Wednesday June 20, 2018

Sri Lanka's UNP pays the price for currency depreciation, REER targeting: Bellwether

By Bellwether

Mar 23, 2018 05:36 AM GMT+0530 | 2 Comment(s)

ECONOMYNEXT - Sri Lanka's central bank and policymakers of the United National Party sowed the wind from 2015, printing money to destroy the rupee and inflate prices, and is now reaping the whirlwind with the inevitable political instability that comes with unsound money.

Then Central Bank Governor Arjuna Mahendran said in November 2015 that the rupee had been overvalued and it had now been 'corrected', when the rupee collapsed from 131 to 143 to the US dollar under his watch.

As inflation rose after the currency collapse (and some East Asian weakened, and US also tightened), his successor, Indrajit Coomaraswamy said a real effective exchange rate index (REER) would be targeted, because East Asia 'undervalued' their currencies repeating a Goebbelsian lie spread by US Mercantilists that has become an 'accepted factoid' through repetition.

US mercantilists do not uniformly say a currency is 'undervalued' because of REER (because many East Asian currencies had REER indices in their 120s or 130s at times) but because East Asian central banks collect reserves and invest in the US while keeping exchange rates fixed.

As of October 2017, China's REER calculated by the Bank for International Settlements was 121.4 (despite depreciation), Hong Kong 118.8 (currency board), Korea 110.5, Singapore 107.6, Taiwan 106.8 Thailand 104.4, Malaysia whose currency collapsed and there was political unrest recently, 86.9 and climbing back now, and the laggards of East Asia who export labour to the Middle East, Philippines 105.3 and Indonesia a basket case, 91.7. A REER can also change based on how it is calculated.

According to Sri Lanka's re-based 2010 REER index, the number was below 100 until February 2013 and it was 102 by June 2014. In mid-2014 several East Asian currencies including China and Malaysia started to fall pushing our REER up as the dollar rose. Oil and commodity prices fell, keeping inflation in check.

(US Mercantilists used econometrics to falsely claim that East Asian nations were 'undervaluing' their currencies precisely because nominal exchange rates were strong)

East Asian currencies are now strengthening, Sri Lanka is still weakening.

Unheeded Warning

This column warned several times that the inflation generated by currency depreciation was making lives difficult for wage earners and there will be political consequences. When there is economic hardship from currency depreciation and inflation, voters are more willing to listen to alternative voices and change governments.

In fact voters will also listen to nationalists when credit bubbles burst, currencies fall and economies contract as happened in Germany with Hitler and in the US and other countries during the delayed recovery from the 'mother of all liquidity bubbles' fired by the Fed.

In February 2015, when the Central Bank was taking the baby steps to generate the 2015/2016 balance of payments crisis and credit bubble under then Central Bank Governor Arjuna Mahendran in the wake of Ravi Karunanayake's disastrous 2015 budget, this column warned (Sri Lanka needs Central Bank reforms for a Social Market Economy: Bellwether) as follows:

"Without sound money, inflation and currency depreciation can lead to social unrest and strikes especially in the private sector and the blame will not fall on unsound money, state spending and public sector expansion.

"Instead it is the 'free economy' or 'open economy' that will be blamed just like 'capitalism' was blamed in Europe for all economic ills coming from state and central bank excesses."

True to form it is not the 2015 budget and the central bank's currency depreciation and inflation that is being blamed for the crisis but the good budget and policies of finance minister Mangala Samaraweera.

The column also warned:

"The new administration came to power partly helped by the economic hardships imposed from currency depreciation in 2012 and the downturn that always accompanies a balance of payments crisis or burst credit bubble."

Without sound money and a strong currency with low inflation it will not be possible to achieve a Social Market Economy, it was pointed out.

"Chronic currency depreciation and inflation, doesn't only destroy real wages. It also destroys accumulated savings in banks and pension funds," this column warned again in the column "Sri Lanka should beware of false claims over 'undervalued' East Asia currencies: Bellwether."

"Unsound money destroys society. It can also create political upheavals and wars."

Now all this has come to pass. The BOP crisis happened, the currency fell, inflation rose and there is the inevitable economic downturn as foreign reserves are collected and credit slows. This is the typical cycle of a Keynesian boom-bust in a pegged country.

The central bank could have allowed the exchange rate to appreciate during recent months, amid the credit downturn and alleviated some of the hardships of the people, but it did not.

Dangerous Delusion

Governor Indrajit Coomaraswamy is targeting a Real Effective Exchange Rate, under the delusion that the East Asian nations 'undervalued' their currencies through depreciation. The most successful East Asian countries had low inflation through a strong currency, which also brought it political stability and stopped social unrest, unlike Sri Lanka.

Sri Lanka, the Philippines and some South American countries had central banks built with US advice to join the Bretton Woods system, breaking a link with Sterling (sterling area). These countries also suffered similar instability.

US Mercantilists primary lay the charge of 'undervalued currency' against Japan and China, because there was a big trade deficit with those countries. In fact Mercantilists claimed that the currency was 'undervalued' through real effective exchange rate indices and other methods primarily because nominal exchange rates were very strong first in Japan and then in China.

To understand what happened to Sri Lanka currency and the most successful East Asian nations it is necessary to understand several key events and upheavals in the global currency and monetary systems after World War II.

The US, despite objections from Keynes, bulldozed the world into dollar pegged Bretton Woods system, breaking up the Sterling area. The US currency was pegged to gold at 35 dollars an ounce and the rest of the world, including Sterling was pegged to it. In order to keep the peg, the Fed however had to practice monetary policy consistent with gold. Instead in the 60s and especially in the early 1970s under Fed Chairman Arthur Burns, it printed money leading to the collapse of the Bretton Woods system.

Burns was a proponent of the idea that some mysterious part of inflation was due to cost-push (wage-spiral inflation, drought and so on) eerily like what Sri Lankans are hearing today. But that is another story.

Among key events to watch when looking at currency movements in East Asia or Sri Lanka are the following.

a) The Sterling crisis of December 1967 when British loose policy forced the soft-peg to break (BOP crisis)

b) The Smithsonian Agreement of December 1971, a desperate attempt to preserve the Bretton Woods….

c) ….which eventually failed in March 1973 leading to the collapse of Bretton Woods (a gold BOP crisis) creating free floating currencies backed by Treasury bills (fiat money).

Other key milestones are:

d) Fed Chief Paul Volcker's radical tightening in 1979/80 with 18 percent policy rates that squeezed inflation from the world and brought oil and gold prices crashing down.

e) The Plaza accord of September 1985, which was a Mercantilist attempt at reducing a trade deficit with Japan by weakening the US dollar/strengthening the Yen (which failed), And

f) The Louver Accord of February ‘87, which attempted to stem the depreciation.

Singapore (and Malaysia)

Singapore and Malaysia are countries that Sri Lankan policymakers and politicians have aspired to follow.

In sharp contrast to statements that East Asian nations were 'undervalued' Singapore is a country that overtly maintains a strong exchange rate to keep inflation down. Malaysia with whom Singapore had a joint currency board and later went for a fully-fledged central bank with policy rates, followed with only slightly less sound money.

The common currency board was dismantled in June 1967 but both Malaysia and Singapore initially kept the peg at 3.06 to the US dollar and 8.5 to the Sterling, with the idea that it had a sterling peg. Sterling was the intervention currency.

In the December 1967 Sterling crises, Britain devalued 14.3 percent. Both Malaysia and Singapore did not devalue with the pound. The key architect of Singapore's economic and monetary policies and first Finance Minister of Independent Singapore was Goh Keng Swee.

The Singapore and Malaysian dollars appreciated from 8.5 to the Sterling to 7.3 dollars.

"Dr Goh Keng Swee had reasoned that although the devaluation of the Singapore dollar would create more export opportunities for Singapore's manufactured goods, this advantage was likely to be outweighed by the increases in import costs, cost of living and wages," the Monetary Authority of Singapore noted later.

Sri Lanka's rupee which had already fallen to 4.86 to the US dollar from 4.76 to the US dollar collapsed to 5.95 to the US dollar in January 1967. Against the Sterling also it collapsed to 14.30 by January 1968 from 13.5 in October 1968.

But Sri Lanka did not become an export powerhouse.

In August 1971 following Arthur Burns' policy miss-steps, the US dollar suspended gold convertibility. In December 1971 the US devalued against gold under the Smithsonian agreement.

Singapore then revalued against the US dollar 9 percent, and kept parity with the Sterling which was stronger. The Singapore dollar appreciated to 2.8 to the US dollar from 3.05. Sterling was the intervention currency.

In 1972 Sterling again came under attack, essentially ending the last remnants of the Sterling area. Singapore then officially shifted to US dollar parity. In 1973 with the Pound floating, the Singapore dollar also floated.

The Singapore dollar strengthened to 2.4 to the US dollar in 1973, 2.3 in 1975. The MAS later moved to its exchange rate-based monetary policy. It largely kept parity, gently appreciating even during the better monetary policy of the Fed under Volcker and then Greenspan.

Sri Lanka's rupee generally held parity with small changes in 1971 and 1972. In 1973 the rupee collapsed to 6.5 - 6.3 levels and held. But the country was in a shambles with draconian exchange and trade controls and a general economic collapse.

By January 1997 the Singapore dollar was 1.39 to the US dollar. During the East Asian soft-peg crises it weakened to about 1.7 to the US dollar. The Sing dollar appreciated during the Great Recession and has fluctuated between 1.3 and 1.4 to the US dollar since then.

In Sri Lanka the central bank printed money and kept the peg with exchange controls until 1977. After 1977 Sri Lanka switched to a policy printing money and relaxing controls and allowing the exchange rate to collapse steadily, generating high inflation, strikes and instability.

The central bank has kept to the policy of printing and depreciating ever since, though there was some policy improvements from 2000 to 2011. After the 2008/9 BOP crisis the rupee was allowed to appreciate (a bit like Singapore for once in its history) and Sri Lanka's economy rebounded, partly helped by the end of a 30-year war, despite a global downturn.


After weakening to 1.4 during 2016 (when oil prices fell and the US tightened) the Singapore dollar is now again appreciating to 1.31 as global commodity prices are moving upwards. The Malaysian Ringgit which weakened to 4.45 to the US dollar a year ago is now back to 3.9 to the US dollar. The Malaysian ringgit collapsed from 2.5 to 4.1 during the East Asian crisis. In 1960 both currencies were 3.06 to the US dollar.

Sri Lanka's rupee in the meantime has collapsed from 131 to around 154 to the US dollar from 2015 to 2018 and is still falling, generating instability and political unrest.

Social Market Economy Doomed by Keynesian Stimulus

The UNP which tried to start a 'social market economy' was doomed to failure because no such result can come from a country that depreciates its currency and try to boost exports by destroying real wages of workers. The foundation of Germany's social market economy was a strong low inflation currency.

Money printing by central banks and stimulus, which result in BOP crises require corrective measures which will slow credit and investment more than if rates were allowed to rise earlier. The collapsing currency will push up inflation, making paupers of everyone.

The UNP came to power in 2001 and 2015 on the backs of hardships created by two such crises. But probably advised by people who said it was too conservative in 2002 and 2003, this time the UNP decided to give subsidies and run a massive deficit at the start of the administration.

"In 2015, when we built the government, there was a collapse in aggregate demand," Prime Minister Wickremesinghe told parliament in 2016, (Rupee, Sri Lanka in trouble after Keynesian stimulus) though credit had already started to recover strongly by the fourth quarter of 2014.

"In that situation in April we raised (state worker) pensioners' payments by 1,000 rupees, we raised state workers' salaries and private sector salaries were raised.

"Gas prices were reduced by 300, milk powder 68, wheat prices by 12.50 rupees sugar 10 rupees, green gram 40 rupees, sprats 15. Sustagen 100 rupees. Tinned fish 60 rupees. Maldive Fish 200, Chillies 25, kerosene 06 rupees."

If credit was negative such deficit spending could have been accommodated by selling bonds into the credit crunch. But by the fourth quarter of 2014 credit has already started to recover.

The deficit spending required a higher interest rate to curb spending and investment elsewhere. In the absence of central bank money printing, deficit spending cannot create greater demand - there is only a shift in spending from those who buy government debt to those who get the handouts or salary hikes, when private credit is strong. Sri Lanka central bank printed over 600 billion rupees through the course of 2015 and 2016 and lost over 4.0 billion dollars from the imports generated and capital flight.

Currency Depreciation

Goh Keng Swee said the Singapore did not set up a central bank unlike other post-independent nations because the rulers did not believe in money printing and BOP crises that comes from credit surges and inflation that accompanies currency collapse. Goh explained that the Keynesian remedy to boost aggregate demand in the "form of expansion of bank credit through Central Bank policies to finance government expenditure," could only work when a country was self-sufficient.

"This is admissible in theory, but in practice, since all modern states engage in foreign trade, a Keynesian stimulus will lead eventually to balance of payments deficits if government do not exercise restraint in time," he noted.

"A part of the increased incomes people receive will be spent on imports and when exports do not increase in proportion a trade deficit will occur."

"Our economy was and is both small and open. Financing budget deficits through Central Bank credit creation appeared to us as an invitation to disaster.

"There was no effective way of exchange control in an open trading economy like ours to deal with the inevitable balance of payments troubles.

Singapore decided to keep its currency board (Sri Lanka abolished it in 1951), as it saw how Britain got in to sterling crises and the Fed had to stop gold convertibility in 1971. Singapore wanted a strong currency to stop capital flights and inflation.

Goh argued the purpose was to "inform the financial world that our objective was to maintain a strong convertible Singaporean Dollar.

"This remains the best protection against inflation," Goh said.

"When nearly two-thirds of our citizens’ expenditure is spent on imported goods, a strong Singapore Dollar helps to keep consumer prices down."

This is in stark contrast to the REER targeting (the REER index can go up when other countries depreciate and worsen when inflation from currency depreciation materializes) followed by Sri Lanka now, and a general race to the bottom to be export competitive.

Singapore now practices its exchange-rate-based-monetary-policy (indirectly so do floating rate countries because raising rates makes a currency stronger against reserve currencies like the US dollar as well as traded commodities), based on this philosophy. Poor countries will be particularly badly hit by such printing and depreciation.

"'…[I]n poor countries, punishment comes quickly in a cruel way — high rates of inflation, economic decline and political instability," Goh explained.

"These three factors reinforce each other in a way which makes escape from misery difficult." This is what has happened to the Yahapalalanaya administration due to the combined effects of the 2015 budget, printing money to accommodate it and the REER targeting, after the BOP crisis ended. Prime Minister Ranil Wickremesinghe is now reaping the whirlwind from trying to boost 'aggregate demand' in 2015 as well as the bondscam.

From mid-2017 most East Asian currencies have started to appreciate. This may make the REER index better (through an appreciation of the nominal index) and may help reduce further misery from unsound money if REER targeting stops in Sri Lanka.

Korean REER fiasco

It is however never too late to change. Korea's REER targeting fiasco is an example.

Korea had a central bank as bad as Sri Lanka and Vietnam had one that was very much worse but they later fixed themselves, leading to very strong growth phases with stable conditions. The Korean won was 63 to the US dollar in 1960. It broke repeatedly during the Bretton Woods period.

Even in Sri Lanka the word 'Korea' had negative connotations. Of course it was not all currency.

Both Korea and Taiwan were Japanese colonies and had seen industrial investment from Japanese firms. But Japanese rule in Korea was unusually brutal compared to Taiwan. People were literally enslaved, taken to Tokyo as nationalists and the military took control of the polity in Japan, and liberal leaders were shot.

After liberation by US forces, post-independence Korea also had somewhat authoritarian rule, which kept labour unrest down when inflation surged and the peg broke. However the peg also had long periods of stability allowing wages to recover.

 In the early 1980s there was sustained depreciation of the Korean won for several years not unlike in Sri Lanka.

In 1980 the won collapsed from 484 to 671 as US tightened policy. Inflation was over 30 percent.

Amid continued macro-economic trouble, Korea then tightened policy in subsequent years and the government was trying various adjustment policies. By the beginning of 1986 the Korean won hit 890 to the US dollar, and then started to stabilize with adjustment policies bringing results.

But by then continued depreciation and adjustment policies had taken their toll. This was also the time of the Plaza accord when the US was trying to depreciate the European and East Asian currencies in general and the Yen in particular in a failed bid to stem its trade deficit. The depreciated Won (and an appreciating yen due to the Plaza accord) also helped Korean exports, particularly cars.

Since depreciation eventually leads to salary increases and any profit gains made by exporters at the expense of workers are temporary, the government tried to keep wages down to maintain a low REER index, claiming inflation was low, giving extra profits to export firms.

All incomes policies are dangerous and actually has no effect. Incomes policies are dangerous because it assumes that inflation is not monetary or part-monetary, like Arthur Burns did.

The Won depreciation has stopped by early 1987 and the currency started to strengthen with the budget getting better and credit slowing, but it was too little too late.

Workers were suffering from earlier depreciation. In May 1987, protests erupted with workers demanding an immediate 30 percent salary hike. There were so many workers on the streets that even the police fled in some areas. The government was forced to recognize unions.

Western-style liberalism burst forth in Korea. Credit policies were good and the Korean won appreciated for the next few years improving livings conditions for the people. Korean industry now had unions but economic conditions were stable, and liberty advanced even after the East Asian soft-peg crisis.

The memory of brutal suppression by Japan probably helped anchor liberty and freedom. Having suffered under Japan, countries like Korea and Singapore and Taiwan became close to Western ideas of freedom.

As the Won appreciated, people's living standards rocketed in a few years to almost near a developed nation, leaving countries like Malaysia behind. The Korean Won which hit 890 to the dollar in 1985 and later appreciated did not hit 890 until nearly 12 years later during the East Asian soft-peg crisis.

Unfortunately because North Korea came under Soviet control after World War II and became Communist, the country is still a basket case, where monetary reform involves issuing new notes with less zeros and shooting some senior officials.

The Korean currency collapse during the East Asian crisis, was much worse than that of Singapore and Malaysia. The Korean won fell to as much as 1,700 won to the US dollar and has since appreciated to a little over 1000 to the US dollar.

In February 1998 Sri Lanka's rupee was 62 to the US dollar. The Sri Lanka rupee is now 155 to the dollar.

Sri Lanka is no longer printing money, but REER targeting continues to weaken the rupee adding to the hardships of the people. Under the previous regime there was some hope that if a person paid higher taxes, the rupee would be strong and inflation low. Now the currency depreciates on top of paying higher taxes. There is no hope.

Nationalists are now in the ascendancy, unlike in Korea.

It is not just office and factory workers who have been hit. Unlike in 2015 parents are now finding it much harder to send kids abroad to get a tertiary education and knowledge, with the factory floor backed by a 'competitive exchange rate' being preferred over service exports.

Many parents with kids abroad who voted for the current administration are cursing them. Ordinary people find that even imported rice is expensive with the rupee collapsing to 155 from 131 to the US dollar.

The new constitution and devolution for the North has been left on the wayside with the combined effect of a massive bondscam, currency depreciation, (and REER targeting that stopped an appreciation of the rupee) making the ruling coalition unpopular.

The planned 'flexible' inflation targeting also sounds like a soft-peg complete with forex auctions and with REER targeting thrown in.

Sound money, serious central bank reform, or abolishing the agency altogether is an absolute requirement for freedom and liberty. There will be no financial centre in Colombo without a strong exchange rate.

Sri Lanka has serious problems, a mid-night gazette which makes nonsense of tax predictability, expropriation which makes uncertain property rights and a nationalist visa regime which discourages foreign direct investment and knowledge transfer. All these impedes investments and exports, rather than a faux 'overvalued' currency.

In December 2014 shortly before this administration came to power the REER index was 107.3. Now the REER index is at 105.6 after generating more than 17 percent inflation in the period. The price paid by the people and the ruling administration was high.

Until Sri Lanka realizes that sound money is the basis for a free society like policy makers in Germany, Japan and later Korea did, Sri Lanka will remain a miserable country.

This column is based on 'The Price Signal by Bellwether' published in the March 2018 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.