ECONOMYNEXT – The question is often asked whether Sri Lanka do without an International Monetary Fund program. It is certainly possible to do so if there is knowledge about monetary policy and pegging and there is an ideology based on classical economics and a return to sound money.
The world managed without the IMF before World War II. Some may say there was the gold (or Silver) standard at the time, which provided a simple basis for sound money, which is also true.
However there are enough ways to provide better fiat money than a money printing soft-peg with ‘flexible’ policy and modern monetary theory.
Though there are many examples, with the current fixation with Asia, Japan and Malaysia are good candidates.
There was no IMF before World War II
Any soft-peg crisis (read BOP crisis) can be fixed without the IMF, especially if it only involves current or capital transactions of private citizens and not state debt. All that needs to be done is to raise rates to slow credit.
Some fiscal fixes are needed since a currency collapse puts energy prices out of kilter and tariffs have to be raised. Usually in countries prone to currency crises, energy utilities that are state owned and money is printed to give energy subsidies and they have contributed to the crisis along with the central bank.
State banks, which give credit to loss making SOEs breaking prudential norms also contributes to the balance of payments crisis.
Energy subsidies financed by central bank credit is a key driver of the crisis in the first place and a reason for a monetary meltdown as a crisis gets underway.
Income tax also collapses as consumption falls. There may be bank failures or not, depending on how severe the currency crisis is and how long it progresses, but bad loans always rise.
State expenditure cuts are needed since taxes will fall after the currency crisis and the general public cannot bear the entire burden of a profligate state.
In Sri Lanka there is an excess of state workers, who are always molly coddled by the anti-austerity brigade. Austerity for the poor by currency depreciation is perfectly fine but cutting benefits to state workers are out of the question according to them.
To stop future crises the central bank has to be overhauled.
If that is not done, the country will go the IMF again and again and again … and yet again until default or a monetary meltdown drives the country to dollarization which is an extreme case of central bank bankruptcy.
There are many cases of countries fixing themselves without going to the IMF. Before the World War II all countries fixed themselves without going to the IMF.
Germany (Ordoliberals) and Japan (Ordoliberals inspired Joseph Dodge) did after World War II, simply with Austrian economics.
These people could teach a thing or two to the New Dealer inspired IMF.
The Meiji better-than-IMF- program
Japan had done it much earlier also in the 1880s after Meiji reforms failed amid SOE losses and an uprising in Seinan which triggered money printing. Japan had borrowed heavily in the London financial market.
Japan in fact probably invented privatization.
At the time Finance Minister Masayoshi Matsukata engaged in a mass-privatization. That saved the Meiji reform program and made Japan an industrial power by the turn of the century and it fought on the side of Britain in World War I against Germany.
The business houses that bought privatized assets became the big names that people now know, Sumitomo, Mitsui and the Zaibatsu system. Some of these firms dated back from the Tokugawa Shogunate trading houses.
International treaties limited protectionism and these firms become strong and competitive by the turn of the century. Taxes started to rise later after nationalists got control of the polity and import duties were raised to finance military spending and war.
But the recovery program was based on monetary reform involving creating a silver-backed yen and setting up the Bank of Japan similar to Dodge reforms after World War II involving closing the central bank re-financed Reconstruction Bank and fixing the Yen at 360 to the US dollar.
The return to sound money at the time came to be known as the ‘Matsukata Deflation‘ in similar vein to the ‘Dodge line Stabilization’ after World War II.
He went on to become the Prime Minister of the country he saved with privatization and a silver backed yen. He was also an architect of Western style taxes and freehold land which was the basis for Meiji reforms.
Anyone who digs into the real history of Japan will realize that there is more to the country than Chalmers Johnson. And there is more to Malaysia, Korea and Taiwan also.
The return to sound money protects the poor, limits the state spending to taxes and brings back stability. IMF programs fail primarily because money printing soft-pegs with ‘flexible’ policy are allowed to persist and currencies continue to collapse.
In 1985 as Latin America printed money and collapsed amid a Fed rate hike, Malaysia with Bank Negara, which is a much better agency than Latin American ones but not as good as Singapore, Hong Kong or Taiwan, kept the system fairly steady allowing a reform program to be rolled out.
In a monetary meltdown like in Latin America there is usually an ‘inflationary collapse’ with up to triple digit inflation in some cases.
If the crisis is averted with a smaller fall with tight policy there will be a less inflationary or a deflationary collapse and perhaps a recession or smaller economic contraction.
This is similar to 2017 and 2018.
In the 1980s commodity prices collapsed in dollar terms as the Fed and also the Bank of England tightened monetary policy under Thatcher-Reagan return to sound money. Then commodity and energy prices collapsed.
As tin prices also collapsed Malaysia’s then Finance Minister Daim Zainuddin – a British qualified lawyer and not anti-austerity Keynesian – slashed state spending and set about fixing a credible budget. He was the Treasurer of the UNMO and Barisan National at the time and a businessman.
Reducing State Intervention
Malaysia had engaged in a series of interventionist nationalist policies as part of its New Economic Policy to promote ‘Bhumiputras’ (read non-Chinese) in 1971, which also involved setting up state enterprises.
“By the time I came in, that was 13 years later, they were making losses,” Daim was quoted as saying in an interview in Sri Lanka which is today found at DaimZainnuddin.com. (Lessons for Sri Lanka from Malaysia: Interview with Daim Zainuddin).
“Lots of these companies were making losses, because they were run by ex-civil servants and people with no experience.
“And there was the 1985 recession and so the government needed funds for development.”
“So, I say look, why don’t we shut down those companies that were making losses, the good ones … also privatize. So that in the process when they do well, then the government can benefit from taxes.
“My view is, if after 15 years if we still do not do well, we must have a re-look at it, instead of wasting more money.”
In Sri Lanka today privatization would also get some immediate cash as well as income taxes in the future. Privatization transforms the economy and reduces room for future political interventions. The past privatizations of telecom, port projects are examples.
Daim is credited with paying back loans ahead of time.
He was also a good diplomat and was credited with fixing a spat with between Britain and Mahathir Mohammed which was known as the Buy British Last policy.
“A few years ago, some of our less robust spirits shuddered when they heard you exhorting your businessmen to look East,” British Prime Minister Margaret Thatcher said during a visit to Malaysia after relations had been fixed.
“You told me this afternoon that “look East” did not mean “buy only from the East”… With the evidence which you provided this afternoon that British industry is really welcome here, I am sure that British business will want to invest in the opportunities Malaysia offers and although, Prime Minister, you may sometimes look East and sometimes may travel East, if you look far enough East and travel far enough East, you always come to the West!”
Malaysia powered ahead, with nationalism muted for a time. He retired in 1991 and went back to business.
East Asia Crisis Fix
Malaysia also managed the East Asian crisis without an IMF program. Malaysia tried to defend the peg, with high rates, but speculators were hitting it with swaps.
It quite difficult to halt a currency crisis (the credibility of the peg is lost) when a country is doing really well and domestic credit is growing fast, since there is a lot of approved but undisbursed credit in banks and companies do not want to abandon these debt financed projects halfway.
Domestic credit was growing 36 percent in Malaysia and property credit was also around 30 percent when speculators the peg. Bank Negara was already applying selective credit controls to property when the crisis hit.
Applying administrative credit controls selectively may have partial success but is less superior to market rates which automatically selects the highest return projects in whatever sector and discourages others.
Malaysia then pushed up its 3 month policy rate to over 10 percent, which was very high for its highly leveraged firms that were used to low rates coming from its peg which was credible for many years. Overnight rate spiked over 40 percent at times.
The so-called ‘capital controls’ were misreported in many Western media, who seem to be confused by both monetary policy and pegs but glorifies ‘stimulus’ and heedless Keynesian spending.
This is personified in the view that ‘the government must do something’.
Malaysia closed the offshore ringgit market and stopped the outflow of ringgit.
Bank Negara stopped the outflows of new ringgit through credit and swaps to non-residents and to several offshore markets and restricted offshore ringgit financing. Hand carrying Ringgit notes were slashed from 100,000 to 10,000.
It was done to stop the monetary based from expanding and falling into the hands of speculators which would then come back to hit the peg. To hit a peg it is necessary to get hold of domestic currency, not foreign currency.
By that time credit growth had collapsed and there were bad loans. As a result maintaining the peg was not that difficult.
Hong Kong, which has a near-orthodox currency board, did not put any controls, kept the swap market open but allowed interest rates to rise each time the peg was hit and then. When the swaps came for renewal the speculators were badly hit due to high premiums and they had to leave with massive losses.
After the Asian Financial Crisis, Malaysia continued to grow. But it started to lose ground a later.
Korea is a free country after ‘IMF crisis’
Korea liberalized dramatically under its IMF program going so far as to break up chaebols (people in Korea call it the ‘IMF crisis’ due to bank failures among others which were blamed on the agency) which helped make it an advanced nation, but such changes are not necessary to stop a currency crisis per se.
Korea had fixed its central bank in the early 1980s as Latin America collapsed in to a ‘debt crisis’ and became an OECD country within a decade of dumping the ‘dictatorship’.
However in the old days it was the practice to ‘front load’ all the pending reforms in the expectation that the country will grow fast after the program.
Korea had a very bad Latin America style central bank set up by a Fed ‘expert’ in 1953 like the Central Bank of Ceylon in 1951, which brought the ‘First Republic’ down and created the military rule.
Korea is now a free country and is still in the OECD. Malaysia on the other had more problems with nationalism and religion which have become election gambits now.
IMF programs can vary in quality and success.
It will depend on how good the mission leader and the resident representative and whether they are grounded in classical economics.
More will also depend on whether there are like minded reformist bureaucrats, central bankers and politicians who are itching to make changes.
If a country keeps going back to the IMF repeatedly with currency problems, the problem is with the peg and money printing.
While it is not necessary to go to the IMF and a country on its own can do a stronger liberalization program – if it knew how – it certainly helps since the agency can help do a debt restructuring which will bring back confidence – misplaced or otherwise – and reduce the squeeze on the financial account.
China is also on the second G20/G22 debt framework that has been introduced for example.
Any reduction on the squeeze on the current account will translate into a stronger initial recovery backed by higher domestic consumption and investment and smaller current account surplus, or a higher current account deficit than would otherwise have been.
This column is based on ‘The Price Signal by Bellwether‘ published in the February 2021 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.
To reach the columnist: BellwetherECN@gmail.com
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