stressed that the Government would have to maintain a low fiscal deficit since this deficit was the root cause of the present crisis. He added that unless the Government reduced its spending and addressed the fiscal deficit, the CBSL would struggle to balance interest rates and exchange rates.
Maintaining a competitive exchange rate
Meanwhile, speaking to The Sunday Morning Business, University of Colombo (UOC) Department of Economics Prof. Priyanga Dunusinghe emphasised the importance of maintaining a competitive exchange rate in Sri Lanka.
“Moving forward, we have to maintain a competitive exchange rate at all times,” he said, explaining that the CBSL typically smoothed out daily fluctuations in the exchange rate.
“In a small foreign exchange market like Sri Lanka’s, large fluctuations can harm both imports and exports. If there is a significant upward or downward movement on a day-to-day basis, it could hurt economic activities in the country, both in terms of imports and exports.”
He noted that while the CBSL aimed to control sharp fluctuations depending on supply conditions, it was essential to ensure that the country’s competitiveness was properly reflected in the exchange rate. “Those who import, export, or send money will get the right signals when the exchange rate reflects the true cost and competitiveness of the country,” he explained.
Prof. Dunusinghe also underscored that artificially maintaining the exchange rate at a certain level would encourage certain economic activities in the country that were not necessarily detrimental to the economy.
“Interest rates and the policy rates of the CBSL should target inflation,” he added, stressing that inflation needed to be kept in the single digits to encourage business activities. “We need to maintain a single-digit inflation level, for which we must use monetary policy tools, particularly the policy rates.”
He also pointed out that adjusting the policy rate was key to keeping inflation stable. “The policy rate has to be changed in order to maintain inflation at a certain rate,” he said.
Future exchange rate policy
Commenting on the advantages of the current floating exchange rate policy, First Capital Chief Research and Strategy Officer Dimantha Mathew said: “Currently, they are maintaining a floating exchange rate policy. The advantage of this is that whenever there is excess demand, the exchange rate will adapt fast, which is why the currency is appreciating.”
He further explained: “Before adjusting interest rates, the exchange rate will automatically adjust fast. That is a quicker way of adapting and it is beneficial for the economy. It is possible to maintain stability in interest rates if there is a floating exchange rate.”
Mathew emphasised that moving forward, the floating exchange rate system was likely to be the most suitable for Sri Lanka.
“The current situation is beneficial for exports as well. The IMF programme promotes a flexible exchange rate. The IMF supports a more market-oriented approach as it believes in more market-oriented pricing.”
Frontier Research Research Analyst Navinda Meepe told The Sunday Morning Business that what had been observed thus far was that when growth was constrained, disposable income available for consumer demand was also reduced, leading to lower imports, which was why it had been relatively easier to manage exchange rate stability.
“However, the crucial question is how will the situation be managed if growth recovers along with a recovery in imports and with additional pressure on external debt repayments?” he questioned.