Sri Lanka is on a recovery path and anchor conflicts in flexible inflation targeting will rear their ugly head as private credit recovers, hits the currency, and destroys savings, forcing more people to leave for currency board regimes or countries with a 2% inflation target.
A tiny minority of macroeconomists in the central bank, the Treasury, think tanks and especially after 1978, the International Monetary Fund have promoted monetary instability, forex shortages and high inflation for around 72 years in this once paradise island.
Until 1978 the macroeconomists printed money, created forex shortages and made the rupee lose its attribute of being a medium of exchange with trade and exchange controls.
In the 1970s in particular – as the Bretton Woods collapsed – people were starved with the ‘closed economy’, and malnutrition rocketed leading to Thriposha being invented to save the kids, while import substitution businesses got fat on the misery of the people.
After 1978, the currency started to collapse as the IMF suddenly reversed direction on its founding ideal of currency stability and deprived countries of the attribute of money as a medium of exchange and a store of value as well. As a result, countries had to borrow abroad as domestic savings were destroyed, leading to wider current account deficits.
Creditor nations with high savings rates, with central banks that borrowed from the IMF to widen or create current account deficits gradually from the 1960s were turned into debtor nations in a few years.
The key victims were Latin America, Africa and South Asia with the notable exception of Maldives. Even Zimbabwe, once called the bread basket of Africa, had a per capita GDP higher than South Korea until the restraint of the external anchor was taken away after 1978.
All this suffering is due to the power given to the central banks or the bureaucrats and to their advisors to cut rates by printing money for macroeconomic policy. When macroeconomists decide to cut rates the public and politicians are helpless. Politicians get kicked out and a new set comes in.
They try reforms. If the reform is deep and there is a swift recovery and private credit grows, there is a fresh round of monetary instability and the reformists get kicked out as the currency collapses and a stabilization programme is done after going to the IMF again. Or the new set turns authoritarian and hangs onto power.
In Sri Lanka each year two hundred or more migrate to currency board-like regimes in the Middle East which have to import labour to their stability, and to clean floating regimes in the West with a 2% inflation target.
But people should not have to leave the country of their birth just so that a few macroeconomists and the IMF can practice ‘monetary policy’ with central bank independence, cut rates with standing facilities and term reverse repo facilities and cut the ground from under the feet of 20 million people in the process.
To give due credit, the current Central Bank Governor has beaten all IMF forecasts on rupee depreciation. However, the inherent legal framework is completely flawed. There is opposition to East Asia-style currency boards from inflationists from within and without the money monopoly.
One surefire way to rescue the people from the IMF-mandated deadly flexible exchange money monopoly is to break it. Breaking the monopoly will help restore to the people their country of birth so that they do not have to go to Dubai, Qatar, Saudi, or Bahrain, as boat people to Australia or as mercenaries to the Russia-Ukraine front. Or indeed stop macroeconomic policy from driving young mothers and girls to the proliferating ‘spas’.
What is needed to break the monopoly?
What is needed to break the monopoly is some political will and the courage to defy inflationism and reject the false lure of the macroeconomic policy. Sri Lanka’s legislators have to get over years of brainwashing in inflationist universities and wake up and look at what is happening in the world.
Exchange rates are a matter of law, which is why before 1978 (and before 1971) exchange rates did not depreciate even if there were forex shortages from macro-economic policy or central bank re-finance.
Before the 1920s there were no forex shortages or depreciation at all, except in wartime. The Sterling depreciated a handful of times from 1797 in particular and was restored at pre-float parity.
After World War I it was not possible due to the invention of the policy rate. People find it difficult to grasp the concept of a currency board or a fixed exchange rate without a policy rate due to a lack of knowledge about operational frameworks and years of brainwashing on mercantilist spurious doctrine. Instead of worrying about operational frameworks competition can be brought through dollarization.
Javier Milei could not navigate the insane arguments put forward by foreign macro-economists against dollarization and is now faced with a depreciating currency and his whole ambitious reform programme is in tatters. They criticize the IMF and support the peso with a policy rate in the same breath.
Once he is kicked out by currency depreciation and social unrest, liberal economic policies will be further discredited not only in Argentina but also in the rest of Latin America. This is the general outcome when flexible exchange rates collapse during and after IMF programmes due to central bank liquidity tools.
How to dollarize?
If the monopolists, inflationists and other mercantilists can be defeated by legislators it is a simple matter to implement. The big challenge is to go past the lies and false doctrine repeated ad nauseam.
The best reforms in the UK – the birthplace of Keynes and Cambridge economics – were carried out by a lawyer who was a finance minister, advised by classical economists. It is easy for a lawyer to grasp the logic of how central banks work and that it has nothing to do with trade or current account deficits as mercantilists claim.
What are the common arguments put forward against dollarization? These are mostly the same that are put forward against currency boards as well. The main argument is that there are not enough dollars at the central bank to exchange for the monetary base foreign currency and there are not enough dollars to circulate within the country.
This is a mistaken idea about money, in line with all ideas peddled to unstable countries. Exchange rates and money are ultimately legal matters which can be easily solved by bold and courageous legislators who are willing to challenge inflationism and mercantilism.
A central bank which collects reserves runs a much more tighter system than a currency board as does any reserve-collecting central bank whose forex reserves are bigger than the monetary base.
There is no need at all to exchange the monetary base instantly for dollars. In market-dollarized countries, nothing like that has ever happened.
What usually happens is that politicians and police no longer listen to the central bank and its money monopoly is broken as a cash dollar economy emerges. Macroeconomists and other mercantilist inflationists are then forced to accept it as a fait accompli.
The Monetary Freedom Law
It can be done by a few legal changes that take monopoly powers away from the central bank. Its inflationary power to hurt the poor drive away citizens to foreign shores and scare away investors – the transmission mechanism – will go with it. The Monetary Freedom Law should have provisions to allow for several steps.
Step 01: Abolish all legal tender laws that prevent holding dollar notes by the people, or marking goods in dollars to sell in shops. Shops should be freely allowed to sell goods in US dollars or any other currency like the Euro. US dollars will generally win.
Step 02: Allow domestic clearing in dollars including credit and debit cards. This will clear the perceived problem that there are not enough dollar notes to circulate. Forcing the central bank to allow dollar debit and credit will free people to use remittance and export dollars coming as electronic credits for domestic transactions.
Step 03: Taxes should be allowed to be paid in dollars as well as rupees. It is important to allow taxes to be paid in rupees.
Step 04: The central bank should be required to extinguish some or all of the excess liquidity that is likely to end up as excess liquidity due to Gresham’s law. (See how later in the column)
Some other measures need to be taken including preserving the legal tender of rupees especially for bank deposits, but those are just details.
How will the dollar monetary base build up?
The monetary base will be built up as monetary bases were built in all market-dollarized countries, ranging from jurisdictions like Montenegro in Europe and Cambodia in East Asia. People who are hoarding dollars will start to use them for one thing.
At the moment the rupee monetary base is about 1,400 billion rupees. At 300 rupees to the dollar to completely replace the monetary base about $5 billion is needed. As soon as the legal tender monopoly is ended, notes coming from tourism and returning guest workers will be used domestically instead of going back for smuggled imports and legal tourism. From January to June smuggled import receipts were $2.6 billion and tourism receipts were $1.4 billion.
All export sector workers, all tourism sector workers who are paid dollars and all remittance families who either keep the dollars or transfer cash from their accounts will progressively end up with dollars instead of rupees in their purses or bank accounts and debit cards helping build the dollar monetary base.
Initially, due to holding dollars in their hands, imports will decline and bank deposits will slow down in step with the expansion of dollar reserve money. The reduced imports will feed the dollar monetary base just like deflationary policy now feeds central bank reserves through a balance of payments surplus and reduced investment-driven imports.
Gresham’s Law
However, at the same time, rupees will be deposited in banks by businesses and others who do not want to keep them in their hands and the notes will end up as excess liquidity in the central bank as the dollar monetary base grows.
This is Gresham’s law in action. The rupee monetary base will essentially freeze with liquidity ending up in the standing facility.
The central bank can buy them for its Treasury bills from banks and extinguish them (See Step 04 in the liberalization law earlier). There will be no liquidity shortages as the rupee monetary base will shrink. As the rupee monetary base is extinguished banks will end up with Treasury bills denominated in rupees.
After a while, the rupee and dollar can circulate in parallel. As the rupee stops depreciating people will again be willing to use rupees.
In any case, they can be used to pay taxes to the government and the government can use them to pay interest on rupee debt or even part of the salaries of the state workers until taxes no longer come in rupees. People can have rupee or dollar deposits and some may prefer it as interest rates in the rupees will be initially higher than the dollar deposits. A fixed exchange rate and higher rates.
Over the medium term, there are two choices: one, completely extinguish the rupee monetary base, or two, allow a frozen monetary base to circulate in parallel. Interest rates will eventually fall and will be around 5% or less like in Cambodia. If the rupee monetary base is completely extinguished, all deposits and government securities can be denominated in dollars.
Or they can be allowed to naturally expire and new debt be re-issued in dollars. Rupee and dollar interest rates will equalize. If rupee interest rates remain at higher levels, dollar Treasuries can be issued to arbitrage the difference and repay rupee securities.
Prolonged monetary stability will lead to foreign investments and improvement in fiscal metrics. Interest rates will collapse.
Can a dollarized Sri Lanka Default?
Yes. If there are sovereign bonds in particular and for some reason or other they lose confidence and start selling it will be difficult to re-finance them. But if there is a default only the lenders to the government will be hurt in a dollarized country.
There will be no currency depreciation to make people starve like in Sri Lanka now. There will be no central bank-driven defaults and no exchange or trade controls. But defaults can take place, especially if there are illiquid sovereign bonds with jittery investors.
This is generally the case in low-rated developing countries which have a history of bad central banking and socialism before dollarization. And defaults will take place at much lower debt-to-GDP ratios. That is one of the reasons currency boards and dollarized countries eventually end up with debt-to-GDP ratios of around 30 to 40%.
The problem can be avoided by going into syndicated loans. One of the advantages of dollarization is that fiscal metrics will improve due to rock-bottom rates and a lack of crises. Low debt to GDP is not a pre-condition as macro-economists falsely make out. It is a result of a monetary system that is tighter than the anchor.
In both currency-board and dollarized countries, banking crises are minimal even if there is a burst bubble in the anchor currency country due to the lack of excessive reverse repo facilities for banks.
However, since capital accounts are free banks can be hurt in cross-border lending as was seen in the case of Singapore in the Asian currency crisis. Cross-border deposits can also hurt banks in a dollarized or currency-board country in a global crisis if there is no history of stability.
Hong Kong had its baptism by fire during the East Asian crisis, and during the Housing Bubble, it was flooded with cash driving rates to negative territory. But that was not the case with Denmark.
It is also not the case in monetary unions. Due to the availability of reverse repo facilities banking crises can take place. This was the case in the EU region. But without macro-economists to depreciate the currency, people will not be hurt and the country will pick and go even if there is a default.
While default in a dollarized country is rare, unless there are a lot of sovereign bonds, under flexible inflation targeting, potential output targeting and depreciating flexible exchange rate, default is almost inevitable.
Will dollarization bring growth?
Dollarization will bring stability and conditions for growth, but not growth itself. However bad policies can still drive away investments and capital.
Cambodia is growing like a bomb with high levels of corruption partly due to Vietnam being near it and its proximity to Korea. Vietnam also benefited from the proximity of Korea and the country’s rising wages amid exchange rate stability from 1987. Sri Lanka being near India does not have the same advantage.
Compared to many countries in Latin America where prolonged monetary instability of around 20 IMF programmes led to entrenched socialism, Sri Lanka still has some market policymaking ability left.
Sri Lanka can perform much better than Cambodia, especially in services. But it may not be able to do so well in goods due to lack of coal power. Since Sri Lanka is in a major sea lane and near India, it will grow.
The only disadvantage is that, unlike a currency board, the profits from note issues will go to the US, not Sri Lanka. That is why this column generally advocates a currency board. Profits from the currency board can be used to build a sovereign wealth fund or a lender of last resort facility. However, that is another story.