Sri Lanka’s politicians, especially from the United National Party have taken extremely difficult decisions to fix the country macro-economists who do not appreciate sound money created monetary instability and economic collapses.
Ranil Wickremesinghe is now taking very difficult political decisions. People are also watching with an unusual degree of patience – so far. A break on inflation has been put in after running as high as 70%, and the currency has fallen from 200 to 360 against the US dollar.
In Sri Lanka economists like to depreciate the currency like many in other basket-case countries. They think devaluation will boost exports even though depreciation and the resulting misery triggers strikes, and social and political unrest and makes budgets unmanageable.
It was J R Jayewardene who gave the power to the country’s macro-economists to print money at a time when the State Department was intent on breaking the Sterling Area trade bloc and belief in interventionism was high.
Shortly after the War, only a few countries like Germany did not believe in printing money. Japan fixed itself in 1948, after about 700% inflation helped by Joseph Dodge, a US banker who was involved in German monetary reforms.
But Sri Lanka set up the central bank when JR was finance minister. These columns had shown previously that he had warned the central bank. JR was a lawyer, not an academic economist. To his credit, he tried to get the best classical economists in Asia to advise the country and correct his initial mistake. But what they were saying was apparently beyond the grasp of the country’s economists and policymakers.
POLITICALLY IMPOSSIBLE REFORMS
The UNP administration wanted to create a Singapore after they came to power in 1977 after the country was strangled by severe exchange and trade controls. By 1980 amid a very strong economic recovery, Sri Lanka was in the middle of a balance of payments crisis and was going to the International Monetary Fund. And he got the economic architect of Singapore Goh Keng Swee to advise the country almost like a second opinion.
After the 1960s and 1970s, money printing boom led to exchange controls, import controls, black markets, permits, dual exchange rates and high unemployment, JR liberalized the economy. Like Ranil Wickremesinghe today and Mangala Samaraweera a few years ago, JR took very difficult decisions.
“You introduced a number of economic reforms which most people had considered politically impossible,” Goh told him.
“The abolition of price controls for most commodities, the abolition of the food ration system, which provided free rice to the general public, the increase in the nine administered prices – rice sold by co-operatives, flour, bread, kerosene, electricity, bus transport, coconuts, coconut oil and milk powder – virtually ended the black market in these goods as supplies from official sources were adequate to meet demand.
The exchange rates were unified in November 1977; imports were liberalized and the rupee was allowed to find its level in the free market. The result was a flow of imported goods previously unavailable.
“These are actions which required considerable courage. They constitute a break with the conventional wisdom of past decades based on a re-distributive ethic, extensive state control and hostility to free enterprise and private ownership.”
CORROSIVE EFFECT ON PERSONAL INTEGRITY
The liberalization brought multiple benefits. “These and other measures to free the economy achieved three immediate benefits. First, a substantial increase in the supply of consumer goods, previously unavailable, improved the living standards of the people. It brought to an end shortages, queues, and black markets with their corrosive effect on personal integrity.”
Sri Lanka’s public sector and also the private sector started to become corrupted during the closed market period, not as claimed by others after the opening.
The permits and controls made it impossible to engage in economic activities which were perfectly legal before the central bank, like sending money abroad or selling goods at market prices. To get permits palms had to be oiled.
Goh more than anyone knew the bad effects of price controls. Price controls are trying to defy the reality of money printing. When prices rise, there is no way to bring it down except by raising rates and halting money printing.
However price controls invariably force people to break the law, and create a black market. Businesses sell illegally and people buy illegally, leading to corruption of an entire society and a disrespect for rule of law.
Goh more than anyone else knew the problem. After Singapore fell, Japan introduced so-called Banana Money and inflation rocketed.
When the British took the territory back, wartime controls continued. The British Military Administration generally called the BMA was referred to as the Black Market Administration by ordinary Singaporeans. Singaporeans, more than anyone, therefore, knew the problem of monetary instability.
PRINTING MONEY
Economists at the central bank printed money for about 55 years with no questions asked. In 2004 after the central bank printed 60 billion rupees driving inflation up and creating forex trouble, people started to protest.
W A Wijewardene, Harsha de Silva and sections of Sri Lanka’s financial media led the battle. But other economists continued to dismiss it. That was apparently in line with the views of Sri Lanka’s economists who were deep believers of state interventionism and money printing, essentially John Law.
Goh Keng Swee warned JR that the central bank was buying up large volumes of money. “This method of financing has high inflationary consequences,” Goh told JR. “The scale of such inflationary financing is alarming. It began early this year. In January, the volume of Treasury bills issued was Rs3,000 million. In March, the Parliament approved an increase to Rs4,000 million and by June 16, this limit was reached. In July, the limit was raised to Rs6,000 million and by September, the limit was reached.
“On October 17, the limit was again raised to Rs8,000 million and during my stay in Colombo, Parliament again raised it to Rs10,000 million. Based on past performance it is safe to assume that the limit of Rs8,000 million had already been reached and it will not be long before the volume reaches Rs10,000 million.
“A three-fold expansion of the volume of Treasury bills in a year has few precedents in the world. The impact has already been felt in the large increase in prices this year and further price increases cannot be avoided next year”.
The printed money will blow a hole in the balance of payments. “The second effect of excess expenditure met by deficit financing works through the foreign exchange. Where goods are imported under a system of open general licensing introduced by your government, imports of these goods will increase because people have more money to spend. If foreign exchange earnings do not increase in step, either through increased exports or capital inflows, the result would be a run on the country’s foreign exchange reserves or a depreciation of the currency’s rate of exchange or both. In Sri Lanka, both these have occurred in 1980.”
DEPRECIATION WILL NOT BOOST EXPORTS
In Sri Lanka, inflationist-devaluationism is almost a religion. Despite 70 years of failure and the living examples of Germany, Japan, Thailand, Taiwan and China where strong, stable exchange rates led to massive investment and export growth, Sri Lanka economists still believe in depreciation.
“The brief expressed the fear that an appreciation of the rupee will weaken Sri Lanka’s competitive position and stifle future growth,” Goh said in reply to a question in the 1980s.
I believe these fears to be groundless for two reasons. First, since the bulk of Sri Lanka’s present exports comes from tree crops where prices are determined in foreign currencies, mainly in the London commodity exchange, a rupee appreciation will not mean an increase in the Sterling price of Sri Lanka’s products. Prices in foreign commodity markets are the same for similar grade of products from all countries producing them. Where prices differ, they result from variations in quality. A stronger rupee would mean, however, that the rupee incomes of tree crop producers would go down.
“As regards, exports of Sri Lanka’s manufacturing industries, an appreciating currency would have limited net impact. Both in Sri Lanka and Singapore, manufacturing activities consist mainly of the processing of imported semi-finished material such as textiles into garments, silicon chips in semiconductors, steel sheets into refrigerator cabinets, etc.
“A stronger rupee would mean that import costs would be lower and thus offset the effect of currency rate appreciation. Contrariwise, a weaker rupee will mean an increase in import costs of raw materials and intermediate goods used in manufacture, largely offsetting the competitive advantages arising from a lower exchange rate. “The position is different in industrial countries. The finished manufactured product is the end of a long chain beginning with the mining of iron and going through intermediate stages of production so that the domestic content of the finished product is much higher than the finished products coming out of factories in Sri Lanka and Singapore.
WATCH THE ECONOMISTS
In 1980 only a part of the Treasury bills was bought by the central bank for deficit financing. With a balance of payments crisis already underway, other bills were bought to offset foreign reserve losses. Goh told JR to watch five economic indicators to monitor the economic health of the economy.
The first was the central bank’s Treasury bill purchases.
You may need some signposts by which you can find your way through the intricacies of economics and be able to assure yourself whether or not the measures are taking effect. I suggest five principal economic indicators.
(1) The volume of Treasury bills bought by the central bank. This is by far the most important statistic to watch
(2) The central bank’s foreign exchange reserves.
(3) The exchange rate of the rupee
(4) The Consumer Price Index
(5) The prices of construction materials
Though all this was told to the political leadership in 1980 the economists ignored it. Until W A Wijewardene started to write about it earlier this year, no one knew that Goh Keng Swee, the economic architect of Singapore had advised Sri Lanka.
SINGAPORE WITH A LATIN AMERICA MONETARY FOUNDATION
Nobody knew that the advice had been comprehensively ignored. Or that Sri Lanka was trying to build a Singapore with a Latin American monetary foundation. Now people are talking about Vietnam. But the State Bank of Vietnam is trying to operate a better peg and is fighting with the IMF and US to be allowed to do so. Whether it will succeed is not known, but at least.
After the UNP got into power in 2015 the central bank started to inject money through other means with the public more aware of the effects of T-bill purchases. From about three months before, liquidity was injected by terminating repo transactions. Outright bill purchases started later.
With public opposition to direct purchases of Treasury bills, the central bank started to buy them from commercial banks through overnight and term repo transactions. By this time, in such a childish move that it was difficult to believe, the Bills purchased through the term and overnight transactions were removed from the daily released data.
In 2018 money was also printed through dollar swaps to inject liquidity. None of this was done to finance the budget. It was done to manipulate rates downwards and try to boost growth.
Now a new central bank law is being made. Again, it is promised that there will be no direct purchases of bills from auctions. But there is nothing to prevent bills from being purchased through other means like in the 2015 to 2019 period. In the new law, there are no such safeguards.
Moreover, it is still a soft peg or flexible exchange rate, the most dangerous monetary regime that is found in all basket case countries.
Soft-peggers are planning to set themselves a 5 or 6% inflation target. High enough based on the 2012-2019 experience to easily trigger serial currency crises.
The new law will undoubtedly be passed by parliament just like the original soft peg law that went into effect in 1950 forcing all subsequent economic plans to be made on a foundation of monetary instability.
The legislators will also probably pass the 5 or 6% inflation – double that of stable countries – with no questions asked, just as they passed the original law and amendments to print more money. And other laws like exchange and import control laws, rob the economic freedoms of the people rather than control the open market operations and mistargeted policy rate of the central bank.
It took more than 50 years for realization to dawn. With ‘fear of floating’ and ‘currency board phobia’ firmly entrenched in Sri Lanka’s policymakers the chance of escaping the deadly soft peg is almost zero.
Hopefully, it will not take another 50 years for the realization to dawn that the ‘flexible’ exchange rate ‘ is also another unstable soft-peg regime which will be plagued by the same problems as before, as seen in the last 7 to 10 years. Sadly, many are leaving the country without waiting to find out whether economists can be tamed or not.