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Monday November 29th, 2021

Too late for Sri Lanka currency board, tool to control central bankers, politicians: Wijewardena

ECONOMYNEXT – It is now too late to convert Sri Lanka’s soft-pegged central bank into a credible currency board (hard peg) which brings discipline to politicians and central bankers as too much foreign reserves have been lost, W A Wijewardena, a former Deputy Governor of the agency has said.

“The currency board is the best for a country which has a chaotic monetary and fiscal situation,” Wijewardene said in an online forum hosted by Advocata Institute, a Colombo-based think tank.

“Because the currency board will introduce discipline to political leaders as well as those in the central bank and also the members of the public.”

Credible Mechanism

A currency board is legally barred from buying domestic assets and cannot buy Treasury bills to operate policy rates and will automatically discipline the rate setting monetary board.

It can neither buy Treasury bills to push up excess liquidity nor can it fill liquidity shorts from interventions (sterilize any forex sales).

A currency board also cannot mop up liquidity from bought dollars and prevent interest rates from falling to low levels close to zero (sterilized purchases) and build up large forex reserves.

The currency board rule will bring discipline to a central bank whose rate setting monetary board will no longer be table to delay rate corrections by printing money and boosting imports above foreign receipts, giving various excuses such as that part of the inflation was cost-push (supply constraints).

Because money is not injected, the public cannot import anything more than the inflows of dollars, or remit out in exactly the same way as a country that is dollarized without altering bank rupee reserves and raising interest rates, giving free capital mobility.

Sri Lanka is dollarizing a Colombo Port City area to liberate it from depreciation and exchange controls.

If the budget deficit goes up in a currency board, rates go up, perfectly crowding out private credit, keeping the exchange rate fixed and any failed Treasury bill auctions will signal default clearly, teaching politicians and stimulus-happy bureaucrats a lesson (a hard budget constraint).

Under a currency board default in domestic bond auctions cannot be hidden from the public and translated into currency depreciation and forex shortages without a central bank to buy Treasury bills and create excess rupees.

Without the hardships of high inflation (cost of living) and currency depreciation, calls for subsidies and government support disappear as happened in East Asia.

When the central bank was created in 1950 from a currency board, Sri Lanka had foreign reserves of 11 months and interest rates Treasury bill rates were 1.4 percent.

No reserves

“But right now we cannot go back to a currency board, because the central bank of Sri Lanka has a huge asset base which has not been backed by foreign exchange reserve,” Wijewardene said.

The central bank has acquired domestic assets (Treasury bills) running into a trillion rupees injecting unprecedented volumes of rupee notes (which are zero coupon liabilities) under so-called Modern Monetary Theory over 2020 and 2021.

The soft-peg has lost close to five billion US dollars in forex assets as the extra note issue (excess liquidity) was redeemed against a peg (weak side convertibility undertaking).

There have been outright reserve appropriations also to repay sovereign bonds for which book entry domestic asset purchases were made. (Sri Lanka’s Rs213bn money printing to repay foreign debt: Treasury Secretary explains)

The central bank’s note issue (the monetary base) was 1.07 trillion rupees in June and net foreign assets the equivalent of 306 billion rupees in June. Sri Lanka’s monetary meltdown will accelerate unless quick action is taken: Bellwether


By July net foreign assets would fall to very low levels analysts have said.

Analysts who closely track the central bank have warned against looming quasi fiscal losses when foreign liabilities exceed assets.


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A Reserve Handout

To create a credible currency board, some benevolent person will have to give billions of dollars to cover the existing monetary base.

“So if we are to convert Sri Lana’s central bank into a currency board today one thing we have to do is to infuse new dollar balances to central bank holdings,” Wijewardena said.

“That we cannot do unless we are being supported by some foreign country. China will give us 10 billion US dollars and we would be able to move back to a currency board.”

IMF has given a free 800 million dollar reserve asset which can potentially be used to create a currency board, through strictly speaking special drawing rights are not net foreign assets as the SDR holding (assets) is balanced by an SDR allocation (liability).


IMF allocates new SDR tranche, Sri Lanka to get US$800mn equivalent

To create a currency board at 250 to the US dollar with a 20 percent haircut about 5 billion US dollars would be needed, analysts say.

Wijewardena said from 2001 to 2004, through central bank reforms an attempt was made to mimic a currency board.

Most high performing East Asian nations (other than Hong Kong, Macau, Brunei, which have true currency boards and Singapore which has a modified one with an appreciating peg) operate systems which are tighter than currency board with foreign reserves in excess of reserve money.

Sri Lanka has been battered by a so-called ‘exchange rate flexibility’ advocated by the International Monetary Fund, involving ‘now-you-give-convertibility-now-you-don’t-policy’ unlike credible consistent convertibility that is available through unsterilized interventions of a currency board.

When all else failed in Argentina the IMF had also allowed a currency board rule for unsterilized interventions for what was quaintly called a disorderly market conditions (DMC) outside a ‘non-interventions’ zone in the latest (2018) monetary collapse.

“In the event the currency were to move outside of this zone, the BCRA would have the option (but not a commitment) to announce a competitive auction to either buy or sell up to US$150 million per day,” the IMF said in its 2018 program giving into ‘fear of floating’, soft-peggers are well-known for.

“The central bank is committed to ensuring that all FX purchases/sales are unsterilized, which would result in an expansion/contraction of base money (i.e. base money would grow at a faster/slower rate than the announced monthly targets).” (Colombo/Aug27/2021)

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