ECONOMYNEXT – Sri Lanka is suffering the worst currency crisis in the history of its central bank, with the rupee halved in value, children suffering malnutrition, high interest rates, sovereign default and the banking system also taking a beating.
In an island where rule based monetary policy is viewed with disdain by policy makers and flexible or discretionary policy depreciation and mis-targeting of interest rates is revered, it is opportune to consider what the creator of the central bank said in hindsight.
John Exter created the central bank abolishing a Singapore and Hong Kong style hard peg in Ceylon at the request of the then Ceylon government giving a long list of reasons why a central bank was more appropriate than a currency board.
Exter in 1949
The supposed drawbacks of currency boards now claimed even by some present day economists – despite the malnutrition of little kids and out-migration from flexible central banking – was also detailed in Exter report.
The Report contained the standard US post-World WarII propaganda used to break the Sterling Area.
“The decision of the Governor of Ceylon to establish a central bank was a decision with far reaching implications for the people of Ceylon,” the report began.
“One implication already stands out very clearly; in taking steps to establish an independent monetary system to be administered by a central bank the government has demonstrated unmistakably its intention to achieve genuine economic freedom as a corollary of the political freedom achieved a year and half ago.”
“This type of system, therefor is a mark of colonialism,” he added for good measure, which may have been lapped up gleefully by the newly independent nation, little knowing that the public would soon be enslaved by draconian exchange controls, import controls and the import substituting robber barons.
The lofty ideal of ‘economic freedom’ however did not last long. A brand new exchange control law came in 1952 and in 1969 an import control law to deny economic freedoms to citizens.
“For a developing economy it has a number of serious disadvantages,” the report continued.
“The role of the Currency Board must remain purely passive; it cannot influence the money supply in any way and thus relieve the pressure to which rapid swings in the balance of payments may at times subject the economy.”
This claim is oft repeated.
“A 100 percent system is this a ‘fair weather system”,” he also claimed falsely.
A currency board’s value comes not in a fair weather system but protection from the worst type of economic storms possible.
By that time the currency board had already protected Sri Lanka during the Great Depression and two World Wars, from which both Singapore and Thailand suffered as central bank money was circulated by the Japanese.
“Under such a system banks are vulnerable, for without a Central Bank, they have nowhere to turn for help in case of need,” he added.
This criticism is only partially true, as Hong Kong and Singapore had easily solved the problem with overnight liquidity without a fixed policy rate. Also it is quite easy to set up a separate bailout fund with currency board profits if need be.
In practice however banks in currency board territories tend to be more prudent and manage with deposits largely avoid failure due to the inability to overtrade with CB window money.
The large liquidity shorts now found banks in Sri Lanka in 2022 due to giving loans with window money after reserves are sold for imports, are not found in currency boards.
To be fair in 1949 that was the prevailing Keynesian, Latin American dogma. Sri Lanka’s central bank was built on a blueprint devised for Latin America by Robert Triffin, the head of Fed’s Latin America division before World War II.
The US was intent after World War II on getting as many countries as possible to join its dollar pegged Bretton Woods system.
Exter in 1968
However a few years later Bretton Woods itself was under pressure from US monetary activism. In 1968 – a year before Sri Lanka enacted the Import and Export Control Law and around the time that official parallel exchange rates were – Exter had visited Sri Lanka.
In the publication Central Bank of Sri Lanka in Retrospect, a lecture he delivered at the Institute of Chartered Accountants is detailed.
In the Ceylon leture he was quoted as saying that creating excess credit by the central bank was “bound to cause inflation, balance of payments difficulties and generally unstable conditions.”
“Mr Exter said Ceylon could benefit greatly from the example set by several small countries in the area such as Malaysia, Singapore and Thailand,” the news report said.
“Hong Kong was the most remarkable economic in the world – its population had risen from 800,000 to four million in the past 20 years or so and yet there was no unemployment, wages had risen in the sixties by 75 percent while prices were kept at a low level.
“There were no exchange or trade controls of any significance in this small ‘city states’ exported almost as much by value than India, a nation of over 500 million.
“The thing about Hong Kong and Singapore was there were no Central Bank like institution and monetary policy was determined by what he called ‘market conditions’.
“There were no organization which could disturb the stable dynamism of the economy by introducing control by resorting to deficit financing.”
He had also criticized the monetary policies of the US, the report said.
By this time Exter had predicted the collapse of tthe US dollar and had in fact started collecting gold eagle coins according to an interview given to Franklin Sanders, the founder of the Liberty Dollar.
“I should not say that I rejected Keynesianism right away,” Exter told The-Money Changer many years later, a publication linked to Franklin Sanders, who founded the Liberty Dollar.
“I had it pumped into me in those early years and actually taught it in the entry level economics course at Harvard. As the years wore on I became more and more sceptical.”
Barely three years later the Bretton Woods soft-pegs lay in ruins.
Fear of floating and currency board phobia
While Exter had changed his views, it was too late for Sri Lanka.
“…[I]n May 1968, Ceylon implemented a dual exchange rate (FEECS) that was commonly used in Latin America with tacit acceptance of the IMF,” top economist Saman Kelegama wrote in a summary of memoirs of Gamani Corea, a Sri Lanka planner and central banker.
“The Fund was not entirely happy but approved it by saying it was ‘a wrong step in the right direction’.”
In 1969 an import and export control law was enacted, the Dudley Senanayake administration’s attempts to open the economy was at an end.
Sri Lanka’s open economy was closed and the roots of two uprisings in the North and the South was to be laid shortly after.
Neither Washington based policy-makers nor Sri Lanka’s have changed their views even now.
Consistent single anchor regimes are viewed with fear and macro-economists cling to unstable intermdiate regimes which are prone to collapse and external default. There is both ‘fear of floating’ and ‘currency board phobia’.
Deep in the grip of Latin America disease, the country has defaulted, poor children are starving and another ‘flexible’ and ‘discretionary’ monetary law in line with ‘fear of floating’ and ‘currency board phobia’ is planned under an IMF program.
This column is based on ‘The Price Signal by Bellwether‘ published in the November 2022 issue of the Echelon Magazine. It is updated with recent data and the impact of the relief package. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link.
To reach the columnist: BellwetherECN@gmail.com
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(Colombo/Dec14/2022 – Update II)