Sri Lanka — Exchange Rate, Balance of Trade and Twin Deficits

Answers

(i) Relationship between exchange rate and standing deposit rate [3] — explain

There is a positive (direct) relationship: over 2018–2020 the standing deposit rate fell (8% → 4.5%) while the exchange rate rose to 187 LKR per USD, i.e. the rupee depreciated as the rate fell.

The mechanism runs through capital flows. The standing deposit rate is the central-bank benchmark interest rate. As it falls, the return on holding Sri Lankan assets falls, prompting an outflow of hot money as investors move funds to higher-yielding economies. This raises the supply of rupees on the foreign-exchange market, depreciating the currency — a higher number of LKR per USD.

(ii) Effect of the exchange-rate change on the balance of trade [5] — explain

The rupee’s depreciation works on both sides of the balance of trade:

Sri Lankan exports become cheaper in foreign currency, raising quantity demanded for exports and so export revenue (X) [2].
Imports become more expensive in domestic currency, reducing quantity demanded for imports and so import expenditure (M) [2].
Whether net exports (X − M) actually rise depends on the Marshall–Lerner condition: provided the sum of the price elasticities of demand for exports and imports exceeds one, the depreciation improves the balance of trade [1]. (Where demand is price-inelastic — as Extract 8 hints, with exports concentrated in textile and food products — the improvement may be muted or, in the short run, reversed.)

(b) Reduce the BOT deficit or the fiscal deficit first? [8] — assess

Scope and stand. “Economic performance” here means lower unemployment and higher economic growth. Of the two deficits, this answer argues that resolving the fiscal deficit is the more crucial.

Reducing the BOT deficit improves economic performance. A smaller balance-of-trade deficit, driven by rising X and falling M, raises net exports and shifts aggregate demand right. Through the multiplier effect, real national income rises by a multiple of the initial impulse, delivering actual growth.

A narrowing balance-of-trade deficit raises net exports, shifting aggregate demand right from AD₀ to AD₁; real national output rises from Y₀ to Y₁, yielding actual growth.

Reducing the fiscal deficit improves economic performance. A smaller fiscal deficit signals a more stable public balance sheet and greater capacity to respond to shocks, which improves investor confidence and attracts FDI and hot money. Investment expenditure (I) rises, shifting AD right; the resulting unplanned fall in inventories prompts firms to hire more factors of production, lowering demand-deficient unemployment.

Evaluation and judgement. Resolving the fiscal deficit is the more crucial of the two for Sri Lanka’s specific context. Attempting to defend the currency or narrow the trade deficit can cut further into the fiscal budget — if the central bank exhausts its foreign-exchange reserves and must draw on public funds to support the rupee, it deepens the very debt problem Extract 9 warns risks “national bankruptcy”. By contrast, fiscal consolidation directly relieves the “historically high debt repayments” and unlocks the investment opportunity Extract 8 describes — MNCs “diversifying production outside of China” — which raises both AD and, through capital formation, productive capacity. The trade deficit matters, but for an economy facing a debt spiral the fiscal deficit is the binding constraint, so it should be prioritised.