Thread by @ChayuDamsinghe

Going to explain depreciation, how the official market failed and the unofficial market took it up, and what's needed for the two to come together.

#SriLankaEconomicCrisis #SriLankaCrisis #SriLankaProtests

(1/20)

Exchange rate is basically the value of a currency in terms of other currencies. Eg- 1 USD is worth XX LKR and vice versa.

Depreciation is when 1 currency loses value against another. Eg- 1 USD going from 200 LKR to 300LKR

Appreciation is opposite.

(2/20)

What determines this value?

Simplified, this is through a demand and supply mechanism. The more demand for a currency, the stronger (appreciation) it will get. The less demand for a currency/more supply, the weaker (depreciation) it will get.

(3/20)

How this practically happens can be thought of as an auction. Let me explain with an example.

Assume Sunil wants 100 USD to import paracetamol. He goes to the bank and says, hey, I want 100 USD, I'm willing to pay 300 rupees for each USD.

(4/20)

If the bank has 100 USD and they agree to that price, this transaction will conclude. Tada, the value of the LKR according to that transaction is 1 USD=300 LKR.

But where does the bank get the 100 USD in the first place?

(5/20)

That's where Nimal comes in. Nimal has 100 USD he earnt from selling fish, he's bringing that to the bank and he wants rupees. He says, hey, here's 100 USD, I want 300 LKR for each USD

If the bank agrees, this transaction happens and tada, there's the exchange rate again

(6/20)

In reality, the bank will buy LKR from a customer at a slightly lower rate than they sell LKR to a customer - that's the "buying and selling rate" you might see.

Don't worry too much about that for now, think of it as a fee.

(7/20)

Now, if Nimal the exporter thinks 300 is not fair enough, the bank won't be able to buy USD from him at that rate - and there is 100 USD less in the system. But Sunil the importer still wants 100 USD.

So the demand for dollars is greater than the supply.

(8/20)

When this situation happens, there are one of two things that can happen.

1. If the bank is willing to buy the dollars at 320 and Nimal is willing to give the dollars at that rate and Sunil also agrees (because better to get at 320 than not at all), the rupee depreciates

(9/20)

That's how the system will normally work. Similarly, if the dollars coming in exceed the demand, then the rupee can appreciate.

But what happens if due to whatever reason, Nimal the exporter DOESN'T agree to the rate the bank says?

(10/20)

Say Nimal says, no, I want 350 per USD, but the bank says no, I'll only give you 320?

Then of course, is option 2 - the transaction doesn't take place.

However, importer Sunil still needs to import paracetamol. What does he do?

(11/20)

Demand is greater than supply here, but the price doesn't change to meet that. The only option for Sunil is to go to a different market, not the official one, where he CAN get the USD at whatever price.

There's your black/grey/unofficial/kerb market.

(12/20)

The reason the unofficial market gives a higher value isn't because of any other reason, but because someone still wants the dollars, and they'll pay a higher price in order to get so.

As long as dollars are missing from the official system, unofficial exists.

(13/20)

But how does the unofficial system work?

I'll simplify it, but it's basically a question of trust.

An unofficial dollar dealer here will give dollars at the rate you want. Then, they will coordinate with a foreign party with another customer who wants to sell dollars

(14/20)

While the local dealer and the foreign dealer are often linked, they don't have to be the same party. They balance their books based on trust (I sell 1 USD from my side, you buy 1 USD from your side).

Don't worry too much on how this works. It does.

(15/20)

These dollars do still either come into the system through deposits into local accounts OR they cancel out as imports going out.

But because it happens out of the official banking system, there are questions of whether there is illegal money also involved.

(16/20)

So as long as the demand for dollars is not fully met by the official, the unofficial will exist

So why is this demand not being met?

Expectations mostly. If you expect more depreciation, you won't bring all your money in now. You'll keep asking for a higher price

(17/20)

What will change these expectations is difficult to answer. It could be policy, government change, some USD-LKR number, or many other factors.

That's what to watch out for, will more money come in? If it does, the gap between official and unofficial shrinks.

(18/20)

So then the question everyone will ask me is, at what USD-LKR level will this happen? What's my forecast?

That's a question I can't answer. But what I can do is explain the process like I have, and it'll be upto you to decide based on that.

(19/20)

In the end, all of this is about confidence in the system. Whatever brings confidence, will work out. Whatever doesn't, won't.

So let's hope for more action that brings confidence, whatever that action may be.

(20/20)

Mistake here, it should be USD not LKR