ECONOMYNEXT – Sri Lanka should have wider consultation on a planned new monetary law, and should not repeat the mistakes of the past made by ignoring the advice given to the island by the best economists in the region, opposition legislator Kabir Hashim said.
“Before passing the new central bank law there should be a wider consultation in the country and the parliament,” Hashim, an economist, told parliament in a debate for the budget 2023.
Sri Lanka had suffered steep depreciation and economic instability in recent years after following ‘flexible’ or discretionary monetary policies which the country had been advised against for over 40 years by top classical economists in Asia.
“European countries or stable East Asian countries and stable countries in the Middle East do not follow flexible exchange regimes,” Hashim said. “They can withstand shocks.”
“This time also we are not doing a complete structural change. I think we are only going halfway.”
Most advanced countries have clean floating exchange rates with low inflation targets. Stable Middle Eastern countries have currency-board-like systems while the best East Asian countries have similar systems or orthodox currency board with no policy rates.
All countries with monetary troubles have flexible regimes which are neither clean floats nor hard pegs.
Forex shortages and balance of payments crises are impossible in clean floating regimes as well as hard pegs, generally called currency boards.
In 1980, then President J R Jayewardene had sought the advice of Goh Keng Swee the economic architect of Singapore who had set up a currency board to eliminate forex shortages and currency crises.
“The key advice he gave was to stop the central bank from buying Treasury bills and printing money,” Hashim said.
“He warned that it will lead to high inflation and balance of payments problems. J R did not just take the advice given by the IMF and World Bank, he sought the advice of the best experts in Asia.
Hashim said the advice was ignored and it was a lost opportunity for Sri Lanka.
Critics say the problem is found throughout South Asia and any other country with monetary and external troubles.
A survey by the World Bank had come up with a shocking revelation that only 2 percent of ‘experts’ surveyed by the agency recently knew that balance of payments problems were created by central banks.
Related South Asia, Sri Lanka currency crises; only 2-pct know monetary cause: World Bank survey
Ignored advice from Singapore
Goh was not simply an academic economist who gave advice but a politician and a practitioner who ran Singapore based on currency board principles and gave stability for his country to grow.
President Jayewardene summoned Goh Keng Swee as the country was about to go the IMF after experiencing balance of payments troubles after he liberalized the economy a little over two years earlier and the country was experiencing strong growth.
Economists in Sri Lanka were printing money to keep rates down when Goh came and inflation was already in the double digits.
“There have been a relentless increase in the issue of Treasury bills and unless the process is immediately stopped, the country faces the near-certainty of galloping inflation,” Shenoy told J R.
“…[T]he 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.”
Goh warned Sri Lanka against depreciating the currency again, which had become fashionable in Washington policy making circles that were peddling advice to troubled third world countries, though the US itself was clean floating by then.
“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,” Goh said.
“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.”
“On balance, the disadvantage of a depreciating rupee will, I believe, outweigh the advantages.”
Sri Lanka took Western advice to depreciate the currency rather than curtail the central bank’s money printing powers to maintain external stability, through open market operations and other means.
Ignored advice from Shenoy
In 1966, J R had seen the currency problems Sri Lanka was experiencing and had asked B R Shenoy, probably the best classical economist in South Asia, to advise the country, Kabir said.
Shenoy had also advocated against printing money.
“Unfortunately the administration of Dudley Senanayake did not take the advice,” Kabir said.
“I see this as a lost opportunity for Sri Lanka.”
Shenoy had also warned against depreciating the currency based on various calculations. He advised to have a permanently floating exchange rate.
“..[I]t is almost an impossible task to arrive at the equilibrium value of the rupee, through any slide-rule technique,” he said warning against econometrics that is popular in Sri Lanka to this day.
In the run up the 2022 default Sri Lanka’s rupee had collapsed despite being ‘undervalued’ based on real effective exchange rate calculations, showing the validity of Shenoy’s argument.
“But the floating rupee will be always an equilibrium rate,” Shenoy said. “There can be no balance of payments head-ache under its regime.
“With so many other problems of great moment to attend to, relief from this major distraction may be a gain of no mean order.”
Instead of controlling the central bank, in 1969 Sri Lanka brought an Import and Export Control Act to control the economic freedoms of the people.
Sri Lanka had not taken the advice to either clean float or hard peg the currency, Hashim said.
“More than a decade later, Margaret Thatcher in the UK followed similar policies that Shenoy advised and transformed the country,” he said. “But we did not do that.”
Due to the economic ideology prevailing at universities after the War in particular, the UK had nationalized and had many state enterprises by the 1970s, which were then privatized.
Shenoy had told Sri Lanka to do the same 12 years earlier.
Some of the policies of the Thatcher administration, was later used in the so-called ‘Washington consensus’, sans the floating exchange rates with a credible anchor, dooming such countries to depreciation and instability under so-called BBB (basket,band,crawl) intermediate regimes.
Singapore had hard-pegged the currency shortly after Shenoy gave monetary advice to Sri Lanka and transformed the economy, Hashim said.
J R was not allowed to follow Goh’s advice to strongly peg the exchange rate.
Instead, Sri Lanka had dabbled with inconsistent monetary regimes, generally complying in line with the principle of ‘impossible trinity of monetary policy objectives’, triggering exchange and trade controls whenever policy rates were mis-targeted.
According to available information a new monetary law planned for Sri Lanka had several good features such halting direct central bank advances and direct purchases of Treasury bills by the central bank from auctions. The central bank will also not be in charge of public debt.
“That is good,” Hashim said. “It looks like we are getting on the right track.”
“But we understand that the flexible exchange rate and flexible inflation targeting which had brought instability for several years will be main strategies of the law.”
“If we do not pay more attention to the problem we will not be able to get away from the problem.”
True inflation targeting also blocks central bank economists from following ‘flexible’ policy forcing it to hike rates whenever inflation goes about 2 percent and taking away their discretion. They also cannot intervene in forex markets or pursue stimulus or accommodate real economic shocks.
Former Deputy Governor of the Central Bank, W A Wijewardena ha said Sri Lanka followed a ‘corrupted inflation targeting’ as the central bank targeted an output gap using flexible inflation targeting.
“Many people think that this country got into a crisis due to corruption and robbery,” Hashim said. “That is partly true.
“But by doing wrong policies we have damaged the economy even more. If we do not look at these we will not be able to go on the journey that we want to.”
It had taken 44 years for Sri Lanka’s economists to learn some of what was told by Shenoy in 1966 and Goh in 1980.
However, Sri Lanka’s monetary troubles in the past few years had come while operating flexible inflation targeting and flexible exchange rates.
Under the flexible exchange rate, a government in which Hashim was a minister was forced to bring trade controls, tightened exchange controls and controlled the import of gold, just like it had happened in the 1960s and 1970s and discredited their free trade agenda.