Monday, April 18, 2016

Revert to a Currency Board to solve Sri Lanka's monetary and fiscal woes

The Sri Lankan rupee has been depreciating rapidly in the last few months and the satirical website NewsCurry suggested that the US dollar be adopted to prevent further depreciation. Although this sounds absurd, as my previous post explained this is actually a workable and serious proposition.
A Currency Board would also achieve the same ends and would be easier to implement than dollarisation. Lets look at the fundamental purpose of money and how a currency board will help stabilise the currency, and therefore the economy.
Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. He was right, money serves as the medium of exchange, and an absence of sound money undermines trade. Historically, the use of money arose due to the inconveniences of barter. Money serves three fundamental purposes:
1. It is the medium of exchange: Money can be used for buying and selling goods and services. If there were no money, goods would have to be exchanged through the process of barter.
2. It serves as the unit of account: Money is the common standard for measuring relative worth of goods and services.
3. Store of value: It is the means by which wealth is stored. Without money people would need to store their wealth as goods, which is cumbersome and expensive.
Money oils the wheels of trade; it is obvious that it performs its functions best when its value is stable. If the value of money fluctuates widely it undermines it's fundamental purpose. A simplistic example drives this point home.

Imagine being contacted by a broker about a 2,500-square-foot house, only to visit and find a house half the size. The prospective buyer would have very little trust in the broker. This is purely hypothetical given that a foot is a foot. Since its definition is unchanging, 2,500 square feet means the same today as it did 20 years ago.

Whatever the level of trust buyers have in their brokers, square footage will never be a factor; that is, unless the length of the foot is allowed to “float,” and its length declines. Suddenly, 2,500 square feet could very well mean 1,500 square feet in “real terms,” and trust in brokers will plummet.

This illustrates the effect of an unstable currency. Sound money has underpinned the growth of Singapore and Hong Kong. What lessons do these hold for Sri Lanka?

Hong Kong has a Currency Board arrangement, which means all currency issued in the territory must be at least 100 per cent backed by foreign reserves. Singapore's monetary policy, although no longer a fixed board (which it once was) retains the key characteristics of a currency board. A currency board is similar to a fully backed gold standard.

As the currency is fully “backed” by hard reserves it is freely convertible and immune from depreciation. The exchange rate can remain fixed but in practice many countries that run currency board arrangements allow a small fluctuation in the exchange rate to reflect trading conditions. The exchange rate may also be revised periodically, to ensure it remains consistent with the underlying fundamentals of the economy; which is what Singapore does.

The currency board guarantees the convertibility between the local currency and foreign currency at the foreign exchange rate in the currency board system. The local currency is linked with the foreign currency by the guarantee of convertibility and the fixed exchange rate. Therefore, the confidence in the local currency is linked with that in the foreign currency by the currency board arrangement, and the local currency acquires the properties of the foreign currency with respect to the basic functions of money.

The Currency Board cannot “create” money, except when actual reserves are available nor can it lend money to the Government, usually described as printing money (or, euphemistically, quantitative easing).

Since the Government cannot borrow from the Central Bank (a source of 'easy' money) it must rely on taxes or debt to finance spending, which imposes a degree of fiscal discipline. This in turn results in low inflation. As the money supply also changes only with movements in reserves, interest rates remain fairly stable and are generally low.

Currency board systems assure convertibility, instil macroeconomic discipline limiting budget deficits and inflation, provide a mechanism that guarantees adjustment of balance-of-payments deficits, and thus create confidence in the country’s monetary system,

In other words; the perfect way to impose discipline when grappling with difficult financial problems.

For this reason Currency Boards were adopted in several East European countries when transitioning from Communism. The transition from communism caused severe monetary shocks in Eastern Europe. To manage the transition several countries including Estonia, Lithuania and Bulgaria implemented currency boards with great success; inflation declined and economic growth picked up.

IMF studies show that historically, countries with currency board arrangements have experienced lower inflation and higher growth than those with other regimes. The lower level of inflation is explained partly by the greater monetary discipline imposed but also by the greater level of confidence engendered by adopting the Board.

Note that a Board is not a simple exchange rate peg (which is what Sri Lanka had pre-1977) the requirement for the currency to be fully “backed” by reserves, the restriction on lending to the state and a long-term commitment to the system usually enshrined in law are crucial differences that underwrite the stability of the currency.

To date no currency board has had to be abandoned as a result of a crisis. The Asian currency crises of 1997 provided a severe test: all currencies of SE Asia depreciated rapidly except those of Hong Kong and Singapore. The worst affected was the Indonesian rupiah which dropped from $1=Rp2,400 to $1=Rp14,500, the Thai Bhat fell more than 50% and the currencies of South Korea, the Philippines and Malaysia were all battered.

Alone amongst its neighbours, the Hong Kong Dollar was unaffected, despite repeated speculative attacks. Although Singapore allowed its currency to depreciate by around 20%, to adjust to the relative weakness of its trading partners during the crisis, it was a matter of choice by policy makers rather than an event forced on them by circumstances.

Currency boards were once the norm. Invented by the British they provided the stability that allowed foreign trade to flourish throughout the Empire. With the decline of the Empire the boards were gradually dismantled by the newly independent states, except in a few places such as Singapore and Hong Kong.

Currency Boards are now coming back in to use, Sri Lanka is grappling with huge fiscal and monetary problems, moving to a Currency Board would improve the stability of the system and provide the platform for long term growth.

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