Currency depreciation, BOP troubles from money printing: Sri Lanka economist

ECONOMYNEXT – Currency depreciation and inflation is caused by printing more money than is required by the people and countries like Singapore had avoided the problem by not setting up a central bank in the first place, top economist W A Wijewardene said.

A monetary authority producing money per se, is not a problem.

Excess Money Leaking as Imports

"The problem arises if a central bank produces more money than necessary," Wijewardene, a former Deputy Governor of Sri Lanka’s central bank said at an oration marking its 68th anniversary (Read full speech here).

"In that case, the excess money will lead to creating an excess demand for goods and services with two interrelated outcomes.

"One is the tendency for prices to go up causing a decline in the value of the real basket of goods and services which people can command by using money.

"The other is the leakage of that excess money out of the country through increases in the demand for imported goods and services.

"If the country does not earn enough foreign exchange to meet that demand, it leads to creating balance of payments difficulties, exerting pressure for the exchange rate to depreciate.

"Hence, both inflation and exchange rate depreciation are the result of a central bank producing more money than necessary."

Rule based





In monetary history various techniques or rules were devised by central banks which survived for long periods, to avoid printing too much money.

Most central banks were set up by clever businessmen who hoped to make profits by printing some amount of money for the king through a monopoly, getting an assured market from competitive ‘free banks’ of the time or eliminating them altogether.

Under a gold standard or gold peg, a central bank had to raise rates and stop printing money as soon as gold started to flow out of it (and the country) under a convertibility undertaking.

Under a convertibility undertaking gold had to be exchanged at the weight written on the note, forming a check on the central bank.

Floating rate central bank use an inflation targeting law to avoid printing too much money.

Many countries also pegged to a foreign currency produced by a (floating) central bank with relatively tighter monetary policy which was showed by a track record.

Under working (hard) peg the money supply is determined by the balance of payments with the exchange rate being the convertibility undertaking.

A hard pegged monetary authority or currency board will purchase of excess dollars when inflows are strong and will not sterilize or mop it up, (expanding money supply), and sell reserves when outflows start later (shrinking the money supply) and pushing rates up.

A so-called soft-pegged central bank will resist the balance of payments and try to plan its own money supply, and its own interest rates, usually driven by Keynesian or interventionist thinking.

A soft-pegged central bank that resists the BOP to sterilize dollar purchases to build foreign reserves will tend to slowdown an economy by giving less money and credit than required, while a soft-peg that sterilizes sales, will provide more money than required and generate a loss of reserves and a balance of payments crisis.

Domestic money supply therefore moved exactly in step with foreign reserves and the balance of payments.

Currency Board

Meanwhile Wijewardene explained that countries like Singapore, which people always hold up as an example to follww, chose currency board (hard peg) after independence to keep the exchange rate fixed and money supply exactly in tune with real demand.

Goh Keng Swee, a classical economist who saw the intrinsic fallacy of Keynesian stimulus explained reasoning in a speech in 1992 why it chose to keep a currency board even though it was a ‘relic of the Colonial system.’

"The reason was, a currency board introduced a discipline to printing money because you cannot print money unless you have sufficient foreign assets in the currency board," Wijewardene explained.

"Sri Lanka also had a currency board before the establishment of the central bank. We went for the central bank."

The British set up the Ceylon currency board in 1885, when the Eastern and Oriental Bank, a chartered bank which printed money up to then collapsed suddenly. It was pegged to the Indian rupee, which was silver based.

The Ceylon rupee only moved against sterling when silver to gold prices changed. Ceylon before 1951 was a financial centre which supplied capital to Malaysian and Singapore companies, analysts say.

No Free Lunch

Wijewardene said the Singapore’s architects the so-called ‘Old Guard’ wanted to achieve several objectives with a currency board.

"They did not believe that prosperity came with money printing," Wijewardne explained.

"Prosperity comes from hard work."

Economists say a currency board sets a so-called ‘hard budget constraint’ automatically forcing governments to run low budget deficits, because no money can be printed and excess borrowings will result in sovereign default.

A strong currency will also stop the need for subsidies.

Wijewardene said Goh wanted to send a message to politicians that populist deficits could not be financed by central bank money and if citizens wanted better services they had to pay taxes.

"There is no such thing as a free lunch," he said. "A third message was for foreign investors who were invited to leave their savings with them (invest). We will not only keep the savings safe but also give a return."

Keeping Inflation Down

Goh had noted their objective was to maintain a strong convertible Singapore dollar.

"This remains the best protection against inflation," he said. "When nearly two-thirds of our citizens’ expenditure is spent on imported goods, a strong Singapore Dollar helps to keep consumer prices down."

In 1967, when the sterling devalued during the latter stages of the Bretton Woods, Singapore appreciated to 7.3 to the Sterling from 8.5 keeping parity with the dollar.

Sri Lanka’s rupee on other hand fell around the time of the Sterling crisis. When the Bretton Woods collapsed in the early 1970s with US dollar devaluing against gold, the entire economy was closed with tight import controls.

Singapore initially shifted back to Sterling to avoid devaluing with the US dollar, and then floated up.

The Singapore dollar which was about 3.0 to the US dollar at the end of the Bretton Woods is now about 1.3. Sri Lanka’s rupee which was about 6.3 to the US dollar around the time of the Bretton Woods break-up is now about 160 to the US dollar and falling.

In 2017 when most East Asian currencies appreciated the rupee also fell.

Goh noted that they did not believe in the claims of John Maynard Keynes, which was used by many countries along with national income accounting devised by another Cambridge economist, Richard Stone to bring stimulus and balance of payments troubles.

The interventionist policies from Cambridge also damaged Britain, until Thatcher came in with Hayekian policies.

Goh had noted that neither the Germans nor Japanese believed in money printing after World War II. Both countries had been hit by hyperinflation.

Unlike Goh, Wijewardene said Sri Lanka’s finance minister after independence J R Jayewardene had been influenced by Keynes.

"That was the difference between the ideology of politicians of Sri Lanka at the time of independence and the politicians in Singapore," Wijewardene said.

Sri Lanka’s first Finance Minister after independence was J R Jayewardene.

Keynesian Fallacy

His biographers K M de Silva had documented that in 1942 Jayewardene had read the John Maynard Keynes book the General Theory (of Employment, Interest and Money) and become a fan.

"Therefore probably he would have been influenced by Keynesian thinking at the time that if we have a central bank we can accommodate the expenditure of the government for the betterment of the nation," Wijewardene observed.

Goh had also said that while deficits could be run if there was depression (credit contraction) it cannot be done at other times.

"If one has to fault Keynes on any point, it would be the title of his book. This should have been — The Special Theory of Employment, Interest and Money," Goh said.

"His prescriptions were intended to address the special circumstances created by the Great Depression.

"By calling it a General Theory, he led lesser minds than his into believing that his prescriptions could be applied under all circumstances, with unhappy consequences, as we have noted."

Wijewardene said John Exter, a US economist who designed the central bank of then Ceylon had warned that financing deficit with money printing will lead to balance of payments troubles.

"If you try to use the central bank’s printing power, to finance the expenditure programs of the government in a small open economy you run the risk of allowing all the money that you create inside your country going out by way of imports.

"As a result you have a deficit in the balance of payments, you run down your foreign exchange reserves and finally you have the pressure for the exchange rate to depreciate."

Analysts had also showed that the Sri Lanka’s central bank purchases excess dollars to prevent an appreciation and re-peg the rupee instead of a ‘flexible exchange rate’, whatever it means.

It then fails to mop up the rupee (unsterilized purchase) or follow through with unsterilized dollar sales when the new money turns into imports making the rupee depreciate. . (Colombo/Sep04/2018)

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