By David Whitehouse
A return to currency board system is the best way to help Sri Lanka escape its never-ending cycle of debt, says Steve Hanke, professor of applied economics at John Hopkins University in Baltimore.
The economic crisis in the country is a “slow-motion train wreck,” says Hanke, who in the 1980s served on US President Ronald Reagan’s council of economic advisers. The solution, he argues, is to adopt a currency board, such as that which existed in Sri Lanka, then Ceylon, from 1884 to 1950.
Sri Lanka in April started talks with the IMF in April after defaulting on its external borrowings for the first time. Widespread shortages of essentials such as food and medicine have led to nationwide protests which in some cases have turned violent. Rating agencies S&P, Moody’s and Fitch have all downgraded the country’s debt.
The country has had 16 IMF programmes. Those programmes have failed because the central bank is unable to provide the discipline that the economy needs, Hanke says. He points to the country’s most recent economic crises in 2012, 2015-16 and 2018. “In each case, the central bank has been a culprit, either playing a starring role or as an accomplice.”
Currency boards, Hanke argues, are the only way to break the cycle. The main difference between a currency board and a central bank is that a central bank can hold domestic assets such as government debt. This allows it to influence the money supply by buying or selling such assets.
A currency board has no discretionary monetary powers and cannot issue money. Likewise, it cannot act as a lender of last resort or extend credit to the banking system. There is still an exchange-rate policy under a board, as the currency is anchored against a reserve currency, in this case the dollar. But monetary policy is essentially abolished. The currency board’s only job is to exchange its domestic currency for an anchor currency at a fixed rate.
‘Golden Growth’ rate
The IMF’s World Economic Outlook forecasts for 2022 released in April project Sri Lankan CPI of 17.2% this year, falling to 9.5% in 2023. Real GDP growth will slow to 2.6% in 2022 from 3.6% in 2021. The bank sees little reason to expect a longer-term acceleration, with growth in 2027 seen at just 2.9%.
Those inflation figures are far from capturing the true picture, Hanke argues. His measure of inflation for Sri Lanka, calculated using the purchasing power parity (PPP) model and free and black-market exchange rate data, shows inflation running at an annual 74.5%.
Hanke argues that inflation is, always and everywhere, a monetary phenomenon. If central banks print too much money, then inflation is the inevitable result. Hanke seeks to show how much is too much by calculating the “gold growth rate” for money supply. This is the rate of broad money growth for 2010 to 2019 which would have allowed Sri Lanka’s central bank to meet its inflation target.
Hanke arrives at a golden rate of 15.8%, which is very close to the actual average growth rate of M3 money supply of 15.5%. Average annual inflation in Sri Lanka from 2010 to 2019 was 5.2%, only marginally above the inflation target of 5%. The picture changes when Rajapaksa took power in November 2019. M3 growth accelerated, peaking at 23.8% in February 2021 and exceeding the golden-growth rate until October.
The poor are those who suffer most for inflation as they have less flexibility to protect their already weak purchasing power. The World Bank estimates that 11.7% of Sri Lanka’s population earn less than US$3.20 per day, a proportion which has increased from 9.2% in 2019.
A currency board is a good way to stabilise inflation in the short term, but in the long run, Sri Lanka needs flexible exchange rates, according to research from Asanka Wijesinghe, an economist at Sri Lanka’s Institute of Policy Studies. The main drawback of currency boards is that the flexibility to manage asymmetric shocks is lost, Wijesinghe argues.
That loss of flexibility becomes apparent when the country with the anchor currency faces conditions which are different from those in the country with the board. Wijesinghe gives the example of Hong Kong’s currency board, which imported low-interest rates from the US in the early 1990s. Monetary easing suited the US, but Hong Kong faced an asset price boom. If Sri Lanka goes into a currency board now, it needs to have an “exit strategy,” Wijesinghe writes.
Hanke denies that Hong Kong’s experience undermines the case. He argued back in 2002 that the Hong Kong in modern times has not had a genuine currency board. On this view, Hong Kong deviated from the required orthodoxy in the late 1980s by allowing the monetary authority to take on the features of a typical central bank. This was possible to detect as early as July 1988, and became obvious in 1993 when the monetary authority changed its name to the Hong Kong Monetary Authority (HKMA), according to Hanke’s 2002 article.
That, he wrote, meant that the Hong Kong merely had a central bank which mimicked currency boards. One result, Hanke argues, was that the Hong Kong dollar was avoidably caught up in the 1997–98 Asian crisis as speculators perceived a lack of commitment to the official parity with the US dollar.
For the real deal, Hanke argues, we have to go back to the nineteenth century. The first currency board was set up in Mauritius in 1849, although it only became explicitly backed by an anchor currency in 1864. Sri Lanka was known as Ceylon under British colonial rule, and established a currency board in response to the failure of the Oriental Bank in 1884. The move was seen by the British as a cheap, easy to administer way of supplying domestic money.
Such boards were later adopted in east and west Africa. More than 70 economies, mostly part of the British empire, operated under currency boards during colonialism. Part of the appeal was simply logistical. The natives were trading in a wide variety of currencies and other tokens, including shells. Currency boards meant that notes could be printed in the colony rather than shipped out. They were obviously in the interests of the colonial powers, as they eliminated any risk of investments depreciating in local currency terms.
But such “orthodox” currency boards have seldom been unwound for economic reasons. When they were ended, it was due to a global upheaval – the end of colonialism and the coming of independence. Every country was now entitled to use the same levers of monetary policy: there was no way this could be denied without appearing to be a neo-colonialist. This was regardless of a country’s economic conditions, or the state of its institutions, which had in many places been completely undermined or crowded out by the political processes of colonialism.
The boards are generally credited with having contributed to low inflation rates, though in statistical terms it is very hard to demonstrate the exact contribution of any particular factor. The Ceylon board issued notes convertible on demand into an anchor currency, Indian silver rupees, at a fixed rate. The rupee was itself linked to sterling, so Ceylon was on a hard sterling peg at one remove. The board held anchor-currency reserves equal to 110% percent of monetary liabilities, and could not loan money to the fiscal authorities.
The system lasted until 1950, when a central bank was created two years after independence. “The net effect was economic stability,” Hanke says. “While stability might not be everything, everything is nothing without stability.”
David Whitehouse is a freelance journalist in Paris.