Sri Lanka Should Not Be Misled By False Claims About ‘Undervalued’ Currencies In East Asia

Sri Lanka’s new Central Bank Governor Indrajit Coomaraswamy has correctly identified the fundamental problem with the country - the excessive cycles of monetary instability that has been created by the Central Bank whether accommodating Treasury excesses or not.

Throughout the country’s post-independence years, Sri Lanka has either printed money and tightened exchange and trade controls to bring the economy to a standstill, or after 1977, printed money and depreciated the currency to generate a high inflation downward spiral.

“The first thing to do if we are to get accelerated and sustained development, growth and employment creation, we have to have strong macro-economic fundamentals,” Governor Coomaraswamy said at his inaugural press conference after being appointed. “If you look at all the successful countries, particularly in East Asia and Southeast Asia, they have based their success on strong macro-economic fundamentals.”

“If you compare our economy over the last 30-40 years with those economies, you will find that we tended to be a high budget deficit, high inflation, high nominal interest rate, and overvalued exchange rate economy. Those countries were diametrically opposite. They had low budget deficits, low inflation and undervalued competitive economies. So we need to have those kinds of macro-economic fundamentals.” Most of this is true. All this trouble started with the creation of a central bank in 1951.b5

However the claim about ‘undervalued competitive’ economies in East Asia needs greater scrutiny.

Econometric confusion
There are multiple methods of calculating how a currency is ‘undervalued’ or ‘overvalued’ or measuring the so-called ‘real’ vs ‘nominal’ exchange rate changes.

The essential argument is this. If inflation in a country is higher than their trading partners, a pegged currency is undervalued. To what degree the currency is undervalued will depend on what currencies are put in the basket and how those countries conduct their own monetary policy.

If, for example, India, Indonesia and the Philippines mess up their monetary policy and their currencies collapse, the rupee could be shown to be ‘overvalued’ if those currencies are on the basket, at least until inflation catches up in those countries. This is well-underlined in our own currency.

In 2015, the year that the rupee collapsed under the weight of liquidity releases and outright money printing (which was painstakingly forecasted and documented by this column from late 2014) the IMF concluded that the rupee was not overvalued.

Based on different methods the rupee was shown to be a little undervalued or overvalued. “Econometric analysis does not suggest a fundamental misalignment of the exchange rate,” the IMF said in a staff report in 2015. “In light of significant shifts in the external environment since the 2014 Article IV Consultation, the staff updated the exchange rate analysis to assess the current level of the exchange rate. The External Balance Assessment (EBA) methodology points to an overvaluation of about 5 percent, with more than half of policy gaps explained by the fiscal balance to GDP and health expenditures.”

“The CGER approaches suggest mixed results—the macro balance and external sustainability approaches pointing to an undervaluation of 2-4 percent, while the equilibrium exchange rate approach suggested an overvaluation of about 7 percent.”

The IMF, however, said the rupee was under pressure, as shown by one-sided interventions. “Qualitative analysis suggests the rupee has entered a period of downward pressure,” the report said.

This column showed consistently that the intervention is to ‘mop up’ the rupees created by the Central Bank itself through liquidity releases (ending term repos) first and then outright money printing (purchasing Treasury bills with printed money). Despite the lack of evidence, ex-Governor Arjuna Mahendran claimed that the rupee was overvalued after it collapsed. Now that the rupee has fallen inflation is again starting to show. This will again take the rupee back to square one.

Sri Lanka’s rupee has collapsed steadily since the Central Bank was created, but it has failed to create an East Asia. It has in fact done the opposite.

Established factoid?
Now that it has been shown that the methodology of calculating exchange rate overvaluation is a bit silly and can go either way, it is worth examining where these claims of undervalued East Asia comes from.

b4The common misconception about East Asian currencies being undervalued largely come from oft repeated Gobbelsian claims by US mercantilists that either the currency of China in particular (until the 1980s it was Japan that was the whipping boy) was or is undervalued.

There is now a fairly widespread (but under-reported) debate about whether the yuan is undervalued as the mercantilists claim. (See for more.)

The mercantilist argument is simply based on trade data. There is a trade deficit between the US and China (or Japan or Malaysia, or whatever country), therefore it is assumed that the East Asian currency must be undervalued. East Asian countries have a trade surplus simply because they export capital to the US in particular. Their central banks sterilized inflows and investments in US treasuries for the most part.

The US government and citizens spend it on imports from these countries. Petroleum exporters in the Middle East also invest money in the US. US citizens will also spend some of this money (money that does not go out as capital investments by the banks and fund managers) in goods imported from East Asia and elsewhere. Trade surpluses or deficits are a function of savings propensities, not the exchange rate.

External anchor
So if all these arguments are mercantilist propaganda, what is actually going on? The bottom line is that East Asian nations have been using the exchange rate as an external anchor to base their monetary policy on and keep inflation around the same levels as the US, with the exception of Japan and now to an extent Korea. Hong Kong, Macau and Brunei have real currency boards while Singapore has a modified one. Taiwan has a central bank which behaves pretty much like a currency board.

b3The other countries have pegs of varied success. Korea became closer to a floating rate after the East Asian currency crisis. Indonesia and the Philippines have the worst central banks in the region and predictably, like Sri Lanka, are exporting their people – made destitute by the weak currency – to the Middle East and also Malaysia.

It is pretty sad about Indonesia, because that country is as resource rich as a Middle Eastern country, is strategically placed with a large population, and has historically been a country with enough economic clout to stand with China, as shown by the civilizations of Srivijya in Sumatra and Shailendra in Java.

There is also something else to contend. Even in a currency board country, the inflation index can be higher than the pegged country as unemployment falls. When the tradeable sector becomes efficient and more productive (with a well-functioning peg with the dollar-area for example) wages will tend to rise in the non-traded sector as well. In some services productivity does not catch up and the price index may rise in education, health, restaurant services and house building to name a few. A doctor can treat only so many patients or an appa bas (hopper maker) can make only so many hoppers (even though they now have five thachties as opposed to one earlier and productivity is up). This phenomenon (Balassa-Samuelson effect) is also found in dollarized countries. But there can be no ‘currency crisis’ in a dollarized country regardless of overvaluation. It is the same in a country with a currency board.

Mercantilist politics vs economics
The claims of undervalued currencies are farcical. Exchange rates are a product of the monetary policy regime and the anchor that is targeted. A floating regime will target a domestic anchor – the consumer inflation index. Pegs target an external anchor – a foreign currency which in turn either targets a floating rate with a domestic anchor (like the dollar) or another well-anchored currency (like in Macau).

Under the gold standard all central banks targeted one domestic anchor – gold. As a result exchange rates were relatively stable against each other. Claims of undervaluation came later. In the US, rising trade deficit (as the Marshall Plan loan was paid back and money printing picked up) led to accusations against East Asian countries.

“From the early 1970s until 1995, Japan was an enemy,” explained Steve Hanke, a professor at John Hopkins University.

“The mercantilists in Washington asserted that unfair Japanese trading practices caused the US trade deficit and that the US bilateral trade deficit with Japan could be reduced if the yen appreciated against the dollar — a “weak dollar policy”.

“Washington even tried to convince Tokyo that an ever-appreciating yen would be good for Japan.”

The Japanese yen moved up from 370 in 1971 to 80 in 1995. The trade deficit continued. With a stronger currency and a stagnant population, Japan invested outside especially in countries like China and Vietnam seeking large pools of labour. US mercantilists then turned their guns on China. US politicians have in fact passed a law to make the Treasury name a country a ‘currency manipulator’. It is to the credit of the US Treasury that it has not done so. “This isn’t too surprising since the term ‘currency manipulation’ is hard to define and, therefore, is not an operational concept that can be used for economic analysis,” observes Hanke.

“The US Treasury acknowledged this fact in reports to the US Congress in 2005.”

Any country that steadily collects foreign reserves above its monetary base is actually running monetary policy ‘tighter’ than a currency board, which is what China has been doing.

The funniest part of the whole situation is that the architects of the Bretton Woods soft-pegs at the US Treasury in the late 40s intended exactly this outcome. When a soft peg (or currency board for that matter) bought the anchor currency debt it made deficit financing cheaper. They were jealous of the demand for British debt in the so-called Sterling era.

Reality vs claims
While it is possible to manipulate ‘real exchange rate’ calculations through the methodology or the currency basket it is not possible to falsify market prices. A cursory look at the nominal exchange rates shows that claims of undervalued currencies are false.

Just like the sharp appreciation of the Japanese yen from 360 during the breakup of Bretton Woods, to 80, many other East Asian currencies have also appreciated since their monetary management improved.

In fact, during Bretton Woods, Germany, an export powerhouse that defied all conventional wisdom had a very strong currency. This is why even the UK, victimized by Keynesianism tried to ‘shadow’ the deutsche mark, until the Bank of England adopted inflation targeting. A weak pound did not help Britain’s export industrial sector either.

b2Over the past 20 years monetary management in East Asia has vastly improved. The People’s Bank of China started reforms from 1987, changing the monetary law. It really came into its own after 1993, when Zhu Rongji the Vice Premier was governor, following a sharp depreciation and a bout of inflation. The Chinese renminbi is now about 6.8 yuan to the dollar, stronger than the 8.7 following the final collapse in 1993. The Hong Kong dollar is at 7.8 to the US dollar from 1982 when a currency board was re-created.

In fact, China’s currency is now stronger than it was in 1993 and stronger than the Hong Kong dollar in 1982, when the currency board was created amid global turmoil following US and UK monetary tightening to kill the 1970s ‘Great Inflation’ which followed the collapse of Bretton Woods.

Nobody has dared to suggest that the Hong Kong dollar is ‘undervalued’. Singapore modified its currency board to be able to counter US inflation, and also to be able to depreciate when the Fed exports deflation after a bubble bursts. It has a unique system which is not well-understood by commentators in the popular press.

Post Asian crisis
After the Asian crisis there was a big improvement in monetary policy. In the early 1990s New Zealand invented inflation targeting. The ERM (European Exchange Rate Mechanism) collapsed. All this improved knowledge. Korean monetary policy in particular improved after the Asian crisis.

Gone are the strikes at factories that were common in the inflation period of the 1980s. In fact Korea has become a non-interventionist liberal democracy where people seem to be having more freedom than in Singapore.

Indonesia and the Philippines’ central banks were the basket cases of East Asia.

The Philippines Central Bank may have turned the corner over the last decade, following bitter lessons after its bankruptcy.

Policy at the State Bank of Vietnam also improved in recent years. The dong collapse after the Great Recession came from an unfortunate stimulus, which was eventually stopped by high interest rates. Vietnam’s policy was so bad at one time that even now salaries are denominated in dollars in many areas and the US dollar is easily used.

When there is a currency and credit collapse, it takes a long time to recover. Sri Lanka’s Central Bank continues to be a basket case.

The Central Bank has given it a one-way ticket in a race to the bottom. In this backdrop it is trying to be a ‘financial centre’. The contrast with Singapore and Hong Kong is not clear. How can a country be a financial centre when the central bank creates monetary instability and balance of payments crises?

It is a pipedream to expect fiscal policy to correct itself. Monetary accommodation has to stop first.

If Sri Lanka believes in undervalued currencies don’t expect the country to go anywhere in a hurry. Until the 2011 crisis, Sri Lanka’s monetary policy was in fact somewhat better than in the past. But it is showing signs of deteriorating again. Far from emulating Singapore, Sri Lanka is closer to Indonesia.

J-curve myth
That currency depreciation generates a boost in exports after a lag, as shown by a J-curve is also a myth. True currency depreciation will cut wages and give extra profits to exporters at the expense of slave labour.

In Sri Lanka exporters also get a benefit because utility prices (electricity, water and also fuel) are not raised immediately when the currency collapses unlike in countries like Singapore. Hence the calls for currency depreciation. Increasing liability dollarization, as well as market pricing of utilities may reduce calls for devaluation.

bIn general currency collapses – this is a disease that hits soft pegged countries – comes from some upheaval in reserve currency countries like the US to which these currencies are anchored. When US inflation goes up and a commodity bubble is fired pushing oil prices up, countries that do not market price oil get into trouble. When the US tightens policy, countries that do not tighten policy also get into trouble.

When the bubble in the reserve currency country eventually deflates, the demand and also the prices of commodities fall. It take a couple of years to recover. Hence the J-curve.

That is why even countries like Hong Kong, which has a currency board, displays J-curve like behaviour. Chronic currency depreciation and inflation don’t only destroy real wages, they also destroy accumulated savings in banks and pension funds.

Savings are the capital that can improve labour productivity and raise living standards. And for those with an export fetish it can also generate high value exports. Sri Lanka can ill-afford to have an ‘undervalued’ or weak currency especially when its population is getting old.

A race to the bottom with an undervalued currency does not improve living standards or increase the pool of labour available for an export industry. With the open borders in the Middle East it simply drives millions of people to the desert where monetary policy is better, with exception of basket case central banks like in Iran.

Unsound money destroys society. It can also create political upheavals and wars.