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Chilling Sri Lanka central bank forecast comes true 59 years later: fuss-budget
07 Jul, 2009 12:08:58
By Fuss-Budget
July 07 2009 (LBO) - As Sri Lanka leaves behind its latest balance of payments crisis, and perhaps the highest inflation in its history, it may be a shock for some to discover that all this was predicted in a remarkable essay written 59 years ago this July.
Most readers of The Thrift Column by fuss-budget are now familiar with the way Sri Lanka's monetary law has made it very easy for the state to mis-use the central bank as a 'cookie jar' to print money and drive inflation up or cause balance of payments crises.

The recent calls for reform of the central bank, or its abolition in favour of a currency board regime, came in hindsight after seeing the Central Bank in action.

Chilling Forecast

But in a chilling forecast made 59 ago, in The Banker magazine of July 1950, the traps the Central Bank later fell into were predicted in an extraordinarily accurate essay titled 'Ceylon's Central Banking Experiment.'

Before the central bank was set up in 1950, there were no high inflation or balance of payments crises in Sri Lanka.

It was not possible to have a balance of payments crisis, because Sri Lanka had a currency board as part of the 'Sterling area'. The Sterling area itself was however under controls due to money printed by the anchor Bank of England to finance World War II.

Under an orthodox currency board or 'fixed exchange rate', all money is created out of foreign inflows, or the acquisition of net foreign assets (NFA), as central bankers say. The exchange rate is fixed and cannot be broken, because no money is printed domestically to put pressure on the exchange rate.

In 1950, the then finance minister J R Jayewardene established a central bank with money printing powers, with the help of John Exter, a Federal Reserve official.

That set off a chain reaction of expanding government, high inflation, price controls, black markets, balance of payments crises, exchange controls, import controls and import substitution that - ironically - Jayewardene himself had to start unraveling 27 years later.


"The law has been drawn up under American tutelage and along the lines that have been the subject of experiment is certain Latin American countries for some eight years past," said the opening lines of The Banker analysis of the underlying monetary law that would later govern what came to be called the Central Bank of Ceylon.

"The step from an "automatic" currency system (such as that Ceylon inherited with its old Colonial Currency Board) to an ultra-modern "managed" currency system is necessarily fraught with great dangers and there may be some who will regret that Ceylon has decided to run such risks at this time," the author said.

Prophetic words indeed.

The misery spread by pegged exchange central banks was much worse in Latin America than even in Sri Lanka. The suddenness with which balance of payments crises can strike - even with good fiscal policy - was shown during the East Asian crisis.

The arguments against currency boards - promoted by US economists as readers will see later - were fairly straightforward. A key 'problem' identified in such a regime was that an external boom could create a domestic bubble and an external bust created a domestic bust.

The local monetary authorities could not do anything to counter the cycle (though fiscal authorities could). They had to wait till the anchor currency country - for example Britain if the anchor was Sterling - to get its own or global economy, back in order.

In short, a currency board could not sterilize the balance of payments by printing money, or fund deficits to 'stimulate' an economy.

The Banker analysis put it this way. It said the monetary authority was "equally impotent to neutralize the gluts or shortages caused by rapid swings in the local balance of payments as it is when faced with appeals for more credit to meet the needs of an expanding economy."

"These complaints against the Colonial currency system are not of course new, and it may be that critics of the system customarily overstate their case;" the author pointed out with remarkable foresight, "in particular they generally exaggerate the potentialities of expansionary monetary policies in such countries as Ceylon."

But newly independent Sri Lanka was not willing to listen to these wise words. The country wanted to go on the express train to 'growth'.

Now, Sri Lanka is suffering due to the problems created by the anchor US dollar currency, and the country is equally helpless to run 'counter-cyclical' policy as it was before. What we have instead, is a debilitating balance of payments crisis on top of an economic slowdown.

The rot

A cursory glance at the final pages of the Central Bank's 2008 annual report shows that the rot set in with frightening rapidity.

Under a currency board, foreign reserves are always greater than the domestic monetary base (reserve money). That is how a balance of payments crisis is avoided. The currency board always has foreign assets to meet its domestic monetary liabilities and no new liabilities (printed money) are created during an outflow.

Sri Lanka's foreign reserves which were 190 million US dollars in 1950 had fallen to 163.8 million just two years after the creation of the central bank.

Expressed in rupees, the 1950 monetary base was 533 million rupees, and foreign reserves were higher at 552 million rupees. By 1952 reserve money was 522 million rupees, and foreign reserves were much less at 400 million rupees.

In 1952 the budget deficit was 6.0 percent of gross domestic product. National debt which was 16.9 percent of GDP in 1950 was 23.2 percent and climbing. Except for two years, we have since never looked back from these deficits.

Failed Experiment

The Central Bank had three aims, a) stabilizing the domestic value of the rupee (controlling inflation), b) preservation of the par value (and the free convertibility) of the Ceylon rupee (controlling the exchange rate) and c) the promotion of growth.

In theory a) and b) seem to be possible. If inflation and money supply is controlled, keeping the exchange rate stable should be child's play. But if 'growth' is also put into the equation, which politicians believe requires money printing, neither a), nor b) is possible.

Further, once printing has started, there is no way to arrest the slide, except by depreciation. Defending a peg once a currency crisis has started only makes the situation worse, as we saw in excruciating detail during the 2008/2009 crisis.

In recognition of this, the second goal was dropped from Sri Lanka's monetary law in a subsequent reform, decades later.

The new central bank also had no requirement to hold foreign assets as a minimum percentage of the domestic monetary base.

If it did, as Exter had pointed out in a special memorandum, the very purpose the Central Bank was set up for - to sterilize the balance of payments - could not be done, The Banker said.

This explains why even to this day, Sri Lanka's central bank persists in sterilizing the balance of payments and tries to hold pegs and creates balance of payments crises in the process.

The great Exter, it seems, had decreed it so!

Though this columnist is a firm admirer of Exter and his accurate prediction of the current deflationary collapse of the global economy, this is something he and the Federal Reserve got fundamentally wrong at the time. Exter only realized the problems later.

Unlike other modern central banks, the third (growth) consideration is still there in Sri Lanka's central bank in an indirect way.

It is also there in the Federal Reserve (the so-called dual mandate) and that is a core cause of the global economic bubble and subsequent meltdown we see today.

After the establishment of the Central Bank of ceylon, the rupee-dollar peg was defended with exchange controls, meaning there was no free convertibility of the rupee. Sri Lanka later not only had ever-tightening exchange controls, but also imports controls and eventually a 'closed economy' in the 1970s.

Rather than promoting growth then, Sri Lanka's central bank became the key agent of economic contraction. It was also the source of currency instability that reduced the economic freedom of the people - especially to trade freely with other countries - a freedom enjoyed by the citizens of the island since the time of ancient kings.

Sri Lanka's central banking experiment had failed miserably.

Blissful ignorance

Surprisingly there was no attempt to reform the Central Bank, until governor A S Jayewardene came to office in the 1990s. Even he did not go all the way.

But there was more in The Banker prediction.

The original proposed monetary law, according to the author, contained a provision whereby "when various economic signposts of economic strain flash red" the monetary authority was could take counter action or issue a report explaining why it did not do so.

"Useful though this provision may be, such publicity is perhaps unlikely, in a country such as Ceylon, to provide any sure guard against imprudence in such highly technical matters," the author noted.

In a nice way the author was saying, that in a country populated by a bunch of ignoramuses there would be no one to question monetary policy, which was considered a big and complicated economic mystery.

Sad but true.

Milch cow

The Banker also dealt with the final problem, which has now attracted so much attention, the issue of 'provisional advances' or straight legalized money printing to finance the budget.

The author comments, that to avoid the trap of "becoming the milch cow of an improvident government" as "so many central banks of developing economies have become in the past," some safeguards were put in the proposed monetary law.

One safeguard was that a cash advance must only be "provisional". The duration should not be more than six months and the total outstanding must not exceed 10 percent of the estimated revenue of the government in that year.

"This is a novel and interesting limitation, although it is not even a technically watertight safeguard against Government misuse of the central bank," the author commented with deadly foresight.

"So long as open market purchases of Government securities are allowed (as, of course, they must be) it is very difficult to prevent these becoming an indirect means of making central bank credit available to finance Government deficits."

Not only was this prediction remarkably accurate, the requirement for paying back the 'provisional advance' had never been followed. In fact the auditors of the Central Bank in 2008 have commented on the fact.

The 'provisional advances' have not only grown year after year, but they have become 'permanent advances' in violation of the original law's intentions.

The author says the original law prohibited the "subscribing to new issues of government stock".

It would be interesting to find out if this prohibition is still in place.

Down the years then the Central Bank has violated its own constitution, created high levels of inflation, created balance of payments crises, and retarded the country's growth and taken away the economic freedoms of the people of this country.

There seems to be a prima facie open shut case if someone wants to pursue the matter in courts.

Monetary Skullduggery

How the USA came to advise countries like Sri Lanka, Philippines and so on, to set up unstable dollar pegs is another story of monetary skullduggery.

After the Second World War, the US had 60 percent of the gold reserves. The US wanted to set up a system of dollar pegs and earn the seigniorage in the same way that the Bank of England was earning through its 'Sterling area' currency boards.

A pegged central bank will buy anchor currency government debt, giving freebie captive money. The US also wanted to break into the Sterling area free trade and create a dollar trade area.

Most European central banks, especially Bank of England, had lost their gold reserves after World War II, and their economies were devastated.

The man who led the dollar peg campaign was Harry Dexter White, a monetary economist from the US Treasury's international division.

(Interestingly, one of White's plans was to reduce Germany to an agricultural economy after the war, to make sure that it did not raise its head ever again, like we are trying hard to do in Sri Lanka now.)

At the time Keynesianism was riding high. White had also been involved in loosening policy to get out of the Great Depression.

Keynes, the principle negotiator for Britain, wanted a new currency, the 'Bancor'. But he died after the first Bretton Woods meeting. Britain - and Europe - lost the plot. White's plan of dollar 'fixed exchange rates' prevailed.

Poisoned Carrot

To bribe countries to break Sterling currency pegs, the tantalizing prospect of 'sterilizing' the balance of payments, discount windows, the lender of last resort to prevent bank collapses - in effect all the carrots described by John Exter - were dangled in front of greedy politicians.

All this and stable exchange rates too!

State expansionist politicians fell for it. But of course it was a pipe dream.

It is clear that the architects of the Bretton Woods knew that the 'fixed exchange rates' were not possible.

They knew that without a currency board (i.e. a process where only the exchange rate is targeted and not interest rates) it was not possible to 'fix' exchange rates and the pegs had to break. Politicians will print money without restraint given the opportunity.

That is why the International Monetary Fund was created to 'bailout' printers and peg breakers. Under orthodox currency boards, no IMF is needed.

Ultimately even the US was not proof against it own system. After printing money for the Vietnam War, the US went off the gold standard and into floating rates in 1971-73 creating the first oil shock and bubble. The Fed did it again in 2007/2008.

But the US benefited enormously.

Not only did trade shift to the US from the Sterling area, but an unexpected bonus came in the form of countries like China, and the Middle East, which built up foreign reserves bigger than their monetary base, at the expense of their own economy.

Singapore and Hong Kong avoided building excessive reserves through currency board type arrangements and overtook China rapidly. They also maintained stability, allowing their economies to grow steadily.

Now suddenly, countries like China are seeing the light. So is Brazil. India is ahead of them all and partway to full floating. In this crisis, the Reserve Bank of India came out on top.

The Euro, is also gaining credibility.

The US Treasury Secretary meanwhile is rushing like a headless chicken around the Middle East and China to stop floats or currency boards/pegs with the Euro.

Developed nations with more knowledge saw the light much earlier in 1971-73 and floated. Australia and New Zealand saw the light in the late 1980s early 1990s.

When will Sri Lanka see the light?

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5. Rukshan Jul 08
Similar discussions is on at:
where Robert discuss how US banks are shaving money and how the Fed is leading a big band of Banking family cartel.
4. fuss-budget Jul 07
More details on now current CB and monetary board tried to make Sri Lanka's central bank more currency board-like is outlined in the story below.

Sri Lanka central bank is like a currency board: official

Ironically the story had been published in September 2008 just as the Central Bank was stepping into the current balance of payments crisis. It warned that as long as the capacity to sterilized was there, a balance of payments crisis was likely.

One way to tackle is to force a float after reserves fall to say 85 percent of the monetary base. Also there has to be provision to stop collecting reserves above say 115 percent.

Or to transfer the money to a fiscal reserve which can be used to settle foreign loans etc. That stop compulsory savings imposed on private sector players by contractionary sterilization and also make the government's creditworthiness its own business.

That way fiscal bankruptcy and the currency will be separated. If foreign debts cannot be paid back, the government will go bust, but neither reserves nor the exchange rate will be affected.

The burden will be passed to the lenders, and both sides will be more cautious in the future.

Unfortunately currency board - like is not the same as an orthodox currency board, as some Eastern European nations are finding it to their cost now.

3. fuss-budget Jul 07
Very true. The US Treasury built the IMF and runs it to this day. Harry Dexter White was the first US executive director and also acted as its managing director because there was no one else at the time.

A home and home operation!

Of course now the IMF helps countries that are pegged to other currencies like the Euro also.

2. WAW Jul 07
This is an eye-opening essay. Having realised the folly of allowing the Central Bank to fund the government without restraint,the Bank officials in the new modernisation programme, attempted to set up a virtual currency board system within the existing central bank framework.

According to this strategy, the Bank was to build its internal reserves equivalent to hundred percent of the domestic assets so that all the moneys it has issued would be covered by foreign assets, a virtual currency board system !

The Bank indeed raised this ratio above hundred prcent by the middle of 2008, but it fell significantly since then. Presently, the Bank strives to raise it back to hundred percent once again.

So, John Exter may have made a mistake, but the successors to the Bank's heritage have tried to retain the virtues of currency board systems.

I also agree that the provisions relating to the provisional advances are a bad element in the law and they should go as early as possible.

1. Ran Jul 07
If the IMF does not give loans on politics won't people abandon dollar pegs?