Sri Lanka is facing a monumental state failure after denying economic and civil freedom for decades, destroying Sri Lanka’s rupee on which families build their lives, doing zero-sum ad hoc interventions to favour special interests and state monopolies against the general public.
After cumulative state failures, strangled markets which have allowed rulers to mis-allocate taxes and savings taken from the people, compounded by left leaning Keynesianism, blatant unsound money with ‘flexible’ policy, the chickens are coming home to roost.
With the State in the driving seat in Sri Lanka, the public and the community cannot do much to get the State out of a crisis of its own making. Both government debt and government money are in crisis. There is no people’s money in Sri Lanka and there is no currency competition – only a monopoly of state money.
There is some light in the tunnel. President Rajapaksa is trying to get private investment into Colombo Port – another special interest admittedly – but a deal that will help keep Indian containers coming to Sri Lanka and is also a foreign policy move. Certainly, the drive to get private investment into infrastructure is a good strategy. Some salary hikes given by the last administration has been suspended.
Sri Lanka can certainly grow and outgrow many other countries if it uses its geographical advantages to the maximum, as ancient kings did, who had generated vast surpluses to build massive monuments. For long term growth, a series of liberalizations which removes state controls on the community, and favours special interests and state monopolies, have to be removed.
ACHILLES HEEL
Sri Lanka’s Achilles heel since independence has been the lack of a rule-based monetary policy and a reliance on highly soft-pegged regimes with ‘flexible’ or ‘discretionary’ policy where some floating rate practices are applied to a peg.
The mixed up peg has an inflation target which is about 300 percent of successful countries. It must be noted that successful countries with a 2 percent inflation target are also located in the same planet and not in some other universe where different rules of nature exist. That money printing to keep down interest rates amid a credit spike will weaken the currency in a peg, is a law of nature, not a figment in the imagination of classical economists.
That has to be fixed first of all. The current administration has said it wants the rupee at 185 to the US dollar. There is no harm. Targeting an exchange rate is the most simple monetary policy imaginable (externally anchored monetary system). But the current money printing and open market operations will go completely against an external anchor.
All the high performing East Asian nations targeted the exchange rate in their growth phase, and many still do. Successfully targeting an exchange rate requires complementary policy. Japan – which was already an industrial nation by World War I with a specie peg – became an export powerhouse after World War II when Joseph Dodge closed the Keynesian Recovery Financial Fund (fukkin) which was financed by selling bonds to the Bank of Japan and fixed the Yen at 360 to the US dollar eliminating multiple exchange rates.
The rate held until the collapse of the Bretton Woods Agreement under output gap targeting. Japan sometimes did not allow market interest rates and instead did credit controls which led to forex shortages in credit spikes and gave the MITI (Japan’s Ministry of International Trade and Industry) un-necessary power to impose its decisions on businesses by rationing forex.
This is how the MITI had the power to almost kill the electronic industry by denying forex for Sony to pay transistor royalties. MITI became a dead-duck as soon as the Yen was free floated with the break-up of the Bretton Woods.
This is Singapore (See Chart 1): The Singapore currency board which was at 3.0 to the US dollar also floated with the break-up of Bretton Woods, and promptly appreciated (like the Yen) and stopped only after Paul Volcker tightened US policy and brought stability under Ronald Reagan (Fed Funds rate around 19 percent), allowing free trade to flourish.
This is Thailand (See Chart 2): Thailand had a particularly good peg which was kept during Bretton Woods, and after it broke-up also. But the Bhat peg broke during the first Volker tightening and also in the 1984 tightening cycle (Fed Funds rate 11 percent) when it fell to 28. Later it was brought to around 25 and kept until the East Asian crisis, when foreign speculators broke it mainly with swaps such as the one used to break the Sri Lanka rupee in July 2018.
It was also in the 1985 Fed tightening cycle that Latin American pegs fell like nine-pins which Mercantilists call the ‘Latin American debt crisis’. Sri Lanka was under severe controls involving the ‘closed economy’ after the Bretton Woods collapsed in 1971.
But in the run up to the collapse, the system came under strain from output targeting and the Sterling collapsed. Sri Lanka was doing a ‘Green Revolution’ with central bank re-financed agricultural credit. The Reserves Bank of Zimbabwe had done similar financing. Today’s Saubhagya loans are a repeat of that.
Governor A S Jayewardene stopped them. Sri Lanka had 190 million dollars in foreign reserves when a currency board was dismantled in 1950. Paddy production has reportedly rocketed from 36.3 million bushels in 1965 to 77.4 million bushels in 1970. Meanwhile foreign reserves fell to 40 million dollars in 1969 and the Import and Export Control Law was enacted (see Chart 3).
This law is being used to control imports in the current crisis. Then Dudley Senanayake got booted out and the 1970s controls were intensified without fixing the central bank, unlike in East Asian nations. Sri Lanka devalued from 8 to 15 in 1978, held till about the end of 1980 and then everything went downhill from there, though there were no import controls and people were able to do things and get more jobs and expropriation ended. Instead there was privatization.
But Sri Lanka was far removed from high performing East Asian nation. The central bank creating inflation, de facto targeted the real effective exchange rate, triggered political unrest, strikes and so on until A S Jayewardene came to office in 1994 and did some central bank reforms. The basic principles behind those reforms were progressively abandoned in favour of aggressive open market operations from 2011 onwards and intensified in 2018.
In 1980 Singapore’s per capita GDP was almost 5,000 dollars. Hong Kong under the British was 5,700 dollars. It was in the mid 1980s that Bank of Korea finally fixed it-self after an almost 30 year struggle with periodic step devaluations. The Won went on a wild ride as Volcker tightened and inflation soared but after a few years, the Bank of Korea managed to come up with a working system.
The won started to appreciate for the first time from 1987, just as the frustrated people hit by inflation and wage controls (to target the REER) went to the streets and the dictatorship ended. From then on, the exchange rate was stable; rates fell steadily, partly helped by Fed under Greenspan, until the East Asian crisis. A country which was body-shopping workers and personnel to the Vietnam War to earn foreign exchange a little over a decade earlier then became an OECD country in a decade.
That Korea was lagging behind some other East Asian nations until the early 1980s was not because the people did not work hard, it was a problem with the Korean Won or more precisely the Bank of Korea and overall state controls, which took the country to some levels, but not beyond.
In 1980 Sri Lanka’s per capita GDP was 273 dollars. In 1980 Zimbabwe had a per capita GDP of 900 dollars or about half of that of Korea’s. Zimbabwe originally had a currency board as did Sri Lanka. Zimbabwe had two, the Southern Rhodesian Currency Board and the Central African Currency Board. In 1980 Mugabe became Prime Minister. The rest is history. Both Sri Lanka and Zimbabwe and Latin America are cases of monumental state failure not of private citizens.
DEBT PROBLEMS
Debt problems are not the same as pure soft-peg problems, but they can be worse in countries with soft-pegs because currency collapses and debt feeds on each other. A sudden peg collapse, as the one that happened with Argentina, will lead to a default of foreign loans even if the country has a low level of debt. If not an outright default due to ‘foreign exchange shortages’ it will at least lead to an inflation of foreign debt.
Currency collapses will also amplify the effect of entrenched problems. Creeping debt problems are linked to bad governments which mis-invest money due to corruption or incompetence or a statist ideology. It may be compounded by controls, interventions or expropriation which block or discourage freedom of the people and free enterprise, stifling them and preventing them from making full use of the investments. Like the situation described below for example.
“Unfortunately, so long as our nation faces the problems of corruption, political instability, lack of transparency in governance and lack of rule of law, we will continue on a downward spiral as investors. Both local and foreign, will shy away.
“Our country cannot afford a repeat of the financial scandals of the past. We are a nation blessed with natural resources, an ideal location along trade routes, high proficiency in English, and so on. “But even these resources are finite, and as we saw with the Fitch downgrade, the consequences of poor management eventually come to a head.
“These polarising issues have scuttled efforts to implement the much-needed institutional and economic reforms, while simultaneously fuelling political instability.
“What is most worrying is that with polarisation increasingly permeating through our society, it endangers inter-ethnic harmony and erodes social cohesiveness. The very fabric of our society is in danger when we fail to see eye-to-eye and respect one another”.
This is not a reference to Sri Lanka but Malaysia. It is the Tun Daim Zainuddin who fixed Malaysia in 1985 with budget cuts, privatization, and debt repayment in an interview with The Edge Malaysia in January 2021. https://www. theedgemarkets.com/article/ vision-2020-mission-unrealised-daim-failure-handle-polarising-issues-hampered-economic
“In this respect, we must also acknowledge that Malaysia has not done well towards a united Bangsa Malaysia, in managing polarisation over race and religion, and undertaking social and political reforms.”
Malaysia dropped its fixed exchange rate in 2005. It suffered the worst currency crisis since the East Asian crisis in 2015/2016 after it adopted a ‘flexible exchange rate’, which prompted then Singapore Prime Minister to advice his citizens not to express too much happiness at low price funds when they visit Malaysia. Without credibility a peg will create un-necessary panic. The incumbent administration was overturned soon after.
Both the United States Treasury and the IMF is relentlessly opposed to fixed exchange rates. But the problems with fixed exchange rates come when floating rate ‘open market operations’ are administered. It is the very same IMF which destroys credible pegs in the path to the holy grail of ‘modernising the monetary policy framework and transmission mechanism’.
The US Treasury in particular imagines that a fixed exchange rate makes a country an export powerhouse that ‘undervalues’ its currency to cause a trade deficit with the US, not understanding that it is domestic stability – monetary as well as policy stability – than brings foreign investors flooding into these countries to export.
Perhaps due to the clout the US has with the IMF, it may also be advising countries to have ‘exchange rate’ flexibility. For several years now the IMF has been making noises to the State Bank of Vietnam about its simple peg and in December 2019, the Treasury slammed the country as a currency manipulator.
Sri Lanka’s low recent growth came with two currency crises coming from the lack of rule-based monetary policy due to ‘flexible inflation targeting’, ‘flexible exchange rate’ involving open market operations that went beyond floating rate regimes to generate excess liquidity.
In Sri Lanka, two currency crises in 2015 and 2018 bloated dollar debt and triggered capital flight. The overall problems with ad hoc policy, nationalism, state enterprises and over large state sector, regulations ranging from the Paddy Land Act to the Import and Export Control Act as well as expropriation have come to a head.
The government’s push to raise salaries of plantations companies is also an expropriation of private property to fulfill an election promise. The last administration engaged in damaging ‘ill gotten gains’ taxes which also frightened investors.
STATE FINANCES
In a debt crisis, a credible plan to fix state finances inspires confidence and persuades lenders to stop demanding their money back and gives motivation to rollover debt. Sri Lanka cut the taxes in 2019 in a misguided move to ‘stimulate’ the economy without waiting for the automatic recovery that usually accompanies a currency crisis.
The revenue problem had been worsened by Coronavirus. Salaries have been frozen, and many expenses cut. However, tens of thousands of people are being hired into the state sector. For outsiders, whether bond or other investors, it looks bad. That is because there are other countries who do not do such things. Communist countries do no such thing.
They are frugal and prudent. Countries like Vietnam are ignoring advice from the stimulus happy International Monetary Fund to print money during the crisis, and is holding its peg like Singapore, Taiwan, Japan did before them. In fact, with weak credit, SBV is buying dollars and interest rates have plunged to near zero.
Cambodia is dollarized so that the country cannot be destroyed with a ‘flexible exchange rate’ or dual anchor contradictory policy. However, the IMF is trying to give them wrong advice and get open market operations to work again.
In Sri Lanka, the tax cut in 2019 had severely eroded confidence. The jugglery with budget numbers had also backfired. Budget numbers should not have been juggled for political purposes. Fitch Ratings went by the numbers and said the budget deficit increased, but actually it is a little improvement from the previous year.
With economic activities recovering there will be some increases in tax revenues. The valued added taxes lost to the budget have increased profits of import substitution companies owned by socalled ‘cronies’ to very high levels. The firms were already benefitting from import controls which are also a loss of taxes to the Treasury. The import substitution companies are not capitalist or free enterprises, they are crony Mercantilists benefiting from controls placed on the people or tax arbitrage.
BLEEDING RESERVES
The Treasury is printing money to make up for lost taxes that are creating foreign exchange problems. The stock market is booming due to low interest rates and also the actual profits made by some firms.
But foreign reserves are steadily declining. Boosting them with swaps is a temporary solution only. If Sri Lanka is not careful, not only can there be sovereign default but the central bank itself could go bankrupt from swaps.
The foreign exchange problems are not coming from lack of tourism revenues. Lack of tourism or other export revenues will lead to an automatic collapse in imports when the salaries of the people in the sector are cut like in other countries including the Maldives.
If a hotel takes a loan from a bank and pays workers salaries, that may also not cause any currency pressure since the money comes from a deposit or a loan repayment by crowding out other credit. However, if a hotel takes a loan re-financed by the central bank, like the rural credit in the 1960s and in the 1980s or from excess liquidity with money printed for the Treasury that had come from a state bank which is in the system as excess liquidity, there will be forex shortages.
When foreign loans are not available to bridge the deficit and spend, imports will automatically fall also. In general, weak credit which stops savings of the people from being turned into imports through the credit system allows foreign reserves to be built in a peg, which can be used for debt repayments.
The government can directly borrow the savings and repay foreign debt also by crowding out domestic credit and therefore imports. There is no ‘transfer problem’ as Keynesians claim. The first step is to stop additional bleeding of reserves through liquidity injections and low interest rates by allowing market rates to come back. Some excess liquidity had already been allowed to leave through dollar outflows.
The Treasury should not reject bids to roll-over bond maturities. Any rejection of bids turns debt from past deficits into printed money and instability in the current year. This is how Sri Lanka’s central bank created crises in 2004 and 2011. In 2018 it was done mostly with open market operations not bill auction rejections despite a correction in the budget. The central bank should always roll over coupon payments as paper Treasury bills or bonds instead of trying to pay cash by printing money.
PRIMARY DEFICIT
The reason that the IMF uses a primary deficit as a target is to allow interest rates to be hiked to stop the currency crisis without disturbing the target. Though lost in the mists of time, interest can also be rolled over as paper in auction, leaving the remaining items such as salaries to be settled via banks notes which are exchangeable for dollars.
In Sri Lanka this is not understood. In 2018 money was injected through open market operations while running a primary surplus. If interest payments are rolled over as paper, a big chunk of current budget spending is taken away from triggering currency pressure. That is the value of the primary deficit.
By rolling over debt and also rolling over interest rate payments as paper debt – at an appropriate market rate, whatever that is each month – a large chunk of state spending can be blocked from becoming reserve money. If money is printed for interest rate payments on debt, more currency problems would come and import controls, weak growth and weak tax revenues would continue in a vicious circle.
Sri Lanka’s negative forward premium is one weird outcome of misaligned interest rates. Closing the forward market may reduce the need for spot dollars but that does not solve the fundamental problem of upside down interest rates. The stock market is another. Importers who were put out of business by trade controls, may continue to use their credit lines and working capital loans to play the stock market as they are now doing.
But that is not sustainable. The Fed’s Jerome Powell is saying that the stock market boom has nothing to do with its money printing. But now people know better that to believe him. The banking system in the US is not damaged like in 2008. So it is a different world now. People are also flushed with savings.
CONFIDENCE
Sri Lanka has to have credible fiscal plan and monetary policy to regain stability and confidence. In Sri Lanka, a rise in interest rates and opening of imports will allow taxes to flow back to the Treasury, in a virtuous cycle.
A steeper rise in rates would also allow all the debt repayments that are coming up for repayment to be paid with domestic debt sales which crowd out consumption and halt imports. However, that has its limits. Sri Lanka also has to raise taxes. A value added tax hike is preferable to steep collapse of the currency.
A 20 percent value added tax and the removal of other niggling taxes under a pre-announced plan is preferable to a meltdown which will also destroy bank deposits, pension funds and salaries. Raising value added tax in 2021 is not the same as ‘revenue based fiscal consolidation’ that the IMF then advocated. It was based on getting the tax take up to some mindless abstract number, which politicians then busted up (quite naturally) in higher state salaries and subsidies. How naïve can one be?
Bangladesh, a high growth country with over 10 years of monetary stability, has revenue to GDP of about 8 percent. But it has a better central bank than either India or Sri Lanka. The Taka has been steady for over a decade giving domestic stability though there are questions about the current Governor. It is not possible to have a stable currency without complementary monetary policy.
It is also vital to allow the Ceylon Petroleum Corporation (CPC) to use its cash to buy dollars. Forcing the CPC to borrow dollars state banks would create the same problems as in 2018, raise debt and allow other borrowers to use its cash deposits for imports. It will also push up domestic dollar yields as state banks compete for non-existent dollars, worsening imbalances.
One fix that can stop future currency crises is to privatize energy utilities. In Sri Lanka, the power regulator failed to fix prices and instead resisted increases proposed by the utility, so that is no longer a solution either.
SUDDEN STOP
Sri Lanka’s falling reserves are only partly due to trade and current account and forcing the CPC to borrow dollars and run positions. Because of earlier money printing and currency falls under the ‘flexible inflation targeting/flexible exchange rate’ framework, Sri Lanka’s debt has been downgraded to CCC and the country cannot roll-over debt. This column warned in 2019 that Sri Lanka did not have the rating space to engage in either fiscal or monetary indiscipline.
“In any case Sri Lanka no longer has the rating space for either monetary indiscipline or fiscal indiscipline,” this column warned in November 2019. “None of the candidates of the 2019 presidential elections have seriously talked about monetary discipline, though there is some understanding about the dangers of currency depreciation. If there is no serious monetary discipline that brings stability, all talk of economic programmes is meaningless.”
Instead, Sri Lanka cut taxes within weeks of that column appearing and was printing money from February. The problem is not just sovereign debt.
Sri Lanka’s banks are finding it difficult to roll-over foreign credit lines. Limits have been cut by foreign counterparties. Import letters of credit from Sri Lanka banks are not being accepted by some foreign shippers. As a result, they have to be re-confirmed back to back by foreign banks. Some foreign banks which used to confirm have run out of limits amid higher demand or limits have been cut. Second tier banks in India and the Middle East are coming forward but premiums are high.
Sri Lanka is drifting closer to a ‘sudden stop’ event, though default has not happened. While it’s possible to raise rates and generate dollars to repay foreign debt by curtailing domestic credit, it is not practical to do it on an ongoing basis for many years.
If investors see foreign reserves going up after debt repayments confidence may come back. But it is a painful affair, which may or may not work given the current ideology. For example, using the stock market boom the government can also privatize and get revenues to fix the budget for a couple of years and boost reserves. But this administration has an ideological problem with privatization. The last administration also failed to do any privatizations based on ideology but engaged in open market operations to bust the currency.
There is a widespread dislike of what are called ‘neo-liberal’, a kind of amorphous term used to describe policies ranging from Pinochet’s Chile (where the term appears to have originated) to policies practiced in Germany to make it an economic miracle, Thatcher’s Britain (which had to reverse Keynesianism and post-war expropriation), Ronald Reagan (who brought free trade allowing East Asia to flourish) Mahathir-Daim’s Malaysia, Singapore, Japan under Joseph Dodge and so on. All of these problems and ideologies have converged to create the current problems.
An effective way to restore confidence is to go for an IMF programme. Whatever the faults with IMF programmes, foreign inves- tors have some confidence in them.
IMF PROGRAMME
An effective way to restore confidence is to go for an IMF programme. Whatever the faults with IMF programmes, foreign investors have some confidence in them. The IMF can, if necessary, do a debt workout and delay some of the repayments giving breathing space and allowing domestic rates to be lower than they would otherwise be.
A front loaded disbursement would also push up foreign reserves and again allow interest rates to be lower than otherwise. Any IMF programmes should come with ceilings on domestic assets of the central bank and a low inflation target of around 2 percent. A 6 or 8 percent inflation target will land the country in another currency crisis, as this column warned before. If foreign exchange swaps are available from India or China, it makes more sense to get them with an IMF programme after raising rates sufficiently to at least stop the forex reserves bleeding from current transactions.
Like privatization, the IMF programme is also held back due to some ideology. Sri Lanka has to change the false world view with which it views the universe around it. Economic programmes made on a false world view will not work. Sri Lanka also has to use foreign policy to make friends.
The cancellation of the Japan funded Light Rail Project makes no sense. It simply upsets the Japanese. Like the tax cut, loss making state enterprises, open market operations, and stifling regulations it is also an own goal. MCC grant was another fiasco. An IMF programme can be used to consolidate available support.
China unfortunately has no skills in fixing monetary or debt problems. Illiberal policy under Xi Jinping is creating problems for itself and its neighbhours. China is in the same boat as the World Bank and Western nations were at one time after giving debt to countries with monetary instability and corruption, which made these agencies give loans with ‘conditions.’
Marshall Plan loans to Europe (where central banks had realized the futility of printing money during the war) was one thing but credit to newly independent nations with activist central banks was quite another. The Economic Co-operation Agency which dispensed Marshall Plan aid failed dramatically in South Vietnam with a Keynesian central bank which it helped create. Japan escaped with the skin of its teeth due to Joseph Dodge. Korea’s First Republic was brought down with zeros taken off the bank notes.
There are always solutions and options. Sri Lanka has a history of taking all the wrong options except in 2001
China realized some time ago that Exim Bank and China Development Bank was heading for trouble and started AIIB staffed with experienced outsiders to work with the ADB (mainly Japan) and World Bank (mainly US) in co-financing. IMF programmes also fail to fix economic problems in the long term due to the failure to fix central banks and leaving room for state interventions. The IMF not only fails to fix Argentina – repeatedly – but also failed to fix the UK in the 1970s due to reliance on Keynesian interventionist monetary policy, which is a mild version of Modern Monetary Theory.
It was a combination of Margaret Thatcher, Alan Walters her advisor, and Geoffrey Howe, a lawyer like Malaysia’s Tun Daim who was not confused by Keynesianism and monetary madness who fixed the UK and ended exchange controls which existed for 40 years and made the Sterling strong again.
There are always solutions and options. Sri Lanka has a history of taking all the wrong options except in 2001 – which was done early and brought benefits, and in 1955/6 where corrective policies resulted in the administration getting booted out. There are mediocre solutions to get over the problems and perhaps grow slowly until the next crisis. There are stronger big bang solutions to become an OECD country involving monetary reform, jettisoning of illiberal laws wholesale, an overhauled public service with constitutional reform to improve rule of law and property rights and an education system that teaches logical reasoning and critical thinking instead of nationalism. Howe ended exchange controls on October 23, 1979 with the opposition yapping at his heels for taking a ‘doctrinaire’ decision.
Sri Lanka can be ‘pragmatic’ and come up with some halfway house that is partially compromised by illiberal ideology instead of a plan grounded on reason and a desire to expand the freedoms of citizens so that they can bloom and flower to their full potential. It is always better to take pre-emptive action, rather than be pushed into a situation where there are no options. But whatever is done, the faster it is done the better. It is messy to pick up too many pieces.
CAN SRI LANKA DO WITHOUT THE IMF?
However, to stop future crises the central bank has to be overhauled
The question is asked whether Sri Lanka can do without an IMF programme. It is possible to do so if there is knowledge about monetary policy and pegging and there is an ideology based on classical economics.
The world managed without the IMF before World War II. Some may say there was the gold standard at the time, which is also true. Any softpeg crisis (read BOP crisis) can be fixed without the IMF, especially if it only involves current or capital transactions of private citizens and not state debt. All that needs to be done is to raise rates to slow credit.
Some fiscal fixes are needed since a currency collapse puts energy prices out of kilter and tariffs have to be raised. Usually in countries prone to currency crises and have energy utilities that are state owned, money is printed to provide for energy subsidies.
Energy subsidies financed by central bank credit is a key driver of the crisis in the first place and a reason for a monetary meltdown as the crisis gets underway. Income tax also collapses as consumption falls. There may be bank failures or not, depending on how severe the currency crisis is and how long it progresses, but bad loans always rise. Expenditure cuts are needed since taxes will fall after the currency crisis and the general public cannot bear the entire burden of a profligate state.
In Sri Lanka there is an excess of state workers, who are always molly coddled by the anti-austerity brigade. Austerity for the poor by currency depreciation is perfectly fine but cutting benefits to state workers are out of the question.
To stop future crises the central bank has to be overhauled. If that is not done, the country will go to the IMF again and again and again… and yet again until default or a monetary meltdown drives the country to dollarization. There are many cases of countries fixing themselves without going to the IMF. Before the World War II, all countries fixed themselves without going to the IMF. Japan and Germany did after World War II, simply with Austrian economics.
In 1985, as Latin America printed money and collapsed amid a Fed rate hike, Malaysia with Bank Negara, which is a much better agency than Latin American ones but not as good as Singapore, Hong Kong, or Taiwan, kept the system fairly steady allowing a reform programme to be rolled out. In a monetary meltdown like in Latin America there is usually an ‘inflationary collapse’ with up to triple digit inflation in some cases. If the crisis is averted with a smaller fall with tight policy, there will be a less inflationary or a deflationary collapse and perhaps a recession or smaller economic contraction. This is similar to 2017 and 2018.
It is quite difficult to halt a currency crisis (when the credibility of the peg is lost) when a country is doing really well and domestic credit is growing fast, since there is a lot of approved but undisbursed credit is growing fast, since there is a lot of approved but undisbursed credit in banks and companies do not want to abandon these projects halfway
In the 1980s, commodity prices collapsed in dollar terms as the Fed and the Bank of England tightened monetary policy under Thatcher-Reagan’s return to sound money. Then commodity and energy prices collapsed.
As tin prices also collapsed, Malaysia’s then Finance Minister Daim Zainuddin – a British qualified lawyer and not an anti-austerity Keynesian – slashed state spending and set about fixing a credible budget. He was the Treasurer of the UNMO and Barisan National at the time and a businessman. He was also a good diplomat and was credited with fixing a spat with between Britain and Mahathir Mohammed. Malaysia had engaged in a series of interventionist nationalist policies as part of its New Economic Policy to promote ‘Bhumiputras’ (read non-Chinese) in 1971, which also involved setting up state enterprises.
“By the time I came in, that was 13 years later, they were making losses,” Daim is quoted as saying in an interview in Sri Lanka which is today found in the DaimZainnuddin.com
“Lots of these companies were making losses because they were run by ex-civil servants and people with no experience. And there was the 1985 recession and so the government needed funds for development. So, I say look, why don’t we shut down those companies that were making losses, the good ones … also privatize. So that in the process when they do well, then the government can benefit from taxes. My view is, if after 15 years if we still do not do well, we must have a re-look at it, instead of wasting more money.”
In Sri Lanka today privatization would also get some immediate cash as well as income taxes in the future. Privatization transforms the economy and reduces room for future political interventions. The past privatizations of telecom, port projects are examples. Daim is credited with paying back loans ahead of time. Malaysia powered ahead. He retired in 1991 and went back to business. Malaysia also managed the East Asian crisis without an IMF programme. Malaysia tried to defend the peg, with high rates, but speculators were hitting it with swaps.
It is quite difficult to halt a currency crisis (when the credibility of the peg is lost) when a country is doing really well and domestic credit is growing fast, since there is a lot of approved but undisbursed credit in banks and companies do not want to abandon these projects halfway.
Domestic credit was growing 36 percent in Malaysia and property credit was also around 30 percent when speculators hit the peg. Bank Negara was already applying selective credit controls to property when the crisis hit. Applying administrative credit controls selectively may have partial success but is less superior to market rates which automatically selects the highest return projects in whatever sector and discourages others.
Malaysia then pushed up its 3 month policy rate to over 10 percent, which was exceedingly high for its highly leveraged firms that were used to low rates coming from its peg which was credible for many years. Overnight rate spiked over 40 percent at times.
The so-called ‘capital controls’ were mis-reported in many Western media, who seem to be confused by both monetary policy nor pegs but glorifies ‘stimulus’ and heedless Keynesian spending. This is personified in the view that ‘the government must do something’. Malaysia closed the offshore ringgit market and stopped the outflow of ringgit.
Bank Negara stopped the outflows of new ringgit through credit and swaps to non-residents and to several offshore markets and re stricted offshore ringgit financing. Hand carrying Ringgit notes were slashed from 100,000 to 10,000.
It was done to stop the monetary base from expanding and falling into the hands of speculators which would then come back to hit the peg. To hit a peg, it is necessary to get hold of domestic currency, not foreign currency. By that time credit growth had collapsed and there were bad loans. As a result, maintaining the peg was not that difficult.
Hong Kong, which has a near-orthodox currency board, did not put any controls, kept the swap market open but allowed interest rates to rise each time the peg was hit and then. When the swaps came for renewal the speculators were badly hit due to high premiums and they had to leave with massive losses.
After the Asian Financial Crisis, Malaysia continued to grow. But it started to lose ground a little later. Korea liberalized dramatically under its IMF programme going so far as to break up chaebols (people in Korea call it the ‘IMF crisis’ due to bank failures among others which were blamed on the agency) which helped make it an advanced nation, but such changes are not necessary to stop a currency crisis per se.
However, in the old days it was the practice to ‘front load’ all the pending reforms in the expectation that the country will grow fast after the programme.
IMF programmes can vary in quality and success. It will depend on how good the mission leader and the resident representative are, and whether they are grounded in classical economics and whether there are like minded reformist bureaucrats, central bankers and politicians who are itching to make changes.
If a country keeps going back to the IMF repeatedly with currency problems, the problem is with the peg. Korea is now a free country and is still in the OECD. Malaysia on the other had more problems with nationalism and religion which have become election gambits now.