COLOMBO (EconomyNext) - Sri Lanka's central bank has defended the validity of new rupee notes signed by Governor Arjuna Mahendran, in a bid to preserve confidence of fiat currency notes among the public.
The Central Bank which has a monopoly in the issue of currency notes since 1951, dismissed concerns over the legality of the appointment of Governor Arjuna Mahendran whose signature has appeared on new 5000 rupee currency notes.
The Central Bank said Mahendran was appointed in compliance with established practice and was not disqualified under section 11 of the Monetary Law Act, which governs the body.
Under section 52 all notes issued by the Central Bank would be 'legal tender' to pay all sums.
"Accordingly, the general public is guaranteed that currency notes issued by the Central Bank of Sri Lanka bearing the signatures of the Governor of the Central Bank of Sri Lanka and Hon. Minister of Finance with the date 2015.02.04 are legal tender for the payment of any amount in Sri Lanka," the Central Bank said.
Opposition legislator including former minister Bandula Gunewardene has claimed that Mahendran's appointment is irregular not valid because he had not taken "an oath of affirmation" under section 165 of Sri Lanka's constitution.
Gunewardene alleged in parliament on Tuesday that Mahendra had not taken such as oath because he was prohibited from doing so under Singapore's citizenship laws. The Central Bank in its statement made no reference to whether an oath of affirmation has been taken by the Governor or not.
However Sri Lanka's first Central Bank Governor, John Extern was also an American Federal Reserve official, who built an unstable of 'soft-dollar' peg in the island with a money printing central bank, giving rise high inflation and currency depreciation in the past few decades.
Modern 'fiat' currency notes have no intrinsic value and are not exchangeable for to gold or silver even indirectly as they were before a 1971-73 breakup of the Bretton Woods agreement.
The Bretton Woods soft dollar pegs collapsed due to excessive money printing by the Federal Reserve, whose notes were in principle pegged to gold.
The US Fed broke a peg to 20 dollars an ounce in 1933 after triggering the Great Depression by excessive money printing in the 1920s helping take the first steps in the journey to totally paper fiat money.
Before the creation of the Fed in 1916 there was no permanent world-wide inflation.
Before the 1933 devaluation, dollar notes were 'payable to bearer' and the Fed was bound to exchange the notes for gold. Similar provisions existed elsewhere. The Bank of England was also restrained in 1844 by the Bank Charter Act, which gave it a monopoly in money.
The promise to exchange notes to gold, helped restrain central banks from printing too much money.
The term became obsolete after the dollar was devalued to 35 dollars an ounce in the US from 20 in 1933. President Roosevelt also brought a draconian law outlawing private gold holdings to shore up confidence on the irredeemable paper dollar which suddenly had no intrinsic value.
Sri Lanka's rupee (then Ceylon) was until 1951 exchangeable to foreign currency at a fixed rate through a hard peg or currency board. But after a money printing central bank was created the rupee has fallen from 4.76 to the US dollar to over 133 rupees now.
Though there is no fixed legal obligation to redeem rupees anymore at a fixed rate, the rupee are exchanged for foreign currency in forex markets each day where they come up for redemption.
The Central Bank's statement on new currency notes comes as the rupee's value is being challenged in forex markets.
Due to an excess supply of rupees which had been left unsterilized (or not taken out of the banking system), large volumes of rupees have been coming up for redemption in forex markets, forcing the Central Bank to pay out dollar reserves as the liquidity is gradually used by the state and others with a recovery in domestic credit, both public and private.
On Tuesday the central bank raised the official 'redemption rate' to 133.80 to the US dollar from 133.90 a day earlier. Exporters have been holding out dollars increasing the pressure. Such a situation is known a 'loss of credibility of the peg'. Rupee bond holders and also now selling out.
Analysts had warned for several months that to maintain the 'external value' of the rupee, interest rates have to go up or liquidity has to be mopped up in the money markets, to prevent rupees coming up for redemption in forex markets, which then leads to a loss of forex reserves.
There has been calls during similar episodes to reform the central bank or abolish it and go back to a currency board.
Confidence in paper money is now artificially held in the word by by so-called 'legal tender' laws which prohibit the use of alternative and less inflationary currency issued by a low inflation central bank and specifying a single type of money to settle 'all debts, private and public'.
Currency competition now exists only in a few places like Zimbabwe where the dollars and South African rand is widely used. Earlier this month its Central Bank ended the circulation of Zimbabwe dollars after generating not just inflation, but also hyperinflation.