Exchange rate regimes of Sri Lanka and their impact on Unilever

An exchange rate regime is the way an authority manages its currency in relation to other
currencies and the foreign exchange market. There are three types of exchange rate systems such
as the fixed exchange rate, managed floating exchange rate and freely floating exchange rate.

Replaced by the Central Bank in 1950, with explicitly defined objectives of stabilizing the
domestic and external values of the rupee and promoting economic growth. The Sri Lanka rupee
became the standard of monetary value and was fixed at 0.88 grams of gold which yielded an
exchange rate of Rs.13.33 for one British pound and Rs. 4.77 per one US dollar (CB report, 2006).

Unilever was established in Sri Lanka in 1938 under the name of Lever Brothers (Ceylon) Ltd was
established in 1938. (UARM - Unilever Sri Lanka, 2016). Given that Unilever was present within
Sri Lanka even before it gained its independence, it is important to understand how Unilever
continued strive within the unpredictable economy of Sri Lanka.

2.1 Fixed exchange rate

During the years 1948-1960 the company grew to be the largest private manufacturer of consumer
items. This was due to the fixed exchange rate regime followed by Sri Lanka at that time. This
measure stabilized the economy of the country promoting growth overall. The reasons for this
growth are, the minimal fluctuations of the currency and the lower inflation rate.

Dual Exchange Rate Regime By the mid-1960s, however, the country faced a balance of payments
crisis, triggered by low export prices and a high volume of imports. The situation was aggravated
by the devaluation of the British pound, forcing Sri Lanka to devalue the rupee by 20 per cent on
22 November 1967, in order to maintain export competitiveness. (CB report, 2006)
In an attempt to ease the pressure on the countrys balance of payments, a Foreign Exchange
Entitlement Certificate system was introduced in 1968. This involved a system of dual exchange
rates with one official rate applicable to essential imports and non-traditional exports, and another
higher official rate applicable to all other exports and imports. The objective of the scheme was
export diversification and import compression by allowing the market mechanism to regulate the
flow of non-essential imports. It was designed to bring the rupee cost of a wide range of such
imports closer to the realistic value of foreign exchange.
However, this amounted to subsidizing the cost of providing the foreign currency at lower rates to
the non-traditional exporters, which eventually had to be borne by the Government. . All these
factors restricted the growth of Unilever when compared to the previous period. As a revival
measure, Unilever focused on exporting soap and cooking fats ultimately accounting them to one-
fifth of the companys revenue by 1970s. Due to the- balance of payments crisis it sparked, Sri
Lanka adopted highly restrictive controls on current and capital account transactions, which
prevailed until 1977.

A fixed exchange rate avoids redundant currency fluctuations which creates uncertainties towards
firms which engage in international trade. They are fixed or pegged in terms of a foreign currency
and are promised by the monetary authority to be able to trade in unlimited amounts (Obstfeld &
Rogoff, 1995). However, it is not easy to implement the right rate as it would lead to account
imbalances.

Maintaining a fixed exchange rate would encourage investments, helps restrain inflation and price
stability. When further explained, if the mobility of capital is high and there is no flexibility for
the exchange rates, the interest rate would be needed to be increased shortly after, in order to
restrain inflation. This in turn would result in slow economic growth and contribute to rising
unemployment in the long run.

3.2 Managed Floating Exchange Rate

From 1977-2001, a managed float exchange rate was in effect; the elected government set the
exchange rates at new devalued levels after which the rupee was brought under a managed floating
system (White & Wignaraja, 1992). Due to this decision, the real trade deficit rose by 560 percent
affected by the increasing imports and reducing exports of the country, which further contributed
to devaluation of Sri Lankan rupees (Weliwita & Tsujii, 2000). The currency was reunified and
set at Rs.15.06 per British pound and a managed float exchange rate regime was introduced. The
rupee exchange rate was linked to a basket of currencies, weighted in terms of their relative
importance in trade. (Fxtop.com, 2015)

The Central Bank announced its buying and selling rates for the pound for its transactions with
commercial banks and commercial banks were to quote buying and selling rates for currencies
within the specified margin for their transactions with customers. Unilever faced issues in Sri
Lanka due to the constant devaluation of the currency during this regime, thereby they sought to
import raw materials and manufacture within Sri Lanka to cater to the locals.
Managed float regime are a hybrid of both the fixed and floating exchange rate regimes. They are
allowed to float on a daily basis until the central bank would intervene when necessary. The
success of this system is determined according to the circumstances (demand and supply, exports
and imports, pricing) and ultimately the decisions taken by the central bank.

3.3 Freely Floating Exchange Rate

In order to provide commercial banks with more flexibility in quoting exchange rates, the margin
was increased to 2 per cent in 1995 and in late 2000, it was raised to 5 per cent in the face of a
large balance of payments deficit. The Central Bank continued to widen the band gradually from
6 per cent in August to 8 per cent in January 2001, allowing market forces greater scope in terms
of determining the exchange rate. (CB report, 2006)

On January 23, 2001, the Central Bank decided to liberalize the foreign exchange market by
allowing the commercial banks to determine the exchange rate. Since then a free floating exchange
rate was used. The advantages of this exchange rate systems are; the absence of capital flow
restrictions, countries are more insulated from other countries economic problem, and there will
be less intervention by the Central Bank. However, the major disadvantage is the high volatility of
this system. Hence, an MNC like Unilever should allocate sufficient resources to manage the
fluctuations of exchange rates which would incur additional costs to them.

Floating/flexible exchange rates on the other hand, completely emancipates the pressure on the
central bank and let the market determine the rates. But then again, there is a tendency of worsening
the economic situation of the country if there is high amount of inflation and unemployment
problem.

Flexible rates can be very volatile, because they are driven chiefly by volatile capital
flows. They do not necessarily move in line with purchasing power parity, nor do their
movements always foster current account adjustment. (Kenen, 2000)

According to the above paragraph, the high volatility can be disadvantageous to a country with
existing economic problems, but it would insulate other countries from exposing to such risks.