ECONOMYNEXT – Sri Lanka is set to institutionalize a ‘flexible’ exchange rate regime instead of a floating exchange rate through a draft law through which the central bank is seeking operate a discretionary ‘flexible’ inflation targeting regime.

Countries with successful inflation targeting frameworks, such as New Zealand, Australia or the UK, have a floating exchange rate, where base money is not altered through pegging in either direction, and reserve money is backed by domestic assets.

Over-issue of money is then controlled through an inflation target.

However Sri Lanka will continue with an intermediate managed exchange arrangement, or a soft-peg which is called a flexible exchange rate under the draft law, which has been made public.

“There shall be a Monetary Policy Board of the Central Bank (in this Act referred to as the “Monetary Policy Board”), which is charged with the formulation of monetary policy of the Central Bank and implementation of flexible exchange rate regime in line with the flexible inflation targeting framework in order to achieve and maintain domestic price stability,” a draft law made public says.

Rates have been cut and money printed at different levels of inflation in the recent past under ‘flexible inflation targeting’. An inflation target will be set in consultation with the finance ministry under the new law.

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Sri Lanka’s central bank was set up in 1951, replacing a rule-based fixed peg with market determined interest rates, with discretionary or ‘flexible’ policy to print money but without a floating exchange rate.

At the time Sri Lanka was to join the Bretton Woods, and the exchange rate was supposed to be fixed, despite the new agency having money printing powers.

“This law has been drawn up under American tutelage and along lines that have been the subject of experiment in certain Latin American countries for some eight years past,” an analyst at the London-based The Banker magazine wrote in July 1950 looking at the draft law for setting up the central bank.

“The step from an “automatic” currency system (such as that which Ceylon inherited with its old Colonial Currency Board) to an ultra-modern ‘managed’ currency system is necessarily fraught with great dangers and there may be some who will regret that Ceylon had decided to run such risks this time.”

Sri Lanka brought in draconian exchange controls and trade controls in order to print money and target interest rates. Interest rates eventually rose to over 20 percent in the 1980s and early 1990s, as money and exchange policy contradictions worsened.

Unlike successful East Asian nations like Malaysia, Singapore, Taiwan and Thailand, Hong Kong which had strong and stable currencies showing monetary discipline by definition, Sri Lanka’s rupee has collapsed from 4.70 to 182 to the US dollar since the creation of the central bank.

Most South Asian central banks’, which also started around 4.70 to the US dollar (the rate of the Indian rupee) also had similar outcomes, though the worst fall is seen in Sri Lanka as it operated variations of soft-pegs or managed floats.

Korea overhauled its central bank in the early 1980s and Vietnam in late 1980s after severe instability. China fixed the currency strongly is 1993 and passed a new law in 1995.

Under pressure from US Mercantilists the People’s Bank of China again shifted to a ‘flexible exchange rate’.

In 2014, new liquidity tools were introduced undermining its 1995 framework and China is seeing now more instability economists have pointed out.

“..[Under pressure from the United States and on the advice of the International Monetary Fund (IMF), China dumped its embrace of exchange-rate fixity and adopted a flexible exchange-rate arrangement,” economist Steve Hanke wrote last year (President Xi’s Nightmare, Instability).

“I, along with Nobelist Robert Mundell and the late Ronald McKinnon, objected to this change and subsequently joined Renmin University in Beijing as Senior Advisers to Renmin’s International Monetary Institute. We anticipated that instability would accompany the introduction of exchange-rate flexibility.”

“Never mind, the U.S. and IMF ruled the day.”

Sri Lanka’s ‘flexible exchange rate’ has seen the rupee collapse from 131 to 182 in the space of four years. Since 2012 the rupee has fallen from around 113 to the US dollar.

The permanent depreciation of the rupee and instability under the ‘flexible’ exchange rate has been so bad that airlines have stopped quoting tickets in rupees, travel officials have complained.

Under the ‘flexible’ regime, some exchange controls were re-introduced on exporters and import controls were slapped hitting a free trade agenda of the current administration.

Gold was also taxed like India to protect the balance of payments.

Analysts who have studied the highly unstable flexible exchange rate has warned that both money (liquidity management with sudden spikes and exchange rate (convertibility undertakings) are against the rupee.

Massive liquidity injections are made to target a call money rate making a policy corridor which would have made the exchange rate somewhat stable irrelevant. (Colombo/Nov04/2019)