ECONOMYNEXT – Sri Lanka’s Institute of Policy Studies, has analysed the advantages of a currency board (an unbreakable fixed exchange rate) and its supposed disadvantages, but also repeated a false claim that Argentina at one time had a currency board.

Mercantilists usually oppose currency boards because they cannot depreciate the currency and tilt the playing field towards producers and exporters at the expense of the real wages of workers, pensions of old people and savings of a society.

An IPS researcher in an analysis said a currency board can have short term benefits.

“A currency board will be helpful to stabilise inflation in the short run but in the long run, Sri Lanka will be better off with a more flexible exchange rate regime,” the analysis claimed.

There are a number of stock criticisms about currency boards made by Western interventionists who lack knowledge of the institutional arrangement of a currency board as well as the process of monetary anchoring to keep inflation down.

What is a currency board?

It is helpful to know what a currency board is.

A currency board is a consistent, neutral policy monetary regime with a single anchor, which for all practical purposes behaves exactly like dollarization, which is the use of a strong foreign currency within a country.

If people wish there can be one or more currency board moneys circulated in a country. The Federal Reserve is about to legalize Tether style cryptocurrencies which are supposed to behave like a currency board, though balance sheet data is not available to confirm whether they are in fact hard pegs.

An American Express Travelers’ cheque operates exactly like a currency board.

Both floating exchange rates and currency boards are consistent regimes which have a single non-conflicting anchor.

A floating exchange rate has has no foreign reserves and the monetary base (the currency notes in use within the country) is determined by an inflation index (a domestic anchor).

A fixed exchange rate or currency board has floating rate interest rates and the monetary base is determined by the balance of payments (an external anchor).

In the gold standard days and the Bretton Woods periods, currencies did not depreciate against each other much because they all had the same anchor – gold. The rupee for was a silver currency until the Reserve Bank of India went to gold.

Regimes with anchor conflicts

Intermediate regimes or flexible exchange rates, are systems that collect forex reserves (targets the exchange rate), but also print money to target an inflation index (domestic anchor).

When inflationary policy is followed (money is printed when domestic credit expands) the flexible exchange rate collapses.

Sri Lanka abolished its currency board regime and an intermediate regime was externally imposed in 1950 amid US attempts to break the Sterling Area, according to critics.

The peg made the island a top customer of the International Monetary Fund and there were steep economic downturns whenever the US tightened policy and the currency fell.

Up to the collapse of the Bretton Woods, soft-pegs including in Latin America did not break as much as they did after 1980s, as the current Mercantilist competitive exchange rates mantra was not so prevalent in Western interventionist circles, analysts say say.

The Bretton Woods was set up in part to prevent competitive devaluation.

Discrimination against the voiceless

In the early 1980s Washington based Mercantilists such as John Williamson started to advocate a so-called basket, band, crawl (BBC) policy of depreciating currencies, but apparently lacked knowledge about anchoring money.

Read Interview by the Centre for Financial Stability Washington-consensus-John_Williamson_Interview

Competitive exchange rates destroy the basis of society by giving zero-sum profits to producers of goods against the well-being of workers, pensioners and savers generally.

Competitive exchange rates undermine a classical liberal concept known as sound money which does not discriminate between various individuals and economic sectors at the expense of weaker sections of society who have no voice.

Though such ideologies were developed in Washington to solve Latin America collapses, developing countries also became victims to the social unrest and out migration that comes with depreciation.

The anchor conflicting, flexible exchange rate has now brought Sri Lanka near to default.

Using the flexible exchange rates, interventionists used monetary policy for stimulus, which cannot be done in a reserve collecting regime without creating a balance of payments trouble (Why Singapore chose a Currency Board). Taxes were also cut, increasing pressure on interest rates.

Significant public opposition is now building up against the 1980s type Mercantilism following the repeated of failure of the intermediate regime and real pain people suffer from deprecation as opposed to the supposed pains of ‘internal devaluation’ as claimed by Western armchair Mercantilists who do not earn or save in depreciating currencies but are protected by single anchor floating rates.

The price of monetary policy independence

Whether Sri Lanka has used its supposed ‘monetary independence’ from a post-Colonial central bank to counter US tightening successfully, as claimed by interventionists, without creating economic mayhem is something that people can easily decide for themselves by a cursory examination of history.

When the US tightens, Sri Lanka suffers forex shortages if central bank prints money to cut rates.

One of the biggest costs of such ‘flexible exchange rates’ or intermediate regimes in addition to inflation, is the stifling of free trade.

Exchange and trade controls follow whether or not the currency is depreciated as forex shortages emerge from the anchor conflicts, fattening the pockets of import substitution oligarchs who claim that forex shortages can be eliminated by picking the pockets of consumers under tax protection.

“In sum it was a story of tightening partial relaxing, and again tightening the trade regime and associated areas to over a perceived foreign exchange crisis,” writes Saman Kelegama, one of Sri Lanka’s most humane economists who wanted free trade for the poor, in ‘Development in Independent Sri Lanka What Went Wrong’.

“In the early 1960s strategy for dealing with the foreign exchange crisis was the gradual isolation of the economy from external market forces.

“It was the beginning of a standard import-substitution industrial regime with all the controls and restrictions associated with such a regime.”

In a hard or consistent peg, there is free trade. Monetary policy tightens automatically as US tightens. Policy then loosens and excess liquidity builds up as domestic credit falls, and there are no forex shortages.

Sri Lanka’s recent currency crises occurred in 2015/2016 (following Yellen quantity tightening in 2014) and 2018 (Yellen quantity tightening and rate hikes), which led to political instability as the currency fell and output shocks as reserves were re-built.

From 2015 to 2019 the currency collapsed from 131 to 182 in two cycles.

To get out of the resulting crises after ‘monetary policy independence’, a flexible exchange rate country not only has to slow the economy sharply to restore stability but also has to re-build reserves under an IMF program creating a prolonged slowdown.

In a currency board or dollarization, if socialist policies lead to default, the fallout is contained in sovereign debt. In a flexible exchange rate with depreciation, the fallout spreads to banks and private firms and also people whose savings evaporate.

Fast Recovery

In a dollar currency board, there is no requirement to re-build reserves at the cost of an 18 month downturn as they are not depleted in the first place but the economy initially slows as the US tightens.

Due to the lack of floor policy rate, recovery would be quicker in a currency board area than if reserves had to be re-built after being lost in a soft-peg.

In fact the danger could be a too-fast recovery and a property bubble as the IPS analysis acknowledges and not a prolonged downturn under an IMF program as in a flexible exchange rate with anchor conflicts.

In a dollar currency board regime, banking systems do not usually collapse even if US banks collapse (in part due to the inability to over-trade without open market operations) helping the economy recover faster.

Sri Lanka now has to severely squeeze the economy to prevent a system wide meltdown following the stimulus (independent monetary policy) allowed to economists under a flexible exchange rate, even as the US begins its tightening cycle.

Flexible exchange rate regimes that try to engage in independent monetary policy, in a country addicted to foreign commercial debt, also end up in sovereign default.

In the 2018 cycle, Sri Lanka cut rates and the currency collapsed and earning lower ratings, while Argentina collapsed and defaulted.

In the 2020/2021/2022 ‘independent monetary policy’ cycle, Sri Lanka is heading for default and severe tightening is required due to exercising monetary policy independence.

In March 2022 the rupee collapsed steeply in a flexible exchange rate and a float has not yet been established and forex shortages persist.

In 1994, Mexico which was running a budget surplus, collapsed due to the flexible exchange rate and defaulted. Mexico was made to run an even bigger budget surplus under the IMF program on top of a steeply depreciated currency.

Argentina False Claim

Meanwhile the IPS analysis repeated a false claim made by Western media that Argentina had a ‘currency board’ up to 2000.

A key feature in a currency board is that foreign exchange interventions are unsterilized and foreign reserves match the monetary base at all times.

Reserves cannot fall below 100 percent of reserve money since interventions cannot be sterilized to keep overnight rates down.

In a currency board, foreign reserves and the monetary base moves lock-step (reserve pass through to the domestic monetary base is one to one).

Under a currency board, foreign reserves usually exceed the monetary base by only 10 percent (from profits of note issue) and any excess reserves are transferred to the government by the governing law.

Currency boards are similar to dollarization (using a foreign currency) except that there are no profits from note issue.

Such profits, annually transferred, can be externally invested to build a bank bailout fund or sovereign wealth fund to spend in a downturn.

Banco Central de la República Argentina law allowed foreign reserves to fall far below 100 percent of the monetary base and the peg collapsed amid sterilized interventions.

Read A MONETARY CONSTITUTION FOR ARGENTINA – A-monetary-constitution-for-Argentina

The BCRA was also allowed to hold domestic government dollar denominated bonds similar to Sri Lanka Development Bonds.

Prior to the fall of the ‘convertible peso’, the so-called ‘currency board’ had collected reserves over 190 percent of the monetary base on one time and fell to 80 percent, which is impossible under an orthodox or credible currency board which cannot sterilize interventions.

Whether or not a regime is a currency board or not can only determined by analyzing its balance sheet as soft-pegs can be stable for long periods as long as deflationary policy is followed (inflows are mopped up and no money is printed) like China from 1993 to 2005.

Flexible Exchange Rate, Flexible Inflation Targeting Peso also collapses

In 2018, Argentina which had operated a ‘flexible exchange rate’ and ‘flexible inflation targeting’ at an unfunny 17 percent, again collapsed and defaulted similar to the so-called ‘currency board’ period.

The IPS also claimed that “flexibility of labour markets is a key to the sustainability of currency boards.”

However in all pegged East Asian nations real wages have risen along with productivity growth, usually in export sectors. In some fixed exchange regimes (dollarized Panama) it was the financial sector, that drove up real wages.

Other counties including Cambodia and several former Latin America flexible exchange rates, which collapsed steeply are now also dollarized.

The original Ceylon currency board was one-to-one with India rupee. Bhutan still operates its peg one to one with India rupee which has not broken.

The requirement to maintain a peg is not the budget or labour laws, but the lack of aggressive open market operations and the outlawing of sterilized interventions.

A currency board country without crises and depreciation usually grow steadily and generate employment beyond 100 percent and attract foreign labour. Guest workers sometime leave when there is a downturn in the anchor currency nation.

However when a flexible exchange rate collapses under US tightening, resident workers lose jobs and expat workers who had gone to work in consistent pegs areas like GCC nations may also return home.

The IPS analysis is reproduced below:

Currency Board: A Solution to Sri Lanka’s Economic Crisis?

By Asanka Wijesinghe

On 08 March, Sri Lanka devalued the rupee against the US dollar, entering into a floating exchange rate regime. The Central Bank of Sri Lanka had to abandon the pegged exchange rate as defending the rupee with dwindling reserves was impossible. The inter-bank exchange rate shot up once the banks were assured that the exchange rate was floated. The initial shoot-up was followed by further rallying of the US dollar reaching close to Rs. 300 per USD. With the gradually weakening rupee, inflation is also ascending to worrisome levels calling for radical changes, including adopting a currency board. This article discusses the effectiveness and suitability of a currency board for Sri Lanka in the current macroeconomic context.

Weakening Rupee, Rising inflation, and the Currency Board Solution

A currency board is a system that issues domestic banknotes in exchange for specific foreign currency – anchor currency like the USD which is used for trade with partner countries – at a constant rate. A cornerstone of the currency board mechanism is the authority’s ability to meet all demand for foreign currency by the holders of the domestic currency.

In Sri Lanka, even after the rupee was floated, reports suggest that an active kerb market with a significant premium above the inter-bank rate exists. While such market behaviour indicates an acute dollar shortage in the market and the equilibrium rate is further away, no official data exists on the kerb market money exchange. However, cryptocurrency platforms provide some critical insights. The Tether coin (USDT), which is closely pegged to the US dollar on a one-to-one basis, is traded for rupees on peer-to-peer (P2P) platforms as USDT is used as a medium to purchase other cryptocurrencies, including Bitcoin.

Data extracted from the P2P platform medium of Binance – a popular cryptocurrency exchange among Sri Lankans- show some supporting evidence for the continually widening gap between official and informal rates again. Significantly, the premium over the official rate plummeted once the rupee was floated, but it gradually recovered to the pre-floated period (A and B panels of Figure 1). The number of sellers and the USDT volume available for sale also went up but riveted back to the levels of the pre-floated period (C and D panels of Figure 1).

The inflationary pressure also does not show any unwinding signs, further eroding people’s purchasing power. These developments encourage the adoption of a currency board as a currency board is believed to be a solution for rising inflation. By the inner mechanics of the currency boards, the independence of discretionary monetary policy is taken away, substituting a disciplined monetary policy – a gold standard without gold – which eliminates the inflationary bias. Indeed, empirical evidence exists in favour of the anti-inflationary effect of currency boards. The inflation rate is lower under currency boards than in pegged or floating rate regimes. Moreover, economies under currency boards grew faster than the average of countries with pegged regimes. However, empirically disentangling multiple influences to pinpoint the low inflation on the currency board is an excruciating task.

Another selling point of the currency board is the fiscal discipline, as currency board regulations prohibit direct monetary financing of government expenditures. A high budget deficit in Sri Lanka and excessive government borrowings from the Central Bank make the fiscal-discipline effect of currency boards much more appealing. Empirical evidence points to low fiscal deficits or larger surpluses under currency board regimes.

Figure 1: Behaviour of USDT Market in P2P Binance Trading Platform

Source: Author’s illustration using Binance data

Challenges in Adopting a Currency Board

A significant drawback of a currency board is the need to surrender the monetary policy independence required for managing asymmetric shocks. Such loss is costly when the anchor currency country responds to cyclical conditions, which are different from the prevailing conditions in the country operating the currency board.

For example, Hong Kong’s currency board imported low-interest rates from the US in the early 1990s. Such monetary easing was appropriate for the US, but Hong Kong faced an asset price boom that called for monetary tightening. A counterargument against the negative impact of losing monetary policy is the availability of fiscal policy at the operating country’s disposal. However, the maneuverability of fiscal policy is determined by the fiscal and debt positions.

In Sri Lanka’s context, the high debt to GDP ratio and fiscal deficits might restrict the use of fiscal policy for pump-priming-stimulating the economy in a recessionary period- due to the fear of losing investor confidence in debt sustainability. Thus, international evidence shows that countries with hard pegged exchange rate regimes generally tighten their fiscal policy in a recession. The Argentinian attempts to bring down the deficit in a recession in 2000 proved to be disastrous.

Sri Lanka’s high indebtedness will also challenge installing a currency board. Once a threat of a possible default looms, the interest rates soar, and refinancing debt will be increasingly difficult. In addition, the operating country needs reserves to back the monetary base in a currency board. In a currency board, the board must continually convert domestic currency for the anchor currency at a constant rate.

It should be noted that the reserve level of Sri Lanka has dwindled over time in the recent past. Another drawback of currency boards is the requirement of real sector changes to compensate for the exchange rate deviations.

For example, if the anchor currency appreciates against Sri Lanka’s main trading partners, wages should fall to compensate for the increase in foreign consumer prices, restoring competitiveness. Such an exercise needs greater flexibility in the labour markets. Thus, the flexibility of labour markets is a key to the sustainability of currency boards. The political feasibility of the institutional attempts to ease labour market regulations is highly doubtful.

Against this backdrop, the decision to install a currency board should be taken after a careful cost-benefit analysis. A currency board will be helpful to stabilise inflation in the short run but in the long run, Sri Lanka will be better off with a more flexible exchange rate regime. In addition, the benefits of a currency board are not exclusive. For example, fiscal discipline should be stronger in flexible exchange rate regimes as fiscal policy effects are reflected immediately and more transparently.

Thus, if Sri Lanka enters into a currency board to stabilise inflation and domestic currency, it needs to contemplate an exit strategy. Generally, it is advisable to leave a currency board when the economy recovers. The requirement to surrender monetary independence and the inability to finance government expenditure under a currency board might reduce the political preference for such a system.