Lanka Business Online
Thrift Column - Currency Crisis:

Sri Lanka's crisis prone currency and sterilized intervention: fuss-budget

August 20, 2007 (LBO) – It seems incredible that Sri Lanka is on the brink of yet another currency crisis less than a year after we got over the last one and the official response and indeed its contribution, to the emerging crisis is comic as it is tragic.

This column has repeatedly warned authorities against the ills of sterilized intervention and its tendency to cause and worsen currency crises. See The Thrift Column - On the Brink , Thrift Column - Monetary Plunder , and Thrift column - Rate Signals.

However from the reactions of the authorities, senior central bankers in particular, as well as reader responses to this column, fuss-budget has come to realize that the deadly phenomenon of sterilized intervention is not very well understood in Sri Lanka.

This is probably why we keep having currency crises every few years.

To understand how a currency crises happens it is first necessary to understand how a currency regime works and what type of currency regime Sri Lanka really has. So here is a crash course on currency regimes.

At one end there are pure floating currencies, and at the other end the fixed ones. Countries that have 'dollarized' or even currency unions are a fixed type of system.

In the middle are pegged currencies or crawling pegs.


The simplest fixed currency regime is dollarization.

Under this regime a country will forgo all rights to independent monetary policy and simply use the money of a low inflation foreign country. Under such a system the monetary base - the basic money supply in the country - is the supply of dollars, or whichever low inflation hard currency that that is picked for circulation.

Since only dollars that are earned are spent by anyone on imports, there is absolutely no chance of a balance of payments crisis or a foreign currency 'shortage'. Such a country will have the same inflation as the foreign currency it circulates. Panama, a dollarized country, seems to have lower inflation than US, but that is another story.

But politicians who constantly want to expand government by printing money at the cost of private citizens do not like this. Socialists and nationalists will also say this is imperialism.

Another problem is that the government cannot even earn legitimate seigniorage revenues (the difference between the cost of issuing paper money and its nominal value) through dollarization. Seigniorage revenues will be earned in the issuing country.

But that is the cost of 'outsourcing' monetary policy and the price paid by the citizens for a hard currency, low inflation and economic stability.

The biggest benefit from dollarization to ordinary citizens is a smaller government. Without the ability to print money taxation suddenly becomes very, very visible.

Currency Board

A currency board is also a fixed exchange rate regime of a sort. Under this system, instead of letting dollars circulate, the currency board (this is a type of monetary authority) will purchase dollars that enter the country and give domestic currency to its citizens.

This is what Sri Lanka had before independence.

A currency board is a kind of diaphragm between the outside world and the domestic monetary system. Like the placenta between the baby and the mother it will take in the blood from the mother (dollars from international transactions) and make the baby's blood (rupees).

The rupee is 100 percent backed by foreign reserves and is exchangeable at a fixed rate. Only 'earned' dollars are used to create rupees. As a result money supply is market based at all times and fully backed by reserves.

While the monetary base fluctuates according to market forces (net foreign exchange earnings), the exchange rate will remain fixed in relation to an anchor currency.

So the system is always in equilibrium just like a dollarized economy, and a currency crisis does not occur again because only 'earned' dollars are used to create rupees.

But currency boards also earn some seigniorage revenues because the cost of the local issue of paper would always be less than the interest earnings of its foreign reserves.

Sri Lanka must be earning more than a hundred million dollars on its foreign reserves a year now.

Most successful financial centres in small economies have either a currency board or dollarization.

We will never become a financial centre unless we either have a currency board, or have a central bank with inflation targeting. Until we do either of that we will not be able to remove capital controls or have a stable economy.

Central Bank

A central bank is also an interface with the outside world like a currency board. But unlike the mother's placenta which will take nutrients out of the mother's blood, it will create blood out of a vacuum by printing money.

Here is where the trouble starts.

In a country which has a central bank with money printing powers, the domestic reserve money supply can be increased independent of the foreign earnings, by purchasing domestic assets.

Reserve money is therefore no longer market based (read real economic needs) but centrally planned.

A central bank that tries to fix or manipulate base money will have to allow the exchange rate to fluctuate according to market needs.

This is what America does. This is what Australia and UK and Europe does.

This allows independent monetary policy as reserve money can be increased to print money. This is politically important because it allows government to tax people secretly. An inflation targeting law will put the brakes on the volume of printing and the volume of the secret tax and bring some stability.

The so-called bi-polar view on currency regimes says that only truly floating exchange rates or a truly fixed exchange rate will work. In both cases only one variable (the rate or reserve money) is controlled.

A currency peg is in between, where both reserve money and the exchange rate is controlled. This is a dicey business and prone to crisis.

This is where sterilized intervention comes in.

Currency Peg

A currency peg also has an anchor currency like a truly fixed currency, but its room for independent monetary policy – read money printing – comes in the form of a mechanism for sterilized intervention.

So under a pegged exchange rate, the central bank will sterilize when dollars flow in as well as when dollars flow out.

One can argue that it is okay to sterilize when dollars flow in. This is why China and India have huge foreign currency reserves, whereas the US does not. This actually creates other problems but let's leave it aside.

The problem starts when the central bank resists pressure to depreciate. The Central Bank tries to control the exchange rate and money supply at the same time by printing money through sterilized intervention. The whole house of cards then starts to unwind, by creating a mis-match between dollars and rupees.

Currency crises seem to be triggered by bad budgets most of the time though not always. A loss of confidence that causes capital flight can also trigger a currency crisis which is then worsened by sterilized intervention.

In Sri Lanka budgets have caused every single currency crisis.

The creation of a central bank in 1951 by JR Jayawardene was the beginning of the end of this country's potential status as a leading nation in Asia. It was inevitable that inflation would go up, and that the exchange rate would fall leading to falling living standards of people.

If we wanted to print money we should have had inflation targeting to limit it and a floating rate to prevent currency pressure.

But floating rates were not in fashion at the time and inflation targeting was not 'invented'.

Those were the days of Breton Woods, fixed exchange rates, Keynesianism and the welfare state. Currency crises were barely understood. Every anti-colonialist politician driven by socialist ideals wanted to have a big government and money printing powers.

Eventually JR had his central bank to print money and he and most other leaders plundered the poor in the mistaken belief that monetary policy could drive growth.

After 1977 Sri Lanka did not try to fix the exchange rate. JR removed most of the exchange controls, kept capital controls and continued to print money.

But through a crawling peg and sometimes with devaluations he and later President Premadasa allowed the currency to constantly depreciate.

Floating Rupee

Sri Lanka 'floated' the rupee in January 2001 after severely worsening a currency crisis through sterilized intervention. International reserves were run to the ground in defending the rupee at one end and adding rupees at the other end to prevent a liquidity crunch.

It is intervention that creates the liquidity crunch, which requires sterilization to preserve base money.

A 'float' breaks this vicious cycle and it stops the currency crises in its tracks. However there were severe after effects in the immediate aftermath as economic activity collapsed.

But later we continued to sterilize, and the rupee never really floated freely on the upside, because there was a need to build up reserves. In 2004 there was sterilized intervention on the downward run again.

In 2005 there was some free float. But in 2006 we were back to sterilization on the down run as well, but pulled out just in time.

The growth in domestic assets in the monetary base (about 30 billion rupees since June) shows that Sri Lanka is engaging in extensive sterilized intervention and running a pegged exchange rate by definition, giving the lie to central bank claims of a 'floating' rupee.

That is partly why IMF re-classified Sri Lanka as a managed float from a free float.

"Directors encouraged the authorities to limit intervention in the foreign exchange market and allow greater flexibility in the exchange rate to help safeguard external reserves and maintain competitiveness," the IMF said last December after the August/September 2006 debacle (See The Thrift Column – On the Brink)

What this really means is "don't engage in sterilized intervention and run down your reserves, inflate the economy and drive the cost of locally produced goods up."

Sterilized Intervention

Kurt Schuler, a one time staffer at the US Treasury and a global authority on exchange regimes produced a lucid document for the United States Congress in 2002 on currency crises called Why Currency Crises Happen?

Because it is written for politicians Why Currency Crises Happen? is easy to understand and would prove valuable for policymakers and financial sector professionals.

Schuler also promoted a US bill to share seigniorage revenues with dollarized countries, which unfortunately never saw the light of day. He was also involved in setting up currency boards in several countries including Lithuania.

Whether sterilization takes place when there is upward pressure (like China is doing) or when there is downward pressure (like Sri Lanka) the monetary authority is sending misleading signals to the economy. Delaying adjustment only makes it worse.

"The sterilized intervention characteristic of a pegged exchange rate allows the central bank to control the real supply of money for a time and to hinder the real supply from adjusting to changes in the real demand," says Schuler.

"The delay reduces the accuracy of prices as signals for guiding economic activity."

Sterilizing capital flows makes locally produced goods artificially cheap – like in China. The injection of domestic money to sterilize central bank currency defence, Schuler points out, will make domestic goods more expensive and imports cheaper.

"The cycle continues as long as the central bank refuses to reduce the monetary base. The central bank eventually loses so many foreign reserves it either must finally reduce the monetary base or it must abandon the pegged exchange rate and go to a floating rate.

"The structure of prices that existed during the period of sterilized intervention contains mistakes that must now be corrected, perhaps at the cost of a recession."

We had a recession in 2001 after extensive sterilized intervention. That is how dangerous sterilized intervention is.

Indonesia was the country that engaged in sterilized intervention heavily and had the most severe recession during the Asian currency crises. (The IMF opposed the creation of a currency board in Indonesia for some reason).

The core causes of the global imbalances that are now unwinding was also partly caused by Chinese sterilized intervention and the purchase of US assets with the proceeds.

Real Money Demand

Argentina's 'currency board' collapsed due to sterilized intervention. There was a loophole in the law as base money had to be only two thirds backed by international reserves, making it a kind of central bank.

While speculators cannot cause a crisis, resisting speculation through sterilized intervention creates more pressure and causes a crisis.

"Mistakes in targeting the real supply of money create opportunities for arbitrage in foreign-currency markets and elsewhere: the bigger the mistakes, the bigger the opportunities," says Schuler.

"Monetary authorities that in effect target the real supply of money by maintaining pegged exchange rates encourage speculative pressure to build until it forces a devaluation."

The Central Bank has to let the rupee go now. It is suicidal to defend the rupee and keep adding cash to base money.

Clearly the economic activity has slowed and the monetary policy road map of the central bank is no longer in step with the real demand for money in the economy. That is why this column was earlier arguing against allowing excess liquidity to remain in the system.

However as pointed out in The Thrift Column – Fiscal Explosion , raising interest rates forever is not possible, because all the mistakes in the budget cannot be corrected with monetary policy without turning an economic slowdown into a recession.

Market pricing energy and cutting government expenditure is needed because the core triggers of currency crises here are fiscal in nature. However the rupee also has to be floated again.

"Sterilized intervention enables the central bank to leave unchanged its issue of local currency even when losses of foreign reserves signal lower demand for local currency," says Schuler.

"However, if the central bank persists in refusing to reduce its issue of local currency, it will eventually lose all its foreign reserves.

"It must choose among abandoning the exchange rate, restricting convertibility by imposing exchange controls, or giving up independence in monetary policy by allowing the money supply to shrink.

"Politically, devaluation is usually easiest because it can be done fastest and can be blamed on external forces."

Sri Lankans have now wised up to a lot of things. They know inflation is caused by money printing. They also know that depreciation is caused by economic mis-management, though not exactly how.

Oil Prices

Currency crises have nothing to do with oil prices. That is a blatant lie told by central bankers and government officials to innocent citizens who do not understand monetary policy.

It is as much a lie as saying oil prices cause inflation.

Hedging cannot 'save' foreign exchange either. Hedging is about fixing prices and giving certainty. Any 'profits' from hedging that is passed on as a subsidy will have no effect on the forex market.

Oil prices of course can worsen a crisis with subsidies which hurt the budget and cause money printing. High interest rates from a budget deficit can also slow an economy or cause bank loan defaults.

Standard & Poor's which upgraded our rating 'outlook' based on a promise to market price energy, despite an on-going war, said out loud that Sri Lanka's problems were more to do with economic policy and budgets rather than war.

But now our clever politicians are saying energy prices will not be raised.

The budget is usually the initial trigger for currency crises in Sri Lanka, but the drying up of tsunami aid flows – which had earlier pushed economic activity to a higher clip – may also be a cause.

Certainly Maldives and Sri Lanka seem to be having similar kinds of trouble according to reports.

Foreign Injection

Getting some foreign money into the system through a sovereign bond at this time will help now because it will help ease the pressure on the system from the budget and also boost reserves.

A bond may help keep the growth momentum and stave off a credit crunch, until fiscal policy is fixed.

UNP is making empty threats not to pay off the sovereign bond if it comes to power. In the unlikely event that it does come to power however, it will have to pay. Otherwise our credit rating will be downgraded to default. It is all a lot of hot air.

However their objections that the money is being wasted on bridging the deficit, is another issue.

When the IMF comes to a country hit by a currency crisis and sterilized intervention, it tells them to cut wasteful government spending, stop intervention and raise rates to the extent that the budget deficit is not cut.

Usually the World Bank will also come through with some cheap funding on the back of some improvements in economic policy that will promote growth and cut the deficit in the medium term.

IMF will also inject money to the central bank directly without affecting the domestic money supply to boost reserves.

However due to problems with our current economic policies we do not qualify for cheap money. So we need the bond dollars to soften the shock that is building up in the system.

One silver lining is that there is a chance that the headlong climb in oil prices will ease, with the collapse in global markets.

According to John Exter's 'inverse pyramid' a flight to quality should push up dollars and gold and cause a relative price collapse in practically everything else. It would be interesting to see if everything would fall in nominal terms under a 'deflationary collapse' scenario, so long predicted by the likes of Exter.

On the other hand the current turmoil may also raise the risk premium of any money that comes our way with investors now shy of investing in risky debt.

By delaying a correction of the exchange rate, the authorities are also giving unnecessary incentives for foreign bond holders to sell by making the exchange rate a sitting duck.

But in the long-term we need either inflation targeting with a truly independent central bank or a currency board to keep this economy stable and safeguard the future of our children.


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