Economics whiz kid Aseni and her Ex-Finance-Ministry-Official Grandpa, Sarath Mahatthaya, have been in conversation on currency board systems as a substitute for central banks. They have discussed that Ceylon had a currency board system during the colonial time, that currency board had been in existence from 1884 to 1950, it had done a good job of stabilising domestic prices and the exchange rate, things have changed after the Central Bank was set up in 1950, and the case for currency boards as presented by the modern-day crusader Steve Hanke. In the present episode which is the last in the series, they discuss the burning issue of whether the Monetary Board of the Central Bank has failed the nation and whether Sri Lanka should go for a currency board system today.
Aseni: Grandpa, at the Committee On Public Enterprises or COPE meeting last week, the Central Bank Governor and the two Monetary Board members present had made a startling revelation. They had said that there had been unwarranted external interference in the work of the Central Bank, Governor and two other board members had acted to please the political masters and refrained themselves from taking correct action in time. This irresponsible behaviour by the top management of the Central Bank has driven Sri Lanka to the present crisis unprecedented in its history. Does this make the case for a currency board stronger?
Sarath: That revelation has pointed to a fundamental weakness in the present central banking system which we discussed last week. That is the danger of the discretionary powers given to a central bank to increase the stock of money at its will. The purpose of giving that power was to facilitate liquidity infusion to an economy if there was a need. But the central bank top leadership was required to use this power prudently always keeping in mind their main responsibility to the people. That responsibility is to keep the value of money they hold at a stable level meaning a near zero inflation rate on the domestic front and a stable exchange rate on the external front. But what has happened in the past, throughout its existence, the Central Bank has failed to keep this promise. For instance, the value of a rupee in 1952 is only less than a fraction of a cent at end April 2022. The promise of a stable exchange rate has been the biggest failure.
In 1950 when the Central Bank was set up, a rupee was equal to 21 US cents. At end April, it is only a fifth of a US cent. But this failing process was accelerated after Gotabaya Rajapaksa became President in November 2019. The revelations at the COPE meeting were relevant to this period. It was the story of the imprudent and unaccountable behaviour of the top leadership in the Central Bank. Hence, we may pass the judgement that we now live in an era in which people have lost faith in the Central Bank and are now looking for a better alternative.
Aseni: You say that people have lost faith in the Central Bank. Why do you say so?
Sarath: I have witnessed the proceedings of previous COPE meetings as an official of the Ministry of Finance. At all these meetings, the Chair of COPE and Government members took the side of the Ministry and maintained that the Central Bank should provide funding to the Government liberally. They held the view that the Central Bank functions under the sovereign state and, hence, it should work under the direction of the state. I have seen the Central Bank officers fighting valiantly for maintaining its independence. But in my view, the Central Bank working under the sovereign government is due to the misunderstanding that the sovereign state and the government are one and the same.
It is the state which is sovereign and not the government. Both the government and the Central Bank are two arms of the sovereign state created for a purpose. The Government has been created under the Constitution, while the Central Bank has been created under the Monetary Law Act, commonly known as MLA. The purpose of setting up both these institutions has been to provide services to people in collaboration with each other. Neither was expected to superimpose its power or authority on the other.
However, the previous Governor W.D. Lakshman maintained that the Central Bank was a state institution and, therefore, it should obey the instructions of the government identifying both the government and state as one and the same. But the COPE Chair had brought to the attention of the members that the fiscal policy coming from the Government should not override the monetary policy being implemented by the Central Bank. That is a good sign, and it actually seeks to establish the independence of the Central Bank.
Another important step taken by COPE is to recommend to Parliament that a special select committee should be appointed to examine the failure of those who had either not taken the decision at the correct time or who had taken the wrong decision and assign accountability to those officers. This is the first time the COPE has made such a decision. It itself shows that they have lost faith in the Central Bank in the past. If COPE does not have faith in the Central Bank, what can you say about the public?
Aseni: What this means is that even when the Central Bank is made independent of the Government, its discretionary power is its worst enemy. That is because it permits the top management of the Bank to abuse that power either for the benefit of their political masters or for their own benefit. Am I right, Grandpa?
Sarath: Most people object to currency boards because they think that it causes them to lose what they call monetary sovereignty. That is because currency boards take the discretionary power away from them. Instead, they allow money supply to be increased according to a rule. That rule, as we have already discussed, requires the currency board management to issue currency based on the reserves it has. If they do not have reserves, they cannot issue new currency. This rule based monetary expansion is considered preferable to discretionary monetary expansion because it cannot be abused.
The claim that the Central Bank should have this discretionary power to provide liquidity to the economy is a misnomer. Even under the currency board systems, as we have discussed earlier, commercial banks can create liquidity by maintaining a reserve less than the total deposit liabilities of banks. The abuse of that power by commercial banks can be prevented by having a strong regulatory mechanism for banks.
Aseni: The new Finance Minister Ranil Wickremesinghe has announced that he has to print new money to the tune of Rs. 1 trillion to pay salaries to public servants. Is he counting on the discretionary money printing power of the Central Bank?
Sarath: You are correct. What he says as money printing is the credit granted by the Central Bank to the Government. The procedure is that the Central Bank will buy Treasury bills worth of Rs. 1 trillion and supplies that money to the Ministry of Finance which in turn can use that new money for making payments. This is a dangerous suggestion.
The book value of Treasury bills held by the Central Bank as at the third week of May has amounted to Rs. 1.8 trillion. If another load of Treasury bills amounting to Rs. 1 trillion is bought by the Central Bank, the outstanding value will rise to Rs. 2.8 trillion. This will increase the total reserve money issued by the Central Bank from Rs. 1.3 trillion today to Rs. 2.3 trillion over the next few months. It is this reserve money which is being used by commercial banks to create additional deposits and credit.
The present rate of creation is that when the Central Bank creates 1 rupee as reserve money, commercial banks can create Rs. 8 as money being used by people. As a result, if the reserve money base increased to 2.3 trillion, the total money in the system will go up to Rs. 18 trillion over the next one to one and a half years. This is a monetary explosion of about 60% over the present explosion of 53% and it is highly inflationary. The chance of this extraordinary monetary explosion is that the present galloping inflation might accelerate to hyperinflation. Hence, the course of action which the new Finance Minister is going to take is a recipe for disaster.
That has been made possible because the Central Bank’s Monetary Board has been given discretionary powers to increase the money stock at its will. A currency board which should issue money according to the value of reserves it is holding cannot do this and hence cannot be the causal agent of this disaster.
Aseni: Doesn’t the Prime Minister with his experience as the premier for five earlier times know of the danger of printing money and meeting government expenditure programs? What are its repercussions?
Sarath: Surely, he should know. If he does not know, he should seek the advice of experts on the matter. Its repercussions are far-reaching. In the first place, it will cause the present galloping inflation to accelerate to hyperinflation. Sri Lanka’s inflation is still galloping because like a horse jumping from one point to another, inflation is also jumping from one level to another. We are not yet at hyperinflation because, by definition, hyperinflation is a situation in which prices go up by at least 50% per month. If it happens for 12 months, at the compound growth rate, it is about 6,500% per annum. If the country is hit by hyperinflation, that will be the end of the present monetary system with rupees as the medium of exchange. Then, there is an impact on the real economy too.
The Monetary Board, in order to remove inflationary pressures, will tighten its monetary policy by increasing interest rates and possibly imposing credit controls. It will cut the economic growth further down which has been marked as a massive shrinkage in 2022. The biggest disaster will occur in the exchange rate. It will put further pressure for the rate to fall and drive the economy toward a bigger balance of payments crisis. Overall, Sri Lanka’s macroeconomic stabilisation program will be at risk. It will thwart its ability to seek a bailout package from IMF. So, money printing will bring cheers today, but tears tomorrow.
Aseni: What this means is that the Monetary Board has a grave responsibility to stop this before it becomes a disaster. But as it was revealed at the COPE meeting last week by two board members, their voice was silenced by the majority decision makers at the Board led by the Governor of the Bank. Given this situation, can the Board function as a responsible body to protect the value of money which people are holding?
Sarath: The position taken by the two board members that they were overruled by the majority votes at the Board is not correct. Ever since the Monetary Board was set up in 1950, its tradition was to have consensus in its decision making. Even if one member objects to a particular policy suggestion, the Board does not approve of it. Hence, any dissenting member can prevent a contentious decision being taken by the Board simply by expressing his or her objection to it. Following this rule, the decisions of the Monetary Board are recorded as Board’s decisions. The dissenting views are not recorded in the minutes.
Therefore, once a decision is made, it is a decision of the Board, and one or two members cannot say later that they were not a party to that decision. They are all accountable jointly and severally for the decisions made by the Board. If their objections have been overruled continuously by the Governor or the Finance Secretary or any other Board member acting in concert, as responsible board members, they should have resigned. There are several previous examples of board members acting responsibly in that manner when pressure was exerted on them by outside authorities.
Aseni: OMG! What this means is that there is a serious deficiency in the governance structure of the Monetary Board. The Board is expected to function as an independent body of experts to protect the financial assets of the people. But if they become a yielding hand to some invisible powers outside and drive a country to total bankruptcy, there is no redress for people. This was evident when Governor W.D. Lakshman at every forum thanked the Secretary to the President for appointing him to the post. People outside made the judgment that he was acting on the instructions of that particular high official who has no authority to do so. As such, people have now lost confidence in the Monetary Board. This may be the reason for the growing demand for returning to a currency board system today. Am I correct, Grandpa?
Sarath: Yes, indeed. The Monetary Board with its discretionary power to produce money has failed the nation. Instead of functioning prudently, its members, as has been revealed at the COPE meeting, have acted in concert with outside powers. Since, this cannot be stopped by having protection laws, the demand today is that this discretionary power should be taken out and a rule-based money issuing system should be started. That is why this sudden love for currency boards. But the establishment of a currency board today replacing the present Central Bank is not an easy task.
Aseni: Why do you say that it is not an easy task?
Sarath: Due to several reasons. The present Central Bank is bankrupt with its foreign reserves becoming negative on a net basis. That negative level had been $ 4.4 billion as at end-March 2022. The figures for later months have not been released but it is now estimated to have increased to about $ 5 billion. In addition to this negative foreign asset position, the Central Bank’s reserve money level is at Rs. 1.3 trillion or $ 3.6 billion. So, to build the necessary capital base of the new currency board, about $ 8.6 billion need be infused. Sri Lankan Government does not have space to do this. Hence, though a currency board is desired, to provide the capital to this board is an impossible task.
One way to avoid this impasse is to liquidate the present Central Bank, hand over its foreign liabilities to a special unit called a Special Purpose Vehicle or SPV and repay it over a period. A similar procedure was adopted in the Philippines in 1993 when the Central Bank of the Philippines became bankrupt due to excessive foreign borrowings. Those loan proceeds were used by the Bank to keep the Peso rate fixed arbitrarily just like our own central bank. A new central bank called Bangko Sentral ng Pilipinas was established but the liabilities of the old central banks were transferred to an SPV which was required to repay it within 25 years.
This course will be unavoidable if the Government goes on borrowing from the Central Bank Rs. 1 trillion to pay salaries to public servants and the Monetary Board chooses to accommodate that request by being a yielding hand to the impending disaster. So, it will be the failed Monetary Board which will be its own destroyer and pave way for a currency board in Sri Lanka.
Part I of this article was published in the Daily FT on 2 May and can be seen at https://www.ft.lk/columns/A-child-s-guide-to-currency-board-systems-Part-I-How-colonial-Ceylon-did-it/4-734214.
Part II, published on 9 May, can be seen at https://www.ft.lk/columns/A-child-s-guide-to-currency-board-systems-Part-II-The-performance-of-Ceylon-s-currency-board/4-734539.
Part III, published on 17 May, can be seen at https://www.ft.lk/columns/Child-s-guide-to-currency-boards-Part-III/4-734878.
Part IV, published on 23 May can be seen at https://www.ft.lk/columns/Child-s-guide-to-currency-board-systems-Part-IV-Prof-Steve-Hanke-s-crusade-for-currency-boards/4-735168
(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at email@example.com.)