ECONOMYNEXT – Sri Lanka’s politicians, especially from the United National Party have taken extremely difficult decisions to fix the country each macro-economists who do not appreciate sound money created monetary instability and economic collapses.
Ranil Wickremesinghe is now taking very difficult political decisions. People are also watching with an unusual degree of patience – so far.
Brakes have been put by the current central bank governor after inflation ran up to 70 percent, and the currency has fallen from 200 to 360 to the US dollar.
In Sri Lanka economists like to depreciate the currency like in many in other basket case countries. They think devaluation will boost exports even though depreciation and the resulting misery triggers, strikes, social and political unrest and make budgets un-manageable.
It was J R Jayewardene that gave the power to the country’s macro-economists to print money at a time when the State Department was intent on breaking the Sterling Area trade bloc and belief in interventionism was high.
Shortly after the War, only a few countries like Germany did not believe in printing money. Japan fixed itself in 1948, after about 700 percent inflation helped by Joseph Dodge, a US banker who was involved in German monetary reforms.
But Sri Lanka set up the central bank, when JR was finance minister. These columns had shown previously that he had warned the central bank not to go down the wrong road as had his Prime Minister at the time.
JR was a lawyer, not an academic economist. To his credit he tried to get the best classical economists in Asia, Goh Keng Swee from Singapore and B R Shenoy from India to advise the country and correct his initial mistake.
But what they were saying was apparently beyond the grasp of the country’s economists and policy makers.
The UNP administration wanted to create a Singapore after they came to power in 1977 after the country was strangled by severe exchange and trade controls.
By 1980 amid a very strong economic recovery Sri Lanka was in the middle of a balance of payments crisis and was forced to go to the International Monetary Fund.
And he got the economic architect of Singapore, Goh Keng Swee to advice the country, almost like a second opinion from a different doctor.
After the 1960s and 1970s money printing boom led to exchange controls, import controls, black markets, permits, dual exchange rates and high unemployment, JR liberalized the economy.
Politically Impossible Decisions
Like Ranil Wickremesinghe today and Mangala Samaraweera a few years ago, JR took very difficult decisions.
“You introduced a number of economic reforms which most people had considered politically impossible,” Goh told him.
“The abolition of price controls for most commodities, the abolition of the food ration system, which provided free rice to the general public, the increase in the nine administered prices – rice sold by co-operatives, flour, bread, kerosene, electricity, bus transport, coconuts, coconut oil and milk powder – virtually ended the black market in these goods as supplies from official sources were adequate to meet demand.
“The exchange rates were unified in November 1977; imports were liberalized and the rupee was allowed to find its level in the free market. The result was a flow of imported goods previously unavailable.
“These are actions which required considerable courage. They constitute a break with the conventional wisdom of past decades based on a re-distributive ethic, extensive state control and hostility of free enterprise and private ownership.”
Corrosive effect on personal integrity
Sri Lanka’s public sector and also the private sector started to become corrupted during the closed market period, not as claimed by others after the opening.
The permits and controls made it impossible to engage in economic activities which were perfectly legal before the central bank, like sending money abroad or selling goods at market prices. To get permits palms had to be oiled.
Goh more than anyone knew the bad effects of price controls.
Price controls try to defy the reality of money printing. When prices rise, there is no way to bring it down except by raising rates and halting money printing.
But price controls invariably force people to to break the law, and create a black markets.
Business sell illegally and people buy illegally, leading to a corruption of an entire society and a disrespect for rule of law.
Goh more than anyone else knew the problem. After Singapore fell, Japan introduced so-called Banana Money and inflation rocketed.
When the British took the territory back, wartime controls continued.
The British Military Administration generally called the BMA was referred to as the Black Market Administration by ordinary Singaporeans.
Singaporeans, more than anyone therefore knew the problem of monetary instability and the corruption that comes with it.
In Sri Lanka JR’s liberalization brought three immediate benefits, Goh said.
“First a substantial increase in the supply of consumer goods, previously unavailable, improved the living standards of the people,” he said.
“It brought to an end to shortages, queues, blacki-markets with their corrosive effect on personal integrity.”
The egg price controls are forcing traders and farmers to sell above the controlled price. They are being charged in court now, for breaking the law.
Economists at the central bank and Treasury printed money for about 55 years, with no questions asked, except by Goh and a few others, which were not known widely.
In 2004 after the central bank was effectively pushed to print 60 billion rupees driving inflation up and created forex trouble that people started to take notice. Unlike in the past, the leadership at the central bank at that time led by Governor A S Jayewardene and his Deputy W A Wijewardene did not believe in printing money.
Then and in subsequent years Harsha de Silva, Wijewardene and sections of Sri Lanka’s media led the battle against printing money.
But other economists continued to dismiss it, making two claims mainly.
That it was (a) perfectly ok to replace liquidity drained from reserve sales with newly printed money to maintain reserve money and therefore (b) reserve money did not expand, going against 200 plus years of classical monetary theory.
Such regimes are essentially what is called a soft-peg or impossible trinity of monetary policy objectives. Any replacement of NFA with NDA purchase made it impossible to maintain external stability.
However, the ideology was apparently in line with the views of Sri Lanka’s economists who were deep believers of state interventionism and money printing for stimulus and re-finance, essentially John Law.
J R had previously brought B R Shenoy in the 1960s to advice Sri Lanka on its economic troubles. Shenoy advice was to first sort out the monetary troubles.
He said to move to a clean float, which also eliminates conflicts between money and exchange rate policies.
Instead, a few years later economic bureaucrats brought the import and export control law, which was used liberally in the past two years to delay rate hikes and continue to print money.
Two decades later Goh Keng Swee warned JR that the central bank was buying up large volumes of Treasury bills.
“This method of financing has high inflationary consequences,” Goh told JR.
“The scale of such inflationary financing is alarming. It began early this year. In January, the volume of Treasury bills issued was Rs3,000 million. In March, the Parliament approved an increase to Rs4,000 million and by June 16, this limit was reached. In July, the limit was raised to Rs6,000 million and by September, the limit was reached.
“On October 17, the limit was again raised to Rs8,000 million and during my stay Colombo, Parliament against raised it to Rs10,000 million.
“Based on past performance it is safe to assume that the limit of Rs8,000 million had already been reached and it will not be long before the volume reaches Rs10,000 million.
“A three-fold expansion of the volume of Treasury bills in a year has few precedents in the world. The impact has already been felt in the large increase in prices this year and further price increases cannot be avoided next year.”
The printed money will blow a hole in the balance of payments, he said. In Sri Lanka exporters, importers and foreign workers are blamed for forex shortages, not the issuer of excess money.
“The second effect of excess expenditure met by deficit financing works though the foreign exchange.
“Where goods are imported under a system of open general licensing introduced by your government, imports of these goods will increase because people have more money to spend.
“If foreign exchange earnings do not increase in step, either through increased exports or capital inflows, the result would be a run of the country’s foreign exchange reserves or a depreciation of the currency’s rate of exchange or both. In Sri Lanka both these have occurred in the course of 1980.”
He warned of the political consequence of printing money against upcoming elections.
Depreciation will not boost exports
In Sri Lanka inflationist-devaluationism is almost a religion.
Despite 70 years of failure and the living examples of Germany, Japan, Thiland, Taiwan and China that strong stable exchange rates led to massive domestic and foreign investment and export growth, Sri Lanka economists still believe in depreciation.
“The brief expressed the fear that an appreciation of the rupee will weaken Sri Lanka’s competitive position and stifle, future growth,” Goh said referring to a question asked from him in 1980s, showing similar ideas.
“I believe these fears to be groundless for two reasons. First since the bulk of Sri Lanka’s present exports comes from tree crops whose prices are determined in foreign currencies, mainly in the London, commodity exchanges, a rupee appreciation will not mean an increase in the Sterling price of Sri Lanka’s products. Prices in foreign commodity markets are the same for similar grads of products from all countries producing them.
“Where prices differ, they result from variations in quality. A stronger rupee would mean, however, that the rupee incomes of tree crop producers would go down.
“As regards, exports of Sri Lanka’s manufacturing industries, an appreciating currency would have limited net impact. Both in Sri Lanka and Singapore, manufacturing activities consist mainly of processing of imported semi-finished material such as textiles into garments, silicon chips in semi-conductors, steel sheets into refrigerator cabinets, etc.
“A stronger rupee would mean that import costs would be lower and thus offset the effect of currency rate appreciation. Contrariwise, a weaker rupee will mean an increase in import costs of raw materials and intermediate goods use in manufacture, largely offsetting the competitive advantages arising from a lower exchange rate.
“The position is different in industrial countries. The finished manufactured product is the end of a long chain beginning with the mining of iron and goes through intermediate stages of production so that the domestic content of the finished product is much higher than he finished products coming out of factories in Sri Lanka and Singapore.”
In sharp contrast to advice doled out by the IMF driven by salt-water economists sitting in the comfort of strong exchange rates from single anchor regimes, Goh said there was no salvation in destroying the country’s money.
“Unless the process is stopped and reversed, the country can find itself caught in the vicious spiral of increasing domestic money stocks, increasing demand for imports, depreciating exchange rates, higher rupee cost of imports and greater demand for Central Bank credit creation,” he wrote.
Such a cycle has occurred in several developing countries, some of whom have inflation rates exceeding 100 percent a year. It is politically easier to break the cycle at an early stage; once it has taken a firm grip on the economy the political cost is extremely high, as witness the present troubles the government of Poland is experiencing.
In the case of Sri Lanka, a depreciation of the rupee must mean that administered prices must be increased and this is never a popular political measure.
In 2022 Sri Lanka’s inflation hit 70 percent a year.
Watch the economists in action
In 1980 only part of the Treasury bills were bought by the central bank for deficit financing. With a balance of payments crisis already under way, other bills were bought to offset foreign reserve losses.
Goh told JR to watch five economic indicators to monitor the economic health of the economy.
The first was the central bank’s Treasury bill purchases.
“You may need some sign posts by which you can find your way through the intricacies of economics and be able to assure yourself whether or not the measures are taking effect.”
I suggest five principle economic indicators.
1. The volume of Treasury bills bought by the central bank. This is by far the most important statistic to watch
2. The central bank’s foreign exchange reserves.
3. The exchange rate of the rupee
4. The Consumer Price Index
5. The prices of construction materials.
Though all this was told to the political leadership in 1980 the economists ignored it.
Until W A Wijewardene started to write about it, hardly anyone knew that Goh Keng Swee, the economic architect of Singapore had given advice to Sri Lanka.
Singapore with a Latin America Monetary Foundation
Nobody knew that the advice had had been comprehensively ignored by the central bank later.
Or that Sri Lanka was trying to build a Singapore with a Latin America monetary foundation.
Now people are talking about Vietnam. But the State Bank of Vietnam is trying to operate a better peg and is fighting with the IMF and US to be allowed to do so.
Whether it will succeed is not known, but at least the SBV is trying.
After the UNP got into power in 2015 the central bank, backed by IMF driven ‘monetary policy modernization’, started to inject money through other means than purchases of Treasury bills at auctions.
By this the public more aware of the effects of T-bill purchases, unlike in the 1970s.
From the last quarter of 2014, liquidity was injected by terminating repo transactions. Outright bill purchases started later.
With public opposition to direct purchases of Treasury bills, the central bank started to buy them from commercial banks through overnight and term repo transactions.
By this time, the Bills purchased through the term and overnight transactions – which was published from the time of Governor A S Jayewardena, had been removed from the daily released data of the Treasuries stock.
In 2018 money was also printed through dollar swaps to inject liquidity.
None of these printing was done to finance the budget. It is done to manipulate rates down to maintain a policy rate and to try to boost growth without working for it.
Now a new central bank law is being made. It is promised that there will be no direct purchases of bills from auctions.
But there is nothing to prevent bills from being purchases through other means like in the 2015 to 2019 period, where currency crises were created.
In the new law there is no such safeguards against mis-targeting of rates, just like there were none from 2015.
Soft-peggers are planning to set themselves a 5 or 6 percent inflation target. The rate is high enough based on the 2012-2019 experience to easily trigger serial currency crises
Moreover, the exchange regime is still a soft-peg or flexible exchange rate – the most dangerous monetary regime that is found in all basket case countries and not a clean float.
Under an IMF program it is impossible to operate a clean float because there is a foreign reserve target.
The new law will undoubtedly be passed by the parliament denying monetary stability to the public, just like the original soft peg law went into effect in 1950 forcing all subsequent economic plans to be made on a foundation of monetary instability.
The legislators will also probably pass the 5 or 6 percent, inflation – double that of stable countries – with no questions asked, just as they had passed the original law and subsequent amendments to print more money.
Politicians misled to control the people instead of the central bank
Legislators had also been misled by economists to pass exchange and import control laws, allowing the state to rob the economic freedoms of the people rather than control the open market operations and mis-targeted policy rates of the central bank.
With ‘fear of floating’ and ‘currency board phobia’ firmly entrenched in the minds of Sri Lanka’s policy makers the chance of escaping the monetary instability is almost zero.
IMF programs now are also contradictory with a high inflation target at odds with a reserve collecting target.
It took more than 50 years for realization to dawn about buying Treasury bills at auction.
Whether Treasury bills are bought directly from the Treasury to finance the deficit crediting the DST accounts of the two state banks, or whether they are bought in the secondary market from banks and other investors crediting accounts of private banks to generate 5 percent inflation, the effect on the balance of payments is the same as Goh Keng Swee explained many years ago.
With the inflation target conflicting with the net international reserve target, countries with IMF programs are now running into currency crises, output shocks before its 4-year program ends.
Pakistan and Argentina now, Sri Lanka in 2018 are examples.
Market access countries are defaulting like Latin America under aggressive open market operations. Until recently, South Asian and Africa did not have aggressive open market operations.
Hopefully it will not take another 50 years for the realization to dawn that the ‘flexible’ exchange rate ‘ is also another unstable soft-pegged regime which will be plagued by the same or worse problems than before, as seen in the last 7 to 10 years.
Sadly, many young people are not waiting to find. They are leaving the country to earn dollars or Euros or Australian dollars, without waiting to find out whether soft-peggers can be tamed or not. Maybe they are right.