Exchange rate politics. Why Sri Lanka falls behind India?
Article's background and purpose
I saw an interesting presentation on how the value of Indian Rupee based on the exchange rate for the US dollar has fallen from Rs. 3 in 1947 to Rs. 94 in March 2026 which has now surpassed 95 (See the video here. India Rupee Slide) and a brief economic story behind this long-term trend of the Rupee as shown in the following chart.
Therefore, Indian exchange rate story is useful to benchmark the long-term trend of Sri Lanka Rupee to understand successes and failures of Sri Lankan economic managers. Although macroeconomic structure and living standards are significantly different between the two countries, the priority attached to the dollar exchange rate in the macroeconomic management and exchange rate policies are almost identical. Therefore, given the economic and political strength of India in the global economy, benchmarking Sri Lanka on Indian Rupee value seems reasonable.
Therefore, this article proposes that Sri Lankan policymakers compare its exchange rate story with Indian story and revisit the exchange rate policy framework in the interest of long-term macroeconomic development and living standards. This is important in the current globally stressful exchange rate environment in which some analysts predict currency crises and international insolvencies similar to country experiences in 2022/23.
Exchange rate economics and politics
Global development
Exchange rate is a price for trade between two currencies. In ancient kingdoms, kings taxed foreign trade but never intervened in prices of currencies exchanges in trades.
However, modern state/sovereign currencies have been invented as political instruments for governments to take control over respective economies through fiscal operations. Therefore, governments across the world commenced intervening in currency prices as a major part of their control of sovereign currencies.
Meantime, the US government since 1944 Bretton Woods agreement for exchange rates has led its currency, US dollar, to be the dominant global currency so that the US government secures the global economic power. As a result, currencies of the rest of the world have been operating largely on reserves built in the US dollar and, therefore, the exchange rate for the US dollar has been the single most dominant macroeconomic target across the world. This has led the exchange rate to be a very powerful geopolitical instrument across the world.
In 1980s, Governments of developed market economies gave up the direct target and control of exchange rate by letting it to be determined largely in currency markets. However, the governments in the developing world continued to intervene in the exchange rate as the key driver in economic development and management based on the US dollar and its flows through global trade of goods, services and finance.
In that background, a lot of exchange rate theories have been invented to detect the macroeconomic impact of exchange rate as well as the use of exchange rate as a major macroeconomic policy instrument. These theories mostly center around three exchange rate regimes, i.e., fixed exchange rate, floating exchange rate and managed floating exchange rate. As such, exchange rate has become both the macroeconomic target and the macroeconomic policy instrument where most governments try to play both simultaneously.
Macroeconomic trap by exchange rates in developing countries
However, governments of many developing countries have been able to drive respective economies to generate a healthy flow of dollars from international trade to support the currency stability, economic growth and better living standards. Therefore, country politics has evolved to raise foreign borrowing for building a dollar reserve buffer to manage the exchange rate for macroeconomic targets such as high growth, low inflation and high employment.
In turn, this exchange rate politics, i.e., foreign borrowing-dollar reserve-exchange rate, has caused these economies in the worst trap as shown by currency crises, international bankruptcies and collapse of living standards from time to time. Even countries such as Malaysia, Philippines, Indonesia, South Korea and India who built sizable dollar reserves through aggressive domestic industrialization policies have been unable to insulate respective economies and living standards from exchange rate risks linked to the US dollar. It is this exchange rate politics that has led the IMF/World Bank to govern the developing world through their loan programmes that support the dollar reserve and exchange rate although IMF/World Bank born in the Bretton Woods in 1944 were dead in 1971-73.
It is in this political background that the long-term trend in the value of the currency of any country should be understood. Therefore, the textbooks-based exchange rate economics has little importance for macroeconomic management of countries, other than its use for understanding of economic principles of currency markets.
Sri Lankan exchange rate policy journey vs India
Irrespective of underlying geopolitics on the exchange rate, Indian video provides an insight into exploring of what might have caused the value of Sri Lankan rupee to depreciate excessively faster than Indian rupee. A trend comparison for the past 76 year-period 1950-2026 is shown in the chart below.
Sri Lankan monetary system and exchange rate policy after independence
Before establishing Sri Lankan currency and monetary system in 1950 by the Monetary Law Act, Sri Lankan monetary system was the Currency Board System which produced Sri Lankan rupee on its reserve of Indian rupee and, therefore, linked indirectly to the Sterling Pound to which Indian rupee was linked. Therefore, the parity or the exchange rate between Sri Lankan rupee and Indian rupee in 1950 was one, implying that there was no discretionary money printing in Sri Lanka.
However, in 1950, Sri Lanka gained the sovereign currency status where the government got the freedom to print money for domestic economic objectives. Therefore, monetary variables such as exchange rate, interest rate, bank credit, foreign reserve, public debt and money supply were managed by the central bank for achieving desirable macroeconomic targets. In that journey, irrespective of sovereign currency powers, relevant authorities continued to manage the monetary system as a de-factor currency board by operating it on the dollar and borrowed dollar reserve with the exchange rate stability as the core of the macroeconomic management. The present macroeconomic management stance is also the same.
Therefore, Sri Lankan policy-making economists who continue to support IMF borrowing programmes to protect exchange rate stability, foreign trade openness and consumer price stability (low inflation) are blessed with a practical research topic to find out why Sri Lanka has miserably failed behind India in its macroeconomic management as reflected in large deviations of the currency values, foreign reserve buffers and underlying policy directions.
Macroeconomic question to be answered by policy economists
The simple question here to be answered is why, despite the fact that both Sri Lanka and India commenced with same dollar exchange rate in 1950, Sri Lankan rupee value has fallen by 6,777% against the dollar when Indian rupee fell by 1,916% during the period from 1950 to 2026. The same question in other words is why Sri Lankan rupee fell by 241% against Indian rupee during that period (see the chart above).
In this period from 1950-1974, exchange rates were fixed rates under the Bretton Woods-IMF system and, therefore, they remained in a narrow band. However, after the collapse of the Bretton Woods-IMF fixed exchange rate system in 1971-1973, countries started experimenting numerous mechanisms for market-based flexible exchange rate regimes. Therefore, large deviations in exchange rates were reported after 1974/75. It is historic that Sri Lanka embarked on a flexible exchange rate regime since 15 November 1977 in order to give effects to the open economy policy model. Therefore, the question is really applicable to the trend of exchange rates after 1973.
The present concern is where exchange rates of both countries are heading to in the foreseeable future. Indian concern is the psychological limit of 100. Sri Lanka's psychological limit is how soon the exchange rate will pass 370, the record highest catastrophically experienced in 2022 economic and political crisis.
Whether the two countries are able to save the limits rest on the level of respective foreign reserve adequacy which are around 8.5 months of imports in India (about 690 bn dollars) and 3 months in Sri Lanka (about 6.7 bn dollars). Both have built the foreign reserve through foreign capital where the private equity is major in India while government borrowing and currency exchange is major in Sri Lanka as both have failed to generate a foreign surplus on the real trade. Therefore, both countries require significant suppression of economic growth and living standards to save these psychological exchange rate limits.
As the answer is not that sample, Sri Lankan policy economists at least can highlight major differences in economic policy politics between India and Sri Lanka and find out how those differences have caused Sri Lanka to be an economy increasingly vulnerable to currency and debt crises directly connected to exchange rate policy.
Concluding remarks
- Exchange rate is a political topic although it can have divergent macroeconomic stories.
- Therefore, macroeconomic fundamentals-based exchange rate stories are pure economic myths.
- The exchange rate in the developing world is a price highly controlled by means of risky foreign borrowing for unachievable macroeconomic objectives.
- Therefore, unless the current macroeconomic management policy framework is redesigned to exclude the exchange rate similar to developed countries in 1980s, developing countries will never see the light of sustainable development and livings standards.
- As Sri Lankan monetary system with the central bank that was established in 1950 was repealed by politics in 2023 with a non-accountable central bank, it is advisable that Sri Lanka goes back to the 1950 Currency Board System from the present de-facto dollar-based currency board system if the country politics continues to depend on the dollar for development and living standards. This system has long survived in island economies such as Singapore, Hong Kong and Caribbeans.
- This system will abolish the present discretionary money printing in rupee that every body dislikes at present and drive the economy and living standards officially on the dollar which is presently pursued unofficially.
P Samarasiri
(35 years of experience in staff class in the Central Bank, inclusive of Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 13 Economics and Banking Books and a large number of articles published.)
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