ECONOMYNEXT – A currency board for Sri Lanka would automatically lead the country to low deficits (a severe budget constraint) and stability, US economist Steve Hanke says as the island faces runaway inflation due to money printing.
A currency board is a “fixed” or “credible peg” where the government or interventionist economists cannot devalue the currency through open market operations or finance the budget deficit, as purchases of treasury bills are prohibited .
Sri Lanka had a currency board from 1885 to 1950, with a fixed exchange rate of 1 to 1 with the Indian rupee in silver (India later switched to a gold standard).
The Sri Lankan Rupee has crashed from 182 in 2019 to 340 so far in 2022, economists have embarked on targeting the output gap (Keynesian stimulus) after also cutting taxes to further stimulate growth creation of a production economy with a developmental state.
In 2018, despite rising taxes, shrinking deficits, and the market price of fuel, money was printed mostly through overly aggressive open market operations (targeting the money rate at the day to day) as the output gap targeting the rupiah was reduced from 153 to 182 for the US dollar. .
In 2015/2016, the rupiah also fell from 131 to 151 thanks mainly to open market operations, but the breakouts were reached within a few months (stop-go policy) with rate hikes to limit the fall of currency and inflation.
Quantity theory of money
Using the Quantity Theory of Money (QTM), Hanke, who is a professor of applied economics at Johns Hopkins University in Baltimore, calculated a “golden growth rate” for Sri Lanka’s money supply for the period 2010-2019.
The QTM indicates that MV = Py, where “M” is the money supply, “V” is the velocity of money, “P” is the price level, and “y” is real GDP.
I then rearrange the QTM identity and solve for percent growth in “M,” which equals the inflation target (5%) plus the average real GDP growth minus the average percent change in velocity.
“According to my calculations, for the period 2010-2019, Sri Lanka’s golden growth rate was: 5% + 4.4% – (-6.4)% = 15.8%,” he said. stated in National Review, a US-based publication.
“For 2010-2019, the average money supply (M3) growth rate, which was 15.5%, was essentially the golden growth rate of 15.8%.
“This translated to an average inflation rate of 5.2% per year for this period, exactly on Sri Lanka’s average inflation target of 5% per year.
Obstruct the stimulus
However, money supply growth began to surge and peaked at 23.8% per year in February 2021.
“M3 growth exceeded the golden growth rate of 15.8% per year from August 2020 to October 2021. As a result, inflation is soaring,” Hanke said.
“What can be done to end the economic crisis in Sri Lanka? It should adopt a currency board. Ceylon established a currency board in response to the failure of the Oriental Bank Corporation on May 3, 1884.”
The Oriental Bank Corporation, one of two note-issuing banks that issued Ceylon rupees, collapsed and closed.
“At the request of Madras Bank and other businesses, the governor has proposed an issue of government notes so that the government can recoup its losses and prevent future trouble,” Hanke said.
“The Imperial Government reluctantly conceded. The Ceylon Paper Currency Ordinance (No. 32 of 1884), passed on December 10, 1884, and with this a currency board was established.
“Three commissioners—the secretary, treasurer, and colony auditor—oversaw the council.”
“Like all currency boards, the Ceylon Bank issued banknotes (from 5 to 1,000 rupees) convertible on demand into an anchor foreign currency (Indian silver rupees) at a fixed exchange rate.
“It held anchor currency reserves equal to 110% of its monetary liabilities. More importantly, the council could not lend money to the tax authorities, imposing a strict budget on Ceylon’s tax system.
“The net effect has been economic stability – and while stability may not be everything, everything is nothing without stability. That is why today, the reinstatement of the currency board of the Sri Lanka is exactly what the doctor ordered.
Sri Lanka abolished the currency board in 1950, as part of US-led efforts to break so-called “sterling area” pegs and establish dollar pegs in newly independent countries where reserves would be invested in US government debt.
The Maldives escaped the carnage as they were still under the British. The U.S. then flip-flopped after the Bretton Woods collapse and began pushing to break stronger pegs in East Asia, saying it had become export engines at the expense of the US trade deficit.
The retained carrot in the period immediately following World War II was that Ceylon would have “monetary policy independence” or the ability to print money to control rates and avoid balance of payments problems. . (Why the Sri Lanka Rupee is Depreciating, Creating Currency Crises)
Economists educated in Western Keynesian universities embraced the misconception with joy.
The promise proved hollow and social unrest ensued.
The country lost most of the 11 months of reserves that the central bank inherited from the currency board, exchange controls were slammed in 1952 (there is free trade and the free flow of capital in a peg hard).
In 1953 there was a “hartal”.
In 2022, there are many protests all over the country, the rupee having fallen to 340 per US dollar, the parallel exchange rates are higher. Headline inflation reached 21.5% in March 2022, as exchange rate effects have yet to be fully passed through.
Hanke says that on a purchasing power parity basis (read how it’s calculated here), Sri Lanka’s inflation is 74.5% a year. (Colombo/Apr24/2022)