ECONOMYNEXT – Sri Lanka’s outgoing Central Bank Governor W D Lakshman, during whose term historic volumes of money has been printed, the rupee is facing severe pressure triggering the worst import and exchange controls since the 1970s, said he was personally not in favour of depreciation.

Sri Lanka recorded the biggest balance of payments deficit in its history in 2020 and is on track to do it again in 2021, while the broader economy is mired in price controls, rationing, sporadic shortages and foreign reserves are falling before reserve liabilities.

“I am personally not in favour of continuous depreciation of the currency based on our own past experience,” Governor Lakshman told reporters at his last press conference.

“Also based on my own studies of the historical experience of other countries.”

Sri Lanka’s rupee fell from 182 to around 230 to the US dollar during the money printing bout and has since been ‘revalued’ by administrative remit to 203, leading to severe forex shortages.

The foreign exchange market has no spot price, forward cover is banned, low rupee rates from money printing has encouraged dollar hoarding which is increasingly translated to food and medicine hoarding at home, as the credibility of an exchange rate weakened sharply, analyst says.

Currency Instability

Lakshman said especially after 1978, Sri Lanka had depreciated the rupee, apparently on International Monetary Fund advice.

Except for short periods, Sri Lanka’s rupee has continuously fallen.

“What did we achieve from depreciation?” he questioned. “Economic theory tells us that depreciation helps us. Nothing of that sort has happened.

“Our trade deficit has continued to weaken. I can go on talking about it. My perception is that if we can we must try and maintain a stable exchange rate. If we can.”

In order to maintain the credibility of exchange rate peg, the central bank has to stop inflationary policy, or halt printing money against domestic assets (Treasury bills) for ‘stimulus’ or budget deficits.

Any central bank that follows deflationary policy (reverses CB credit or sells central bank securities) can build up foreign reserves.

East Asian nations from Singapore, to Taiwan, to China (from 1993 to 2005) and now Vietnam follow such policies.

A fixed or stable exchange rate is an external anchor for domestic monetary stability.

Vietnam has been battling the US to maintain the consistent policy and not be forced into discretionary ‘flexible’ policy.

However Mercantilist theory claims there is prosperity at the end of a depreciation tunnel or unsound money through reducing the trade deficit and boosting exports, though monetary debasement wages destroys real wages and financial savings of old people.

Mercantilists also believe that the strength of an exchange rate (the parity of one note-issue bank against another) is due to trade or real economy factors and not its monetary anchor.

Keynesian Mercantilism

John Maynard Keynes fired the neo-Mercantilist fascination with monetary debasement (a crime for which perpetrators were beheaded or guillotined in earlier times) when the Sterling went off the gold standard (peg) in 1931 after losing too many reserves to sterilized intervention, analysts say.

“For if the sterling exchange is depreciated by, say, 25 per cent, this does as much to restrict our imports as a tariff of that amount; but whereas a tariff could not help our exports, and might hurt them, the depreciation of sterling affords them a bounty of the same 25 per cent by which it aids the home producer against imports,” he wrote in 1931 in a letter to Britain’s Sunday Express newspaper.

Giving rise to later claims that a currency is ‘overvalued’ he also wrote.

“But the great advantages to British trade and industry of our ceasing artificial efforts to maintain our currency above its real value were quickly realised.”

However a float stabilizes a currency at a lower level, not because there is some ‘real value’ but because a suspension of convertibility immediately halts liquidity injections (money printing) to re-fill (sterilize) liquidity shortages coming from an intervention made to provide convertibility, classical economists say.

The liquidity is injected by soft-pegged banks after interventions to maintain an interest rates structure below market (policy or discount rate) and pump non-existent resources into banks to make new loans at low rates which in turn drive imports and results in more reserve losses when convertibility is given.

The currency usually falls before stabilizing after convertibility is suspended due earlier injections made to maintain the policy rate which had deeply undermined the credibility of the peg and confidence is weak.

A currency board (such as Hong Kong now or Ceylon until 1950) also known as a credible or hard peg on the other hand makes unsterilized interventions and has no legal room to keep rates down by printing money.

Therefore the exchange rate is impossible and illegal to break. Sri Lanka had a fixed exchange rate (against silver and the Indian rupee) from 1885, until J R Jayewardene as Finance Minister invited a US money doctor to set up a Latin America style central bank in 1950.

When the currency board was broken in 1950, the rupee was 4.70 to the US dollar.

Economists and analysts have for several years been calling for the creation of a currency board to curb the domestic operations of the central bank to get the country out of the cycle of stimulus, currency pressure followed by high interest rates and inflation, with its attendant political instability, also known as ‘stop-go’ policies.

Sri Lanka’s last administration was also a victim of similar policies, involving Keynesian output gap targeting (stimulus) and REER targeting in the Mercantilist belief that monetary debasement will bring an a competitive advantage and prosperity and not economic instability and social unrest.

Monetary Protectionism

Classical economists from Ricardo to Thornton to more modern ones from Austrians to Ordoliberals and monetarists have advocated sound money and strong exchange rates as the foundation of a free society and prosperity.

“The days are gone in which most persons in authority considered stability of foreign exchange rates to be an advantage,” wrote Austrian economist Ludwig von Mises after Britain went off the gold standard and there were other competitive devaluations before the War.

“Devaluation of a country’s currency has now become a regular means of restricting imports and expropriating foreign capital. It is one of the methods of economic nationalism.

“Few people now wish stable foreign exchange rates for their own countries.

“Stability of foreign exchange rates was in their eyes a mischief, not a blessing.

“Such is the essence of the monetary teachings of Lord Keynes. The Keynesian school passionately advocates instability of foreign exchange rates.”

The IMF was created by Harry Dexter White a US New Dealer and along with Keynes. New Dealers were also driven by interventionism and prominent ones included Alvin Hansen.

Keynes himself wanted to push not for soft-pegs but a uniformly inflating currency called the Bancor.

However the US and advocates of a so-called ‘key currency’ won, with UK itself having run out of foreign reserves and depended on a bailout from America and in no position to negotiate.

But the UK itself paid a terrible price going through multiple ‘Sterling crises’ during the Bretton Woods period, and even more instability during the 1970s (Great Inflation).

The Bank of England went to the IMF until Margaret Thatcher and her advisor Alan Walters re-established monetary stability, strengthened the pound and ended 40 years of exchange controls.

JR and Depreciation

Sri Lanka gradually closed the economy as the money printing central bank created forex troubles. The exchange control law was brought in 1952.

The Import Control Law was bought in 1969 when foreign reserves fell to 40 million dollars after Green Revolution financing and among other reasons. The administration was swiftly defeated.

Controls worsened in the 1970s after the collapse of the Bretton Woods. Like in 2020 and 2021, the central bank bought most if the Treasury bills and its economic controls are the stuff of legend. Now the controls are coming back.

Though the economy was re-opened in 1978, there was no central bank reform.

When the Sterling halted convertibility in 1931 an act of parliament was needed to permit it. In the 19th century floating incidence also parliamentary approval (Band Restrictions Act) was sought.

The rupee was originally pegged to gold at 2.88 grains in 1950. By amending Section 03 of the monetary law it became extremely easy to depreciate the currency in the 1980s.

As a result severe monetary instability hit Sri Lanka during the 1980s and 1990s until A S Jayewardene became Central Bank Governor in the mid 1990s.

Meanwhile Governor Lakshman said he recalled an interview then President J R Jayewardene had with Indian journalists in the 1980s.

President Jayewardene he said referred to a steep devaluation in 1978 and the then current rate and IMF pressure to devalue further.

“There was a very interesting statement Mr J R Jayewardene made in a press conference held in the India I think in the early 1980s.

“He says like this, referring to the IMF. ‘They are telling me to devalue. I have devalued from this to this. Now they are further advising further depreciation. This time I am telling them, that is enough, that is it’.”

In the 1980s however despite monetary instability there were no price controls to create shortages like in the 1970s.

As a result, through prices went up as the rupee fell, there were no black markets and shortages of food or drugs without the Consumer Affairs Authority or an NMRA to impose price controls.

Parallel Exchange Rates

Sri Lanka rupee had fallen steadily from 182 to the US dollar from the end of 2019, when taxes were cut and unprecedented money printing began.

In August the rupee started to fall after convertibility was suspended for trade transactions while liquidity injections were made to maintain ceiling rate at Treasuries auctions, creating parallel exchange rates.

However reserves are still bleeding due to convertibility given to debt.

As the rupee dropped to around 231 to the US dollar the central bank then asked banks to revalue the rupee for trade transactions to 203 (a type of price control order), leading to the drying up of dollar conversion in the expectation of further depreciation (weakened credibility of the peg).

Black market rates are close to 240.

The low rupee rates have made it attractive to borrow in dollars and hoard dollars.

In the broader economy, price controls are being slapped on gas, milk, rice and sugar, leading to shortages like in the 1970s, when the central bank was buying Treasury bills.

Japan

Meanwhile Governor Lakshman said there were countries that had strong exchange rates.

“Let us take for example Japan,” he said. “After the Second World War the US dollar was in terms of Japanese yen was very high. Sometimes around 360.”

After the Second World War, occupied Japan was in serious trouble due to ‘stimulus’ due to money printing, in part due to the Keynesian Priority Production System through various subsidies to industry.

By 1947 inflation had hit soaring. Attempts to reduce inflation through a deposit blockade was only partially successful. By 1948 inflation had again surged to over 200 percent.

Fearing communist take-over of Japan due to the monetary instability, Washington sent Joseph Dodge, a banker, who had worked on currency reforms in Germany with the Ordoliberals to stabilize Japan with the rank of Minister.

Like Sri Lanka now there was no market exchange rate, but a series of parallel exchange rates. The rate for exports ranged up to 600 to the US dollar and imports up to 250 through a complex subsidy scheme.

Dodge Line Stabilization and Fukkin Depreciation

Inflation was being stocked in money printed in multiple ways the Americans found.

A Trade Finance Special Account was financing parallel exchange rate with Bank of Japan credit (like remittances being paid extra two rupees in Sri Lanka despite the budget being financed with printed money).

A Keynesian bank, Recovery Financial Bank (Fukko. Kin-yu Kinko) was giving money to business, financed by the sale of securities (Fukkin bonds) to the Bank of Japan for printed money.

Dodge halted Fukkin loans, closed the bank and set the exchange rate at 360. He also balanced the budget cutting industrial subsidies, helped by a like-minded Liberal Party Prime Minister Shigeru Yoshida, and Finance Minister Hayato Ikeda, helping keep rates low.

No deficit finance was allowed and price controls were lifted. The Ministry of Trade and Industry however kept some controls almost bankrupting car firms like Toyota.

Inflation and economic activity slowed immediately and Japan went into a recession. Then it took off, German style from where Dodge had come, initially also helped by US military orders for the Korean War.

To maintain the exchange rate, the Bank of Japan raised short term rates whenever credit grew and the balance of payments came under pressure. The BOJ also used ‘window guidance’ to directly control credit, reducing investment and import pressure.

Japan maintained the 360 exchange rate until the Fed Chief Arthur Burns printed money for output gap targeting and broke the Bretton Woods and the gold standard along with it, triggering Nixon shock import controls.

The Yen was then floated and started appreciate against the US dollar which was creating the Great Inflation period of the 1970s after collapsing against gold.

The dollar did not have a consistent monetary policy until Paul Volcker started tightening policy from 1979.

Governor Lakshman claimed the Yen strengthened due to exports.

“But with exports growing there was a gradual strengthening of the yen,” Lakshman claimed. “Particularly after the Plaza Accord.

“Similar things have happened in fast developing countries in the same parts of the world. With the development there is a gradual appreciation of the domestic currency.”

The Plaza Accord was an attempt to depreciate the US dollar by Mercantilists at the US Treasury who through that the trade deficit with Japan. By 1985 the Yen had already appreciated to around 238 to the US dollar.

The Mercantilist Plaza Accord predicatably failed to end US trade deficit with Japan did not decline.

Net Creditor

Meanwhile Lakshman said Sri Lanka was a net creditor nation in the immediate years of independence from British rule.

“In 1948/1949 having started our independent policy making with a surplus of dollars in reserves, we were in a net creditor position,” Governor Lakshman said in February 2020.

“And in fact agreed with Britain our colonial master not to spend during the period of dollar shortage. Not to un-necessarily spend our reserves in order to help them.

Britain was at the time under severe currency pressure and mired in price controls and rationing.

Sri Lanka set up a central bank with sweeping money printing power is 1950, abolishing the currency board which had kept stability and protected the people through two World Wars and a Great Depression.

The money printing central bank inherited reserves worth 11 months of imports from the currency board.

The central bank has now has lost all its net reserves and analysts say and market dollarization could be a source of stability. (Colombo/Sept13/2021)