DEVALUATION OF CURRENCY: MYTHS AND REALITIES AND IMPACT ON FINANCIAL REPORTING IN SRI LANKA

Introduction

 Are devaluations contractionary? Do devaluations ensure improvement in the balance of payments? These questions have attracted much attention in recent years, since during that time, macro-economists have developed models involving intermediate imports. In such framework, the exchange rate has both expansionary demand-side and contractionary supply-side effects.

A number of studies, both theoretical and empirical, have explored the relative size of the competing effects that follow from devaluations. The effects of devaluations on the economy have caused a great deal of concern in recent years. Whether devaluations are contractionary, or if they decrease the balance of payments deficit are the issues currently under investigation. These questions in particular were raised in the 1970s when the world experienced the first oil price shock. This oil shock, revitalized economists’ interest in the aggregate supply side of the economy. In particular, the supply-side effects if the exchange rate became under increased scrutiny.

As many countries use oil as an intermediate import, the conventional wisdom that devaluation of the domestic currency improves the payments balance and increases employment is threatened. The reason is that in the presence of imported inputs such as oil the exchange rate has both expansionary demand-side and contractionary supply-side effects. The net effect of the a devaluation policy on real variables of the economy depends upon these competing demand and supply side effects of the exchange rate.    

In simple terms devaluation means a reduction in the official value of domestic currency. It occurs when a unit of a nation’s currency can buy fewer units if foreign currency. In this case the exchange rate is treated as an exogenous variable, where its value is predetermined. Its counterpart, the depreciation of the domestic currency means that the value of the exchange rate is continuously changing due to changes in the demand and the supply of foreign currency. Due to excess supply of domestic currency, the value of the exchange rate decreases. Hence the exchange rate is treated as an endogenous variable. Except for expectations effects, the impact exerted on economic variables by depreciation of the domestic currency is the same as the exerted by devaluation of the domestic currency.

Discussion of the Problem

The main objective of this study is on examining the exchange rate system of Sri Lanka and the impact of devaluation of currency on financial reporting. In this research, exchange rate system is the key. When considering the previous empirical studies, there is a dearth of studies, in local context that examined the exchange rate system and the impact of the devaluation of domestic currency in financial reporting. Therefore, it makes this area further investigable especially in Sri Lankan context. Based on our research problem, this study intends to achieve three main objectives as follows:

In the context of Sri Lanka,

1.    to examine the evolution of the exchange rate system;

2.    to assess the effects on currency realignments on the balance sheet; and

3.    to assess the impact on financial reporting on the changes in Foreign Exchange Rates.

Literature Review

Devaluation of currency caused for many empirical studies and researches as it is one of the main determinants of any economy. Devaluation of currency is the plunging adjustment of the value of a currency when compared to another currency. Courtiers that has a fixed exchange rate regime or a semi fixed exchange rate system would use the devaluation as a monetary policy tool. (Investopedia) Devaluation of currency occurs when a country adjusts its exchange value by a large amount at a given time. For instance, in November 1977, Sri Lankan rupee devalued from LKR 5.95/ 1USD to LKR 16/1USD. (Professor H.M. Nawarathna Banda)

Many examples can be illustrated for the situations of currency devaluation which sometimes caused for a currency crisis. In 1998, Russia faced to a continuous devaluation of the Ruble caused by large deficits and low foreign reserves. (Abbigail J. Chiodo and Michael T. Owyang) During the period of 2007/08, Ethiopian Birr was devalued against foreign currencies at a higher rate and in 2009/ 10 it was devalued from 7.2% against the USD. (Tirsit Genye, 2011) On 14th November, 1997, Zimbabwe dollar devalued due to hyperinflationary situation where 75% of the value against the dollar was lost and it was considered as “Black Friday” in Zimbabwe economic history. (Terrence Kairiza, 2010). In 1994, Turkish lira recorded a depreciation of 70% against the US dollar. This was mainly due to the high intervention of Turkey Central Bank to the foreign exchange market and as a results Turkey lost its most of international reserves. (Fatih Özatay, 2007).

In 2001, Sri Lankan Rupee depreciated by 12.7% against USD. That was the highest ever monthly depreciation recorded in the century. (Daily FT. 9th October, 2018)

Most recent example for devaluation of currency is Sri Lanka. Minister of Finance Mr. Mangala Smaraweera illiutrated that Sri Lanakan rupee has depreciated by 7.4% while Indian rupee, Pakistan rupee, Indonesian rupiah and Russisan ruble are devalued by 13.5%, 12.1%, 9.1% and 18.2% respectively. (Daily Mirror 2018.09.21).

Scholars have also studied the causes for currency devaluation in many different angles. In 2014 Dr. G.S. Gireeshkumar and Deepa Divakaran.N of Mahatma Gandhi University studied the factors that lead to the depreciation of Indian rupee. They disclosed more than ten reasons for Indian rupee depreciation including high demand for gold, wide current account deficit, improving strength of US economy, increased price of oil, high fiscal deficit, volatility of stock market and etc.

 Identifying pros and cons of currency devaluation is also important in the study as many researches have used it as a core area in their studies. Keynesian approach highlights devaluation can cause for an expansion in output and growth. Devaluation stimulates aggregate demand and output. The effect of expenditure switching and reducing, devaluation stimulates the expansionary effect. (Taye, 1999) devaluation creates a demand towards domestically produced goods by increasing the prices of imported goods. According to the Marshal Learner condition, if the absolute sum of the long term import and export demand elasticities is higher than unity, devaluation of currency will help to improve the trade balance.

(Paul, 2006) indicates a positive comment on currency devaluation for the firms that operates both in the foreign and local market. At a time of devaluation, the profit from foreign operations increases, when a firm converts its profits in to the local currency. This increased profit can be reinvested in research and development activities of and it will help to reduce costs while increasing the output. (Gala, 2007) also argues that the devaluation leads for an investments led growth as it ultimately results for a growth in export sector, innovations and Gross Domestic Product. Price competition is also a positive factor in devaluation. (Harris, nd) Reduction in relative prices of commodities can impact positively to the firm’s profits. On the other hand devaluation can reduce cost of production through accelerating the domestic consumption and opportunities in foreign markets. (Branson, 1986) Devaluation is another way of stabilizing the economy through increasing exports and improving current accounts which controls overvaluation of the exchange rate.

Despite the positive effects of devaluation, draw backs of currency devaluation can also be identified through research studies and empirical evidence. According to (Krugman and Taylor, 1978) devaluation can also effect negatively to the growth of a country. There will be a negative effect on aggregate demand if the capital owners and saving propensity are higher than for wage owners and influences the increased profits. Devaluation will result in a high profit and will end up in idling if there is no enough competition and favorable markets. (Exixon, 2007)

Devaluation also effects negatively to the countries that are highly dependent on the non-tradable sector. Cost of price of imported goods and the redistribution of resources to the non-exposed sector from the exposed sector will not be proportional. Therefore, the total output will be lost including unexpected sectors. (Goldberg, 1990; Stryk, Jr, & H., 2000)

According to (Bird & Rajan, 2003; Domac, 1997) devaluation further, accelerates the prices of goods that will end up in a reduction of the total real money in circulation. While other factors remain constant, devaluation results in an increase in the interest rates which ultimately decreases the aggregate demand. This will further worsen a country’s economic conditions, if it is highly leveraged. Local firms will also get affected due to the high interest rates caused by the currency devaluation if they have used bank loans for production. Devaluation of currency shows a contractionary effect in the countries which have a wage indexation system. Accelerated prices of goods will force to increase the wages in order to match with the high living cost. This will reflects a decline in the profits of producers. (Acar, 2000)

It is a known factor that currency devaluation leads for a growth as it can provide lower prices in foreign markets in the short run. But in the long run, this can be changed for developing countries especially for the new entrants.  Normally, Developing countries are highly leveraged and if they continues to use devaluation as a strategy, the profit gain through lower prices will be offset by the foreign debt servicing expenses. (Blecker & Razmi, 2007) When investors assumes a rise in the depreciation rate they will not invest and hold up the investing activities such as research and development. This will ultimately ends up with a low growth in the long run (Courchene, 2002)

Many studies reveal that developing countries like Sri Lanka and India uses currency devaluation as a strategy to achieve growth in both long run and short run. (Ratha, 2010) confirms the Keynesian positive view of devaluations and the multiplier effect on the export. Despite the contractionary effect showed during the short run, this study reveals an expansionary effect during the long run.

A study was conducted by Nunnenkamp & Schweickert in 1990 and tested the hypothesis regarding the negative effect on growth caused by currency devaluation. They used data of 48 developing countries. They tested the relationship between exchange rate and Gross Domestic Product per capita. Further they used certain variables such as terms of trade and government expenditure. However the result of the study was to reject the hypothesis that countries which exports manufactured goods face contractionary effects in short run. By taking the price competition in to consideration, Blecker & Razmi, 2007 conducted a study in both developing and developed countries. The result revealed, devaluation of currency of developing country will have a short run growth and the devaluation of the developed country will lead to a decline in growth. 

Study of Nepalese currency, showed that the devaluation of currency will accelerate the import price which leads to increase the production of export products in the industrial sector. Hence Gross Domestic Product showed a growth due to the increase in that sector. (Acharya, 2010)

Discussion

Evolution of exchange rate system of Sri Lanka

Fixed Exchange Rate Regime

Before the establishment of the Central Bank of Sri Lanka, the exchange rate system was evolved from a currency board arrangement. In 1940s the rupees was pegged to Indian rupee and was maintained by the currency board. A fixed exchange rate regime was maintained during the period of 1950 to 1977 where the exchange rate was fixed in terms of sterling pound and USD. Apart from the advantages of this system, Sri Lanka was directly ulnerable to the economic conditions of these two countries. For an example if the inflation rate increased in United Kingdom, demand for UK goods in Sri Lanka will be decreased. As a result demand for Sri Lankan goods in UK will also get increased. This will increase the inflation of Sri Lanka as it automatically increases the demand for Sri Lankan currency. However in a fixed exchange rate system, currency value will not get adjusted according to the demand conditions in the market. As inflation, many other negative economic conditions were imported from these two countries in that period. In early 1950’s this system performed well as long as the economy earns sufficient foreign currency to spend on exports. However, with the collapse of the Bretton Woods system the whole international community started following floating exchange rate systems which values are determined through international supply and demand.

 Dual Exchange Rate Regime

In mid 1960s a Foreign Exchange Entitlement Certificate system was introduced as a remedy to the currency devaluation caused by a balance of payment crisis at that time. A dual currency system was introduced during the period which one official rate was used to important imports and non-traditional exports and another high rate used for all other trading activities. The main aim of this system was import compression and export diversification.

In 1977, The Central Bank of Sri Lanka made a controversial move towards the economic liberalization. This move allowed Sri Lanka to restrict their inward looking economic policies where trade and payments were liberalized in to greater level. As a part of this process, the system of currency exchange was changed to more flexible and market based system. As a starting point, prevailing exchange rate was allowed to float and it recorded a devaluation of 120% in one night. As a result in the beginning of 1977 the exchange rate was LKR 8.83/ USD and the value dropped to LKR 15.56/USD. This system was truly a remedy for overvaluation of currency observed in the fixed exchange rate regime. 

Managed Floating Regime

Next step of Sri Lankan exchange rate system was a managed float system. This managed float system bought new challenges as the government cannot use exchange rate to influence the inflation like in the past. At that time the currency was reunified to LKR 16/USD and allowed to float. Then the rupee was combined with a weight system where a basket of currencies were weighted under its relative trade importance. The selling and buying rates of the rupee was decided in to two stages. In the first stage, Central Bank decided the buying and selling rates for the USD in order to use in the commercial bank transactions. Then in the next stage, commercial banks were allowed to quote for buying and selling rates for currencies to use in their transactions with the customers. However, commercial banks were allowed to quote within the specified margins.

 Independently Floating Regime

In 1990s’ commercial banks were awarded with more flexibility by allowing them to increase the margins 2% to 5%. In 2000s Central Bank of Sri Lanka took another controversial step by allowing commercial banks to decide exchange rates. This can be identified as an introduction of independent float exchange rate system. Even though, central bank stayed away from buying and selling foreign exchange at preannounced rates, they kept the right to intervene the market when necessary. 

Effects on currency realignments on the Statement of Financial Position

During mid 70’s USA faced a continuous devaluation of USD in relation to many foreign currencies. At this point many accountants faced a problem in reporting this effect on their financial statements. This became worse as many large US companies’ assets, sales, earnings and employees were based on abroad. This was the period that companies were trying to find the most appropriate method of translating foreign currency denominated accounts in to local currency denominated accounts. Companies mainly focused on two school of thoughts in this translation.

The first school of thought elaborates that the balance sheet should be divided to current and non-current items. All current items should be translated in effect at the date of balance sheet. The resulting gain or loss will be identified as a special item to the income statement.

The second school of thought, explains that the balance sheet items should be categorized in terms of monetary and non-monetary items. Items such as receivables, cash, borrowings and etc, are considered as monetary assets and should be converted to local currency, in effect of the date of balance sheet.

However most of the companies have treated translation losses in non- recurring nature in the past and the gains were allowed to flowed through the income statement or deferred against future currency reversals. As many options are available which companies can use in converting balance sheet items in to local currency, the magnitude of the gain or loss should be the main aspect that must pay attention to. This deferring options produce deferring results where the portfolio analysts should pay their attention to each firm’s conversion treatment and the consistency of the auditor’s report.

Financial reporting on the changes in Foreign Exchange Rates 

In 2013 Institute of Chartered Accountants of Sri Lanka (ICASL) introduced Sri Lanka Financial Reporting Standards (with effective from 2012) replacing prevailed Sri Lankan Accounting Standards (SLASs) with the objective of reducing the differences between Sri Lankan accounting standards and the international reporting framework. During the process SLAS 21 have been replaced by LKAS 21 which currently governs the reporting on the Effects of Changes in Foreign Exchange Rates. LKAS 21 shall be broadly applied to following areas;

1.    In accounting for transactions and balances in foreign currencies, except for those derivative transactions and balances that are within the scope of the financial instruments standard.

 Initial recognition

A foreign currency denominated transaction shall be reported, on initial recognition in the functional currency, by applying spot exchange rate between the functional currency and the foreign currency at the date of that particular transaction

Table 01: Subsequent Recognitions at each balance sheet date

Source: Author Constructed

2.    In translating an entity’s results and financial position into a presentation currency.

The financial performances and the financial position of a company shall be translated into the presentation currency using the following procedure;

·      Assets and liabilities shall be translated using closing rate at the date of the balance sheet including comparatives

·      Income and expenses for each income statement shall be translated at exchange rates at the date of transactions.

·      All resulting exchange rate differences shall be directly recognized to equity.

3.    In translating the results and financial position of foreign operations that are included in the financial statements of the entity by consolidation, proportionate consolidation or the equity method

The financial statements are translated as depicted below;

·      Assets and liabilities shall be translated using closing rate

·      Income and expenses – rate at transaction date (for practical purposes a monthly or quarterly rate might approximate the transaction date rates)

·      The resulting exchange differences are recognized in other comprehensive income (foreign currency translation reserve).

Conclusion

Up to 1970s, countries have the same consensus on the possible effect of currency devaluation on economic growth. There appears a consensus view on the fact that devaluation or depreciation could boost domestic production through stimulating the net export component. This is possible because devaluation increases which leads to the diversion of spending from foreign goods. Up to this period, devaluation has expansionary effect on output. It would improve trade balance, alleviate balance of payment deficits, and accordingly expand output and employment. 

In simple terms devaluation means a reduction in the official value of domestic currency. It occurs when a unit of a nation’s currency can buy fewer units if foreign currency. The effects of devaluations on the economy have caused a great deal of concern in recent years.

The main objective of this study is on examining the exchange rate system of Sri Lanka and the impact of devaluation of currency on financial reporting.  It was examined that the negative effect of currency devaluation on output in developing countries  which was used devaluation as a policy strategy. However, many researchers found different results on the effects on the effects of currency devaluation on output in less developed countries. Even though ambiguous results were observed, developing countries have actively used devaluation as a policy instrument. Even though, devaluation helps the growth of some sectors in the economy, the foreign exchange earnings may not be sufficient enough cover imported costs. This is true when the supply side channel is greater than the demand side channel of devaluation. Thus, the final result is reducing the economic growth unless the government reduces imported materials and reverts to other options.

Policy intervention is needed to balance the adverse impact of exchange rate movements until the economy become well transformed and then, the economy becomes less dependent on imported raw materials. To this end, monetary policy plays bigger role since it affects the total output positively and significantly.