Breaking currency board was early birth defect of independent Sri Lanka: Sally

ECONOMYNEXT – Abolishing a rule based currency board in favour of a discretionary central bank which allowed politicians and bureaucrats to print money as they wished was an ‘early birth defect’ of Sri Lanka, as the later experience showed, a top economist has said.

“I think that move away from the currency board to discretionary central banking was perhaps one of independent Ceylon’s, early birth defects in light of what’s happened subsequently,” Razeen Sally, a visiting professor at the National University of Singapore said, speaking at an event to mark 69 years of Sri Lanka’s central bank.

“Ceylon, at independence, inherited a currency board, from the British in common with other colonies that got independence.”

At the moment, a global rule-based order was breaking down with, short-term discretionary actions by key international actors like the US under President Donald Trump, which would pose risks for small countries like Sri Lanka.

Sally said the currency board was a strict rule regime to limit “political and bureaucratic discretion”.

“What was essentially a pretty strict, a pretty strict rule regime to limit political and bureucratic discretion – very roughly equivalent to a fixed and non adjustable peg – was transformed in 1950, thanks to the design the tutelage of John Exter, let’s not forget, under a UNP government with J R Jayawardene as Finance Minister, into discretionary, central banking,” he said.

“And since then, we’ve had at least some periods where monetary policy with discretion over the rules has reinforced the mistakes of fiscal policy rather than leaning against it as it were.”

Under an orthodox currency board, bureaucrats cannot print money either to finance the deficit under political pressure or artificially depress rates on their own volition, when credit demand spikes and trigger currency collapses.

A floating interest rates create is an automatic mechanism to balance external payments, links the monetary base to the balance of payment and the fixed exchange rate.

There is no sterilization (offsetting) of either inflows or outflows to go against the balance of payments to build large volumes of fore reserves at a rate faster than the growth of base money, or attempt to slow the contraction of base money with printed money to and trigger a currency crisis and credit downgrades.

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Countries like Singapore and Malaysia resisted the creation of discretionary central banks.

Sally said for rules to work, there had to be consensus among the elite, that rules mattered over discretion.

“That said, something as strictly rule oriented as a currency board cannot be seen in isolation,” Sally said.

“This is where the political economy is really important.

Sally said successful currency boards set up recently in Hong Kong since 1983 and the Baltic States in the 1990s, where he had personal experience worked partly because there was a respect for rules.

“They worked because that rule, discipline in monetary policy and exchange rate policy had a corresponding rule discipline in fiscal policy,” Sally observed.

“And if you like a generalized consensus among the elite, underpinned by popular legitimacy, not to tamper with independent institutions, and to privilege rules at the discretion.”

He said he doubted whether an orthodox currency board could be set up for political and technical reasons and in currency board in isolation may not work, and the experience in Argentina was a case in point where there was fiscal indiscipline.

An attempt to set up a currency board in Argentina, had failed with the peg breaking after a few years. Argentina did not set up a separate agency, but some rules were brought via a ‘convertibility law’ to the Banco Central de la República Argentina (BCRA).

Classical economists who had looked at Argentina’s convertibility law, found that central bankers who operated the peg could sterilized up to 33.33 percent of the monetary base allowing it to buy up government bonds when bureaucrats wanted, and as well as other lender of last resort facilities.

Between 2000 and 2001 alone BCRA’ holdings of government bonds varied had varied from 20 percent of assets to 50 percent, researchers who analyzed the BRCA, something a currency board should not have been able to do.

Sally said a currency board would not solve all of Sri Lanka’s economic problems.

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“And I do not think it is a panacea today,” he said. “But still, I would make the argument for more rules in the system, to insulate against political discretion, fiscal policy discretion.”

He said a new monetary law proposed tighter rules against fiscal dominance of monetary policy or political pressure.

The law had not yet been made public.

However concerns have been raised that a fully discretionary peg, called a ‘flexible exchange rate’ with money and exchange policies skewed to push the down currency would continue under a new law.

Through various skewed policies the central bank had pushed down the rupee from 4.70 to about 180 to the US dollar since independence.

Critics have also raised concerns about a discretionary ‘flexible’ inflation targeting regime with a discretionary peg, instead of inflation targeting with a non-discretionary floating rate as targeting dual domestic (inflation index) and external anchors (exchange rate) lead to currency crises.

Critics have also pointed out that the central bank printed money to depress rates and triggered currency collapses apparently targeting core inflation, headline inflation, and a perceived ‘output gap’, while operating a peg with multiple convertibility undertakings, including a downward only ‘disorderly adjustment.’

In 2017 the peg was depreciated despite a balance of payments surplus, apparently to target a Real Effective Exchange Rate Index.

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In April 2018, rates were cut by 25 basis points and a call rates were enforced with large volumes of printed money when the ‘headline’ inflation in Colombo was 4.2 percent in March and ‘Core’ inflation was 3.4 percent.

In November 2018, rates were hiked by 50 basis points after monetary instability was triggered and the unstable peg lost credibility with ‘headline’ inflation’ at 3.1 percent in October and ‘core’ and inflation at 3.8 percent.

In May 2018, the floor rate was lowered to 7.50 percent after private credit contracted and no money was printed (liquidity was withdrawn to keep overnight rates around 7.70 percent) as base money was injected through dollar purchases. At the time ‘headline’ inflation rose to 4.5 percent and ‘core’ inflation rose to 5.5 percent.

In August when the rates were cut and more money was printed to enforce a call money rate below the ceiling policy rate, when headline inflation at 3.4 percent and ‘core’ inflation at 5.6 percent. (Colombo/Sept23/2019 – Update II)