The Echelon Reboot Everything Festival discusses preserving the rupee – Central Bank Independence versus Currency Boards, with Dr W A Wijewardena, who had an illustrious career at the Central Bank, where he was a Deputy Governor when he retired. Since then, he has become one of Sri Lanka’s most-read economic commentators. Dr Wijewardena begins the discussion with Echelon’s Editor Shamindra Kulamannage by explaining how the Central Bank lost its independence over the last seven decades, precipitating the worst economic crisis in Sri Lanka post-independence
When you look back at the 72 years that the Central Bank has been around and for most of that time, you would have served in it, how do you rate its performance?
The founding objectives of the Central Bank are lost on the current management. When the Central Bank was declared open on the 28th of August 1950, at the very first press briefing given by the then Governor John Exter, he said, “the Central Bank is not a magic wand to bring prosperity to Sri Lanka, but will facilitate prosperity by providing the necessary credit and monetary facilities”. This mission had been misunderstood by subsequent Central Bankers and politicians, and as a result, instead of using the Central Bank as a facilitator, the Central Bank has been used as the major causal agent for the development of Sri Lanka’s economy. That was the mistake made by all of us.
Since then, except in 1954 and 1955 when Sri Lanka had a very small budget surplus, all Ministers of Finance have used Central Bank money to finance government expenditure programmes, and all those expenditures unfortunately had been for increasing government consumption rather than government investment. Because of this, the consumption money that had been put into the hands of the people had been used for importing goods and services from the rest of the world, resulting in the loss of foreign reserves. So Sri Lanka rupee started depreciating at the same time as domestic inflation set in. If we look at the performance of the Central Bank during the last 72-year period, all I can say is that the Central Bank’s mission has been misunderstood as well as abused by the governments in power.
There have been, I suppose, several economic outlooks about the economy and potentially the Central Bank’s role since it was established in 1950. You had a long tenure at the Central Bank and during your time, Dr Wijewardena, there was an initiative to gain more independence for the Central Bank through a new Monetary Law Act. When you look back at that initiative, what was the thinking then, and do you think we would have succeeded had you been successful with a new Monetary Law Act?
If we look at the original Central Banking Act, the Central Bank enjoys a fair amount of autonomy compared to other government institutions. For example, the Governor who is appointed to the post by the President on the recommendation of the Minister of Finance cannot be removed at the will of the President or any other political authority. The Monetary Board members and senior officers like the deputy governors also enjoy the same independence. Unlike other state corporations where the relevant minister can issue general and specific directions to the particular entity, the Minister of Finance cannot issue any direction to the Central Bank and that’s one of the important freedoms the Central Bank enjoys. And, of course, the Monetary Act has a provision that if there is a difference of opinion between the Minister and the Monetary Board, as a last resort, the Minister can inform the Monetary Board in writing of the desire of the government concerning monetary policy. However, in the same letter, he has to state that the government will take full responsibility for the ensuing consequences.
In fact, during the Central Bank’s 72 years this particular provision was used only once by the Sri Lankan government and that was in 1959, when Dr Dahanayake who was the Prime Minister wanted to win the election, which was scheduled for the following year. He wanted the Central Bank to reduce interest rates but the Monetary Board didn’t agree because, at that time, Sri Lanka had a massive balance of payments deficit. The then Finance Minister, Mr M M Musthapha issued this letter to the Central Bank taking responsibility for the consequences. They took the responsibility at the subsequent election when Dr Wijayananda Dahanayake lost his electorate and even his seat in Galle but it has not been used subsequently.
What we have noted over the years, contrary to what John Exter expected, the Secretary to the Minister of Finance, who is a vote-carrying member on the Monetary Board has been using his power to get the Central Bank to agree to whatever expenditure programmes the government wants to implement. As a result, his presence on the Monetary Board has been the biggest impediment to the independent functioning of the Central Bank.
Dr Wijewardena, you mentioned that the Monetary Board and senior officers in the Central Bank enjoy by law, significant autonomy, so how can one member potentially be overpowering in such a situation?
At the time when the Monetary Act was drafted by John Exter, we had permanent secretaries to ministries who were career civil servants, but following the 1972 constitution, we have secretaries who enjoy the position at the pleasure of the President or the minister in charge, resulting in the loss of independence which the previous permanent secretaries had on the Monetary Board, to steer it in the correct direction. As a result, the present secretaries on the Monetary Board who represent the government and the minister have been pressurizing the Board to carry out most of the decisions which the Monetary Board would not otherwise take.
From my experience, having been on the Monetary Board as an observer since 1978, most of the time, the secretaries to the Minister of Finance have acted very responsibly and never tried to influence the decision-making process of the Central Bank but it has become a recent development where they have intervened in the affairs of the Monetary Board. So, that had to be rectified and an Act was drafted in 2004 as well as in 2018 making the Secretary to the Minister of Finance an observer and not a vote-carrying member of the Monetary Board.
Since Sri Lanka has gotten itself into a fairly complicated economic situation, you and others have been suggesting, that it is potentially not more Central Bank independence that is needed, but that we should turn the other way and have a rules-based system. Can you explain to us the contrast between these two systems that you’re talking of?
When the world went for the central banking system, those central banks were given the power to change the stock of money of the country at their discretion, which is known as the discretionary power enjoyed by a central bank. They can do so because central banks can always print new money just by making a book-entry having a small amount of capital or foreign reserves to back the money they have issued, so, as a result, modern central banks are growing like an inverted pyramid, they have a very small base but grow sideways. So all central banks including our own, have done the same thing, we have a very small amount of capital, but we have grown into a huge body by just printing new money.
This discretionary power was given to central banks to provide additional liquidity to the economy when the economy needed that liquidity because the consideration was that the economy was growing fast, trade was growing very fast, and if the central bank did not provide the necessary liquidity to the economy, trade or economic growth could not take place. But this particular power has been abused by politicians because they found that the central bank is a cash cow they could always milk to provide the expenditure for government programmes as has been done in Sri Lanka throughout its post-independence history. As a result, our money supply has grown much more than real economic growth and the real liquidity requirement of the economy resulting in our inflation rate rising.
If somebody calculates the value of the rupee in 1952 when the Colombo Consumers Price Index was introduced, the value of 100 rupees today is only worth a fraction of a cent. Because of this, some people have argued that instead of allowing the Central Bank to use this discretionary power, let them produce money according to a rule which had been presented to us in the recent times by Milton Friedman, the man responsible for monetarism economics. He had said it would be better for the United States economy if the Federal Reserve was allowed to print money according to a given rate. The same applies to other countries as well. But if you want to have a similar rule-based monetary expansion, we need to have a body like a currency board, which would issue money according to available reserves and if it doesn’t have reserves, it cannot issue money, therefore politicians cannot abuse it.
This discretionary power was given to central banks to provide additional liquidity to the economy when the economy needed that liquidity
In Asia, we’ve seen two countries with currency boards, Hong Kong and Singapore and there have been many others on the sidelines, how have their experiences been with this and what can we learn from them?
In Singapore, which gained independence from Malaya in 1965, they had the choice of either continuing with the currency board system that the British had introduced or setting up a central bank like Sri Lanka, India or other independent nations at that time. In that particular period, Singapore’s top leadership which is called the Old Guard had discussed extensively the pros and cons of having a central bank or a currency board and they decided that the currency board was best for Singapore because it was a nation dependent on foreign trade. And, if a central bank was established, it would print more money than was necessary and as a result, Singapore would not be able to maintain its open economy system. Because of this, Singapore decided to retain the currency board system instead, whereas we abolished the currency board system opting for the central bank system.
The decision taken by the Singaporean authorities at that time was based on the first Finance Minister who was also the Chairman of the currency board, Dr Goh Keng Swee, In 1989, when Singapore celebrated the silver jubilee of the currency board system, they made a publication in which he had written an article explaining why Singapore went for a currency board system. In it, he explained that they wanted to give a message to three sets of people: their citizens, politicians, and the rest of the world. The message was that Singapore wanted to have monetary discipline within the country by having a currency board, rather than indisciplined money printing by a central bank.
If discretionary monetary policy has gotten us into a fairly difficult situation, it is certainly not the only contributor, and there have been many contributors to Sri Lanka’s current predicament. If you are looking to unwind this, is this the right time to be doing it and where do we start unwinding discretionary monetary policy in favour of a rules-based system like currency boards?
I have to admit it will not be an easy task, the main reason being that the Central Bank’s present balance sheet is so corrupted. If we want to convert the Central Bank into a currency board, it’s practically impossible for Sri Lanka to do it right now. One reason is that the Central Bank’s foreign assets are negative to the extent of $4.4 billion as at end of March 2022. At the same time, the Central Bank has issued reserve money, that is money created by the Central Bank, amounting to Rs1.3 trillion which is equal to about $3 billion at the current exchange rate. So, if you want to set up a currency board today, first we have to repay the present debt of the Central Bank amounting to about $8 billion, we don’t even have $25 million to pay for the fuel that has been brought to Sri Lanka, so it’s a humanly impossible task.
So, if you want to set up a currency board today, first we have to repay the present debt of the Central Bank amounting to about $8 billion, we don’t even have $25 million to pay for the fuel that has been brought to Sri Lanka, so it’s a humanly impossible task
n this situation, somebody has to provide funding to Sri Lanka, and there is nobody who would do it. In my view, as a result, the best course of action is to introduce greater independence and autonomy to the Central Bank with checks and balances, because the freedom of a Central Bank governor who is a monster can cause the nation to lose everything. Central Bank leadership should be required to present to Parliament, maybe every three months, the actions they have taken and the reasons. If we want to set up a currency board today, one way we can do that is to abolish the present Central Bank, handover its liability to a special purpose vehicle which would rebate for maybe another 25 years, and then we can restart a new currency board with new capital, that is also a possibility. But given the present level of inflation in Sri Lanka, I don’t think we have a case for the immediate establishment of a currency board.
In this current situation, I suppose there are three ways we can deal with the exchange rate policy, we can try a fixed exchange rate, we can float completely or we can try the peg. What do you think should be the approach of the Central Bank if we don’t move towards a rules-based system?
Right now, our Central Bank has no choice because its foreign exchange position is negative, as a result, it will have to go for a full floating allowing the rupee to reach its realistic level, and then start building it up like what was done by Thailand in 1997. The Thai central bank also tried to fix the exchange rate at 25 Thai baht per US dollar, even though inflation within Thailand had been much higher than the global inflation rate. There had been pressure to maintain the currency at 25 baht per US dollar but they had already exhausted the entirety of their $25 billion foreign reserves. So, when they found that they didn’t have any more dollars to protect the baht, they had to give it up and overnight, the baht fell from 25 to 50 per US dollar.
What Thailand did was introduce a strict budgetary discipline cutting down government expenditure and raising revenue. Then it went for the introduction of high technology to boost productivity in its real sector so that the real sector growth immediately started picking up. With the surplus budget, the Thai government was able to bring the value of the baht from 50 to 30 per US dollar within five to six years by improving the export sector of the country.
If you adopt a market-based mechanism for the currency, will there be an inevitable conflict with fiscal policy, which may not always align with the challenges of a market-based mechanism for the exchange rate?
Well, if you look at the budget today, it has a huge hole. Historically, we have had a budget deficit of about 6% of GDP but to date, it has gone up to 30 to 40%. As a result, whether we go for floated currency or not, the budget is in a very precarious situation and no one can rescue it unless you go for strict austerity measures to cut down expenditure and generate revenue through all other sources available to the government.
We have to compare ourselves to Japan after the Second World War. They were devastated by the dropping of the atomic bombs on Hiroshima and Nagasaki, and the whole economy was destroyed, but the Japanese people stood their ground and the country recovered within a matter of a decade by introducing new technology. Initially, they copied technology from the USA, but soon Japan started to develop their own, and that is what Sri Lanka should also do. Sri Lanka will have to introduce new technology to every aspect, from agriculture and production to services, and then generate an exportable surplus which would enable Sri Lanka to earn foreign exchange allowing the Sri Lankan rupee to stabilize. Without that real sector plan, merely establishing a currency board or even giving independence to the Central Bank will not help Sri Lanka at the present juncture.
Sri Lanka will have to introduce new technology to every aspect, from agriculture and production to services, and then generate an exportable surplus which would enable Sri Lanka to earn foreign exchange allowing the Sri Lankan rupee to stabilize