ECONOMYNEXT – In 2019 Sri Lanka is suffering an output shock and credit contraction after a steep currency collapse from operating a ‘flexible exchange rate’ backed by contradictory money and exchange policies.
The outcomes are broadly similar to all currency crises, including the so-called Asian Financial Crisis, where high performing East Asian nations with stable pegged exchange rates were also hit.
Unlike high performing East Asia, Sri Lanka suffers one currency crisis after the other, like the Philippines, and also Korea at one time, before monetary reforms.
Sri Lanka is suffering similar outcomes with an output shock, a spike in bad loans and an unhappy electorate.
Sri Lankan firms are relatively less leveraged, due to repeated currency crises which generate volatile and high interest rates. Due to exchange controls also coming from money printing, few firms borrow abroad. People are also long-suffering, and banks tend to lend short term, and customers also deposit short term, which allows for rapid re-adjustments.
Speculators lost money heavily in Hong Kong, which had a currency board.
Indonesia is a country that had a weaker exchange rate and generally higher inflation than either Malaysia or Singapore in the run up to the crisis.
While countries like Malaysia, and also Hong Kong also suffered output shocks amid tight liquidity, Indonesia currency melted and the country was slammed with higher inflation, and much bigger output shocks due to Bank Indonesia’s inability to manage liquidity.
Interestingly Borneo, the second largest island in the Indonesian archipelago, has three monetary regimes.
Monetary policy in Kalimantan in Southern Borneo is run by Bank Negara Indonesia, where the currency lost 80 percent of its value.
In the North, in the former British territories of Sabah and Sarawak currency is produced by Bank Negara Malaysia, and it has a stronger exchange rate.
Borneo also contains Brunei, which has a currency board with Singapore and is one of the wealthiest countries in the world.
All three countries have oil. Indonesia has the weakest economy and exports labour to Malaysia and elsewhere in East Asia, like Sri Lanka and the Philippines export labour to the Middle East.
Ross McLeod, Associate Professor at Australia National University College of Asia and the Pacific Indonesia project, has been studying Indonesia’s macro-economic policy deeply for many years.
He has been involved in Indonesia from 1978, speaks Bahasa and in addition to writing academic paper also contributes to mainstream media like the Wall Street Journal.
From 1998 through 2011 he was the Editor of the Bulletin of Indonesian Economic Studies.
Ross McLeod was invited by Advocata Institute, a Colombo based think tank for the Asian Liberty Forum to lead a session on exchange rate policy earlier in 2019.
Following are excerpts of an interview done at the sidelines of the conference.
Question: You have been studying Indonesia extensively. We have seen exports of East Asian countries grow. Unlike countries like Taiwan and Hong Kong, Indonesia’s currency had steadily depreciated. Can you explain to us some of the policies you observed in Indonesia following in terms of monetary policy and exchange rate?
Ross McLeod: In Indonesia, I think there is no clearly settled idea about what monetary policy and balance of payment policy should be. It’s a kind of trial and error and the Central Bank kind of sticks with one policy for quite some time, and then there’ll be some kind of disturbance when the policy gets changed a little bit or a lot.
And I think last year was an interesting period and well Indonesia’s monetary policy history, in that we had a relatively stable exchange rate for quite some time, maybe 18 months to two years or so, and everybody was happy, and then the balance of payment started experiencing deficits.
It was partly because of what was happening on the trade account and partly because of the capital outflow and the capital outflow was happening because global interest rates were beginning to rise, but Indonesia was not following suit. So there was a larger and larger difference between Indonesian and international interest rates. So you’re getting a capital outflow because of that.
But the central bank was somewhat unhappy about allowing the exchange rate to depreciate. Obviously, all central banks get pressure when the exchange rate moves in the other direction. So the central bank was tending to stand against the exchange rate, which meant in those circumstances it had to sell off its international reserves.
International reserves were falling, and the effect of that was for the monetary liabilities of the central bank to shrink. In other words, it was withdrawing Rupiahs from circulation, and that tends to have the impact of increasing local interest rates. And so again the central bank gets pressure because the business community does not like high interest-rates. So then there is a bit more intervention (in bond markets).
So on the one hand in the foreign exchange market, the central bank was selling international reserves, extracting base money from circulation but now in the bond market is started entering as a buyer and re-injecting base money in an attempt to keep interest rates from going up.
So that’s all very fine, but basically, you have got two conflicting policies.
You’ve got the market wanting to shift capital offshore because interest rates overseas are now more attractive, but at the same time, you’ve got the central bank – Bank Indonesia – buying government bonds to keep interest rates down.
And by keeping the interest rates down, that means there’s still incentive to export capital. So basically you’ve got two incompatible policies followed by the central bank, and that’s a recipe for disaster.
As it turned out by the end of last year, things had settled down perhaps because the trade accounts were more healthy and so Indonesia was able to recover some lost ground as far as the exchange rate was concerned.
But the way I see all of that is, that the central bank doesn’t really have a consistent idea about what it should be doing and in particular, it finds it difficult to accept the idea it only has one instrument of policy and that is its control of base money. That is its own monetary liabilities. And therefore it can really only control one nominal variable.
It cannot control the nominal exchange rate plus the interest rate, plus the level of prices. It can only control one of those things. But it just doesn’t seem able to accept that.
Question: Can you explain to us what happened to Indonesia in the 90s?
McLeod: In the 1990s before the Asian Financial Crisis started, Indonesia had steady growth. It was a very healthy economy. It was growing rapidly, it had a low rate of inflation, but its exchange rate was actually depreciating steadily.
No announced policy said it, but nevertheless, if you look at the data of that period, you will find that the Rupiah depreciated at the rate of about 3-5 percent per annum for quite a long period. At the same time, the central bank had a policy of trying to control inflation, and they wanted to keep inflation to less than 5% per annum.
And that meant in practice, the central bank was trying to control two nominal variables at the same time – one being the rate of depreciation of the exchange rate and the second being the rate of inflation.
Now because central banks only have one instrument, they cannot control all two variables simultaneously.
So the way it worked out in Indonesia was that there was a consistent balance of payments surplus. That meant that the central bank to keep the exchange rate depreciating, bought the excess supply of foreign exchange and by doing that – by buying foreign exchange in the market – it was continually injecting additional base money into circulation.
That meant that the money supply was increasing too rapidly to be consistent with the inflation target. So, on the one hand, they met their goal for depreciation of the nominal exchange rate, but they couldn’t meet their inflation target because money supply was increasing too rapidly and inflation was always above target.
They wanted to keep inflation below 5 percent, in practice, it was always in between 5 and 10 percent.
So it’s just an example where the central bank tries to do too much. It seeks to control more than one nominal variable with only one instrument of policy.
Question: In Sri Lanka, there is a widespread belief, among the people who speak in the media, that people are doing something wrong for Sri Lanka to have currency depreciation. That depreciation and balance of payments deficits are all because of something that people do. There’s no talk of monetary policy when people or the media refer to balance of payments. What would you say?
McLeod: Well, it’s not the people at all. It’s the policies of the central bank in all cases. I don’t know the situation in Sri Lanka but in Indonesia written into the law on the Central Bank is the requirement that it is responsible for controlling the value of the Rupiah.
(Sri Lanka’s central bank originally had the requirement – maintaining external value of the rupee-, but with the understanding that the exchange rate cannot be controlled with a policy rate enforced by money printing, it was dropped as a legal requirement in an amendment. However the central bank still de facto tries to target the exchange rate through a variety of ways, without the appropriate monetary policy to support it).
Now, why is that in the law? That’s because central banks – whether they like it or not – do control the value of their own currency. They produce the currency. And just like everything else, you have to have a balance between supply and demand.
There’s a demand for money from the people but the supply is determined by the central bank. If then supply is made too large relative to the demand for it, or if the growth rate of supply is too rapid relative to the growth of demand for it, then just like everything else, the value falls.
The value of money is its purchasing power. That’s kind of the inverse of the inflation rate. If you have the value of the currency falling, it is equivalent of saying prices are rising.
So it’s never the fault of the people. It’s always attributable to the policies of the central bank.
Specifically, if the central bank tries to control more than one nominal variable simultaneously, it’s just going to fail, because it only has one instrument of policy.
Question: Just to look at central banks or monetary authorities that do control one variable. On one side of the spectrum, we have a country like Hong Kong. Can you explain to us, the policy over there?
McLeod: I haven’t read up on Hong Kong in recent times. I guess for a very long period, they did hold the exchange rate constant against the US Dollar. You cannot control the exchange rate against all currencies simultaneously. But against the USD there was a constant exchange rate.
But that’s okay. If that is the sole variable you are targeting, you can do that provided you are willing to relinquish control over the money supply.
So it’s just like under the old currency board arrangements – if you set a fixed rate of exchange for your currency against a foreign currency or against gold or silver or something like that, then that’s fine.
Anytime there’s a balance of payments surplus, the money supply is going to increase, it’s going to increase domestic prices, and that’s going to get you back to equilibrium. And the key to it is just having one nominal variable as your target, not more than one.
Question: Can you explain to us how Australia or New Zealand conducts policy? Do they worry about the current account deficit?
McLeod: Let’s stick to Australia because that’s my country, so I know a little bit about it. In Australia, we used to worry about the current account deficit. Some years ago, we went to a floating exchange policy, and it’s a genuine floating exchange rate policy.
And nowadays nobody talks about a current account deficit. In fact, when I turn on the news every evening, there is a little segment about finance, and the guys come on and tell me what happened to the exchange rate today. We went up against the US dollar, or we went down, it’s no big deal.
It’s the bit of news nobody gets excited about. So that is equivalent to saying that we genuinely have floating exchange rates and the Reserve Bank of Australia isn’t trying to fix the exchange level to this level or that level.
I can say we also have a pretty good inflation record, the inflation rate is always low, and it’s close to the target maybe 2 or 3 percent or even less than that.
In fact, sometimes people get excited that the inflation rate is lower than some target, which seems crazy to me. Like what’s the problem with low inflation?
But my point is that generally, the Reserve Bank doesn’t try to control lots of different variables. It basically focuses on the growth of the money supply, and I guess it’s more accurate to say that it focuses on the inflation rate and so they determine the monetary policy, whether it’s needed to be tightened or loosened, depending on what’s happening to the inflation rate.
And at the same time, they are not trying to control the value of the currency in terms of another currency, they are just letting the market determine that for us. And it works perfectly fine.
And we have a reasonably good growth rate in today’s economy, we have a low inflation rate, everybody is happy.
Question: People also talk about anchoring the monitory policy to particular variable or a target. Can you explain how that works, in the perception of the people?
McLeod: Well by having an anchor for the policy, we decide on one nominal variable that we want to see constant or at a particular level and we adjust the monetary policy settings in order to achieve that.
So in Indonesia for an example I’ve always suggested that the nominal anchor should be the rate of growth of base money.
And I believe that is done then you get the outcomes you’re wanting to achieve. But the minute you start having more than one anchor, if you are trying to anchor the exchange rate as well as the rate of growth of money then that’s the recipe for disaster and disappointment.
Question: So why not do the same thing that Australia does, in Indonesia?
McLeod: Well, you can do that as well. It just seems to me that having a straightforward concept like the rate of growth of base money, which is directly under the control of the central bank.
Base money does not change unless the central bank does something to make it change.
For example, if it lends to the government – that’s going to increase the base money. If it buys foreign exchange, it’s going to increase base money. If it buys government bonds in the open market, that’s going to increase base money.
If you don’t want base money to change, then you simply don’t do those three things. You don’t lend to the government you don’t intervene in the foreign exchange market, and you don’t intervene in the bond market. Stay out of all those things.
Let the government finance its deficits by borrowing from the market. That’s a much better way of doing it.
Let the exchange rate go where it wants to go, where the market wants to go. And that will keep your balance of payments in equilibrium. Stay out of the bond market.
So just sit on your hands do nothing, effectively let the markets work things out. It is the road to peace and bliss as far as I am concerned in terms of the life of a central banker.
Question: Sri Lanka had a currency board from 1885 to about 1950. The British set it up. Why don’t do people set up currency boards any more? Is there any technical or economic reason behind that?
McLeod: Well, it’s partly politics. Politicians in the government and the central bank like to be able to intervene. If you got a currency board, there is no intervention, as you know.
A currency board simply means you have a bunch of people who buy and sell foreign exchange for a fixed rate on demand. If there is a demand for foreign exchange, you sell it to them. If there is a supply you buy it from them; always at the fixed rate.
There is no discretion. There no intervention in anything. You are just doing something very mechanical. Politicians don’t like that kind of situations because they want to say to people; ‘Well we can intervene in markets on your behalf.’
It’s never on behalf of the people as a whole. They will pretend that it is but the fact of the matter is when the governments intervene in the markets it’s to benefit one party at the expense of the rest of the society.
So the politicians like to have something like a central bank because then they can be seen to be doing something. They can actually do things to benefit particular parties and they get the support of whatever nature from those parties.
At the same time, you have the economics profession. I am an economist. And the problem with economics is that if we really believe in markets, then there is nothing very much for economists to do.
We trust the invisible hand to organize all production and distribution of goods and services. What does the economist do? Not very much. And so we do see ourselves out of a job.
And if we want to create a job for ourselves, then we have to persuade people. ‘There is a market failure here, there is a market failure there, I’m the guy who can fix this market failure for you.’
That is just another way to intervene in the markets. You always pretend that it in for the benefit for the people as a whole. That’s almost never the case.
Almost all intervention is to help one party at the expense of another. So I am afraid the economists’ profession has much to answer for, in that sense.
And, going to the case of the currency board as you just mentioned that Sri Lanka used to have a currency board in the beginning and then based on foreign advisors as I understand, it was decided we needed a central bank in Sri Lanka.
And I think you told me the person who became the first Governor of the Central Bank was one of the people who had advised to set up a central bank.
So this to me is a perfect example of economists persuading governments that there’s a market failure here that I can fix. Let’s have some intervention and, by the way, I am happy to do the intervention on your behalf.
Question: I believe he was invited by Sri Lanka’s government to take the job because we did not have experienced people at the time.
McLeod: Well I wasn’t there at the time, so I don’t know anything about this history, but you can say as a representative of the economic profession he was advising Sri Lankan government at their request, that you needed a central bank.
You need a bunch of economists because all of this market failures. And us economists as a profession, we know how to fix market failures. So in that sense, he was generating jobs for economists, doing something completely unnecessary.
As you said, when you had the currency board economy operated just fine. I don’t think you had inflation. So you didn’t have balance of payment problems because the market automatically dealt with those by changing the money supply in accordance with the condition of the external accounts.
So to take it one further step, some countries neither have a Central Bank nor Currency Board. They use some other country’s currency.
So this is the ultimate in no jobs for economists’ in the field of monetary policy.
If you talk about a country like Panama, it uses the US dollar. A small country call Kiribati in the Pacific Ocean uses the Australian dollar, East Timor uses the US dollar.
They just don’t need any economists. They don’t employ any economists to run monetary policy because they don’t have their own money and yet the economy functions just fine.
Question: We have seen some reports recently in the press about dollarization in Ecuador and about how inflation collapsed and GDP went up.
McLeod: Yes, I think the overall experience is that the dollarization, if you call it that, adopting another country’s currency in a way it works pretty well if the initial problem was very high inflation and you knock that on the head straightaway.
So I think there is plenty of experience, not a large number, but enough countries to say – yes, this works.
Interestingly enough, I will give you an anecdote from Indonesia. You know Steve Hanke, who is the world’s guru on currency boards and dollarization.
You remember, Indonesia in 1998 had a terrible monetary crisis. Just before that, as I mentioned before that the economy was in excellent shape. Robust growth, low inflation, stable exchange rate – fairly stable exchange rates.
Then this Asian Financial Crisis comes along and because of the way it was handled money supply went out of control.
Indonesia was quite unique amongst Asian financial crisis countries at the time because all of the others didn’t have this enormous burst of inflation that Indonesia experienced.
The reason was that the central bank abandoned its policy of depreciating the currency at 3 percent to 5 percent which had been the nominal anchor, but it didn’t replace it with another nominal anchor.
Now the central bank must use its policies to control one nominal variable. And the Indonesians just neglected to do that. For 8 or 9 months from August of 1997, base money supply ran out of control.
The reason was the central bank doing a lot of last-resort lending to the banking system. Well, that’s all very fine, but it (the central bank) wasn’t sterilizing that. And that base money was growing very, very, rapidly. It doubled in the space in about eight months. Very predictably, as a consequence of that, prices increased enormously in that period.
Nominal interest rates rose enormously during that time. This just caused chaos for the economy. The rate of real economic growth in1998 fell to minus 13 or 14 percent. So, in other words, awful monetary policy during that period caused the Indonesian economy to suffer greatly.
We were talking about Steve Hanke and the Asian financial crisis in Indonesia as you may know, he became the advisor to the President (Suharto) at that time. And so when he came to Indonesia as I said money supply was out of control.
The IMF had set targets for it, but Indonesians had basically ignored those targets. And the IMF said okay let’s revise the target upwards, and there were several months where the base money was targeted but ignored, and the base just continued to increase rapidly.
So you get this high inflation and interest rates are going up, and there is large currency depreciation.
So the president asked Hanke what can we do about it, and Hanke said ‘I guess two possibilities, one is Currency Board, one is Dollarization’.
Well, dollarization is a bigger fence against the economists’ nationalist feelings than I suppose the Currency Board that president actually accepted at one stage.
And as we mentioned Currency Boards implemented in various other countries has had the impact of stopping inflation in its tracks, so the president accepted the proposal from Hanke.
But then the whole international community came down on him and said ‘No you can’t do this, you can’t do this. You can’t have a Currency Board in Indonesia.’
So Suharto was getting pressure from the United States in particular, from the Western world in general, from the IMF, from the World Bank. And unfortunately, he bowed to that pressure saying, ‘Oh well if everybody is against this idea then let’s not do it’.
And by not doing it, inflation continued to be very high for several more months. President had fallen from office in May that year then he was replaced by President Habibi, and shortly after that the monetary policy was changed to get the money supply under control. Inflation disappeared very rapidly after that.
If Hanke’s proposal had been accepted the same thing would have happened, you know the rapid expansion of the money supply which was the underlying cause of the problem that time, that problem would have gone away instantaneously.
Even the announcement that Indonesia was going to go for the currency board was sufficient to stabilize the exchange rate, in fact, to improve the exchange rate. But as I said, it didn’t go ahead.
But of course, a lot of the opposition was from the economics profession in Indonesia. It goes back to the idea that the Currency Board doesn’t generate jobs for economists. The Currency Board doesn’t need economists. But central banks do.
So trust the central bank. Trust all the economists in the central bank will fix the problem. Well, it was the Central Bank that was the cause of the issue at that time because it didn’t have any monetary policy.
It had abandoned its exchange rate policy, fixed rate of depreciating policy but hadn’t replaced it with anything else.
Question: There is this idea that comes across when you talk with some economists that you can’t do a Currency Board unless there was a service economy. You cannot do it for a manufacturing economy. Then when Hong Kong is mentioned, they say it is a service economy. Or they say you need large labour movements for a currency board, so you cannot do a currency board for Sri Lanka.
Some of these people do not know that we had a currency board at one time. Then they say ‘Oh, it was ok because we had an agricultural economy, but we cannot do it now’. So is the activity that you do a requirement for the monetary arrangement?
McLeod: I don’t think so. I think those kinds of arguments are bogus. All we are talking about is the value of the monetary unit. And as I said earlier, the value of anything is a question of the balance is between the supply and demand.
So it doesn’t matter what your country is producing. People can sort of wave their hands like this and say ‘Oh, it will only work if you are an agricultural economy. Oh, it will work only if you are a service economy’. To me, that’s just nonsense.
It doesn’t matter what you are producing; there is a demand for money, and the central bank determines to supply that money. It has to keep the supply in balance. So if we go to a currency board then it’s all automatic. There is a supply and demand for foreign exchange. The currency board meets that by increasing the money supply or decreasing it and that will simply adjust your prices to be consistence with prices in the rest of the world.
So I don’t see any value in those arguments – that it depends on what your economy produces.
Question: When we had a currency board, we must have been getting along pretty well, as you said. There is a story that economists repeat here that at independence from Britain, Sri Lanka had the highest living standards after Japan. In fact, Malaysian companies used to raise capital in Colombo, and we had free movement of capital, and some of those plantations are still listed here. But exchange controls came soon after independence. It does not seem to have happened over there?
McLeod: I think Indonesia had a reasonable rate of growth for an extended period, apart from the Asian financial crisis period, and that is because its macroeconomic policy has been reasonably good. I don’t think it was perfect by any means, but it was reasonably good.
You can create reasonably stable macroeconomic conditions that give you a good base for reasonably robust economic growth.
But the minute you start so baldly managing macroeconomic policy that you have to impose exchange controls, or if you think you have to impose exchange controls, then people just lose confidence in the economy.
If I am the foreigner and I am interested in investing in Sri Lanka, then I worry about whether I can get my money out later when I want to or whether it’s likely there is going to be a new policy that prevents me from doing so.
And so it stands through reason, that interest on the part of foreigners in investing in Sri Lanka would’ve been falling and that’s going to reduce the growth rate that you can achieve over time.
And people are going to spend more time finding ways around the exchange control, and there are always ways to beat that, and they are going to be more interested in that than being in the business and driving the economy forward.