Sri Lanka is now emerging from a similar experience to the Asian Financial Crisis. Unlike East Asia, which suffered one crisis, Sri Lanka suffers crises one after the other, like the Philippines. Th ere had been contradictory Central Bank policy with the exchange rate and interest rates targeted simultaneously in 2018, which broke the peg and led to a loss of its credibility, triggering capital flight and exporter holdbacks.

Sri Lanka is suffering similar outcomes with an output shock, a spike in bad loans and an unhappy electorate. Unlike many East Asian nations, however, Sri Lankan firms are relatively less leveraged due to repeated currency crises. People are long-suffering, and banks lend short term, and people also deposit short term, which allows for rapid re-adjustments.

Ross McLeod, Adjunct Associate Professor, Indonesia Project, Economics Department ANU College of Asia and the Pacific, has been studying Indonesia’s macro-economic policy for many years and is a frequent contributor to the Wall Street Journal. Indonesia is a country that had a weaker exchange rate than either Malaysia or Singapore. Interestingly one of its largest islands, Borneo, has three monetary regimes. Policy in Southern Borneo, Kalimantan, is by the Bank Negara Indonesia, and it suffered terribly in the Asian Financial Crisis. In the North, in the former British territories of Sabah and Sarawak, currency notes are produced by Bank Negara Malaysia, and it has a stronger exchange rate and people are richer.

Borneo also contains Brunei, which has a currency board with Singapore and is one of the wealthiest countries in the world. All three countries have oil; Indonesia has the weakest economy and exports labour to Malaysia and elsewhere in East Asia, like Sri Lanka; and the Philippines exports labour to the Middle East. Professor McLeod has been working on Indonesia since 1978 and speaks Bahasa Indonesia. In addition to academic papers, he also
contributes to mainstream media like the Wall Street Journal. From 1998 to 2011, he was the Editor of the Bulletin of Indonesian Economic Studies.

Career highlights
Lecturer in Economics, ANU (1982-84); Managing Director, Ricardo, Smith Pty Ltd, Economics and Banking Consultants (1984 to present); Fellow/Senior Fellow/ Associate Professor/Adjunct Associate Professor, Indonesia Project, ANU (1992 to present); Associate Editor, Agenda, (2001-2005); Editor, Bulletin of Indonesian Economic Studies (1998 to 2011). Ross McLeod was invited by Advocata Institute, a Colombo-based think tank, for the Asian Liberty Forum in Colombo to lead a session on exchange rate policy earlier this year. He was interviewed by a fellow of Advocata on the sidelines of the conference.

Excerpts from the interview are as follows:

You have been studying Indonesia quite extensively. We have seen exports of East Asian countries grow. Unlike countries like Taiwan and Hong Kong, Indonesia’s currency had steadily depreciated. Can you explain to us about some of the policies you observed Indonesia following in terms of monetary policy and exchange rate?

In Indonesia, there is no clearly settled idea about what monetary policy and balance of payment policy should be. It’s a kind of trial and error, and the Central Bank sticks with one policy for quite some time, and then there’ll be some kind of disturbance when the policy gets changed a little bit or a lot.

Last year was an interesting period and in Indonesia’s monetary policy history, in that we had a relatively stable exchange rate for quite some time, maybe 18 months to two years or so, and everybody was happy; then the balance of payment started experiencing deficits.

It was partly because of what was happening on the trade account and partly because of the capital outflow due to global interest rates were beginning to rise, but Indonesia was not following suit. So there was a larger difference between the Indonesian and international interest rates. So you’re getting a capital outflow because of that.

The central bank was somewhat unhappy, but allowed the exchange rate to depreciate. Obviously, all central banks get pressured when the exchange rate moves in the other direction. So the central bank was tending to stand against the exchange rate, which, in those circumstances meant it had to sell off its international reserves. International reserves were falling, and the effect of that was for the monetary liabilities of the central bank to shrink. In other words, it was withdrawing Rupiahs from circulation, and that tends to have the impact of increasing local interest rates. So again the Central Bank gets pressured because the business community does not like high interest rates. So then there is a bit more intervention (in bond markets).

On the one hand, in the foreign exchange market, the central bank was selling international reserves, extracting base money from circulation; but now the bond market started entering as a buyer and is re-injecting base money in an attempt to keep interest rates from going up.

That’s all fine, but basically, you have got two conflicting policies. You’ve got the market wanting to shift capital offshore because interest rates overseas are now more attractive, but at the same time, you’ve got the central bank – Bank Indonesia – buying government bonds to keep interest rates down. By keeping interest rates down, that means there’s still incentive to export capital. So basically you’ve got two incompatible policies followed by the central bank, and that’s a recipe for disaster.

As it turned out, by the end of last year, things had settled down perhaps because the trade accounts were more healthy and so Indonesia was able to recover some lost ground as far as the exchange rate was concerned. But the way I see all of that is that the Central Bank doesn’t really have a consistent idea about what it should be doing and finds it difficult to accept the idea that it only has one instrument of policy and that is its control of base money. That is its own monetary liabilities. Therefore, it can really only control one nominal variable. It cannot control the nominal exchange rate plus the interest rate, plus the level of prices. It can only control one of those things. But it just doesn’t seem to be able to accept that.


Can you explain to us what happened to Indonesia in the 90s?

In the 1990’s before the Asian Financial Crisis started, Indonesia had steady growth. It was a very healthy economy. It was growing rapidly and had a low rate of inflation, but its exchange rate was actually depreciating steadily. No announced policy said it, but nevertheless, if you look at the data of that period, you will find that the Rupiah depreciated at a rate of about 3-5% per annum for quite a long period. At the same time, the central bank had a policy of trying to control inflation, and they wanted to keep inflation less than 5% per annum.

That meant in practice, the Central Bank was trying to control two nominal variables at the same time – one being the rate of depreciation of the exchange rate and the second being the rate of inflation. Now because central banks only have one instrument, they cannot control all two variables simultaneously. So the way it worked out in Indonesia was that there was a consistent balance of payments surplus. That meant that the Central Bank, to keep the exchange rate from depreciating, bought the excess supply of foreign exchange, and by doing that (by buying foreign exchange in the market) continually injected additional base money into circulation.

That meant that the money supply was increasing too rapidly to be consistent with the inflation target. So, on one hand, they met their goal for depreciation of the nominal exchange rate, but they couldn’t meet their inflation target because the money supply was increasing too rapidly and inflation was always above target. They wanted to keep inflation below 5 percent, but in practice, it was always in between 5 and 10 percent. So it’s just an example where the central bank tries to do too much. It seeks to control more than one nominal variable with only one instrument of policy.


In Sri Lanka, there is widespread belief, among the people who speak in the media, that people are doing something wrong for Sri Lanka to have currency depreciation, that depreciation and balance of payments deficits are all because of something people do. There’s no talk of monetary policy when people or the media refer to balance of payments.What would you say?

Well, it’s not the people at all, it’s the policies of the central bank in all cases. I don’t know the situation in Sri Lanka, but in Indonesia, written into the law of the Central Bank is the requirement that it is responsible for controlling the value of the Rupiah. (Sri Lanka’s Central Bank originally had the requirement [maintaining external value of the rupee], but with the understanding that the exchange rate cannot be controlled with a policy rate enforced by money printing, it was dropped as a legal requirement in an amendment. However, the Central Bank still de facto tries to target the exchange rate through a variety of ways).

Now, why is that in the law? That’s because central banks, whether they like it or not, do control the value of their own currency. They produce the currency; and just like everything else, you have to have a balance between supply and demand. There’s a demand for money from the people, but the supply is determined by the central bank. If supply is made too large relative to the demand for it, or if the growth rate of supply is too rapid relative to demand growth, then just like everything else, the value falls.

The value of money is its purchasing power. That’s kind of the inverse of the inflation rate. If the value of the currency falls, it is equivalent of saying prices are rising. So it’s never the fault of the people. It’s always attributable to the policies of the central bank. Specifically, if the Central Bank tries to control more than one nominal variable simultaneously, it’s just going to fail, because it only has one instrument of policy.

Just to look at central banks or monetary authorities that do control one variable. On one side of the spectrum, we have a country like Hong Kong. What is the policy there?

I haven’t read up on Hong Kong in recent times. For a very long period, they did hold the exchange rate constant against the US dollar. You cannot control the exchange rate against all currencies simultaneously. But against the US dollar there was a constant exchange rate. But that’s okay. If that is the sole variable you are targeting, you can do that, provided you are willing to relinquish control over the money supply. So it’s just like under the old currency board arrangements – if you set a fixed rate of exchange for your currency against a foreign currency or against gold or silver, etc, that’s fine. Any time there’s a balance of payments surplus, the money supply is going to increase, it’s going to increase domestic prices, and that’s going to get you back to equilibrium. I think that is the way it is still in Hong Kong. The key to it is just having one nominal variable as your target, not more.

Can you explain how Australia or New Zealand conduct policy? Do they worry about the current account deficit?

Let’s stick to Australia because that’s my country, so I know a little bit about it. In Australia, we used to worry about the current account deficit. Some years ago, we went to a floating exchange policy, andit’s a genuine floating exchange rate policy.

Nowadays, nobody talks about a currentaccount deficit. In fact, when I turn on thenews every evening, there is a little segmentabout finance, and the guys come on and tell me what happened to the exchange rate today. We went up against the US dollar, or we went down, it’s no big deal.

It’s the bit of news nobody gets excited about. So that is equivalent to saying that we genuinely have floating exchange rates and the Reserve Bank of Australia isn’t trying to fix the exchange level to this level or that level.

We also have a pretty good inflation record: the inflation rate is always low and it’s close to the target (maybe 2 or 3 percent or even less than that).

In fact, sometimes people get excited that the inflation rate is lower than some target, which seems crazy to me. What’s the problem with low inflation?

But my point is that, generally, the Reserve Bank doesn’t try to control lots of different variables. It basically focuses on the growth of the money supply, and it’s more accurate to say that it focuses on the inflation rate; so they determine the monetary policy, whether it’s needed to be tightened or loosened, depending on what’s happening to the inflation rate. At the same time, they are not trying to control the value of the currency in terms of another currency, they are letting the market determine that for us. It works perfectly fine.

We have a reasonably good growth rate in today’s economy and a low inflation rate, so everybody is happy.


People also talk about anchoring the monetary policy to a particular variable or target. How does that work in the perception of the people?

By having an anchor for the policy, we decide on one nominal variable that we want to see constant or at a particular level and we adjust the monetary policy settings in order to achieve that. So in Indonesia, for example, I’ve always suggested that the nominal anchor should be the rate of growth of base money. According to my sort-of amateurish calculations or estimations, if money grows by that 9% or 10% (the monetary liability of the Central Bank), we are going to have real growth of 5% – that’s typical for Indonesia, we are going to end up in an infation rate of around about 3%. And that’s fine.

Everybody would be happy. So the target is the rate of inflation of about 3%, the nominal anchor is the rate of growth of the money supply, which should be set around 9-10%. I believe if that is done, then you get the outcomes you want to achieve. But the minute you start having more than one anchor, if you are trying to anchor the exchange rate as well as the rate of growth of money, then that’s the recipe for disaster and disappointment.


So why not do the same thing Australia does in Indonesia?

Well, you can do that as well. It just seems to me that having a straightforward concept like the rate of growth of base money is directly under the control of the central bank. Base money does not change unless the central bank does something to make it change. For example, if it lends to the government, that’s going to increase the base money. If it buys foreign exchange, it’s going to increase base money. If it buys government bonds in the open market, that’s going to increase base money.

If you don’t want base money to change, then you simply don’t do those three things. You don’t lend to the government you don’t intervene in the foreign exchange market, and you don’t intervene in the bond market. Stay out of all those things. Let the government finance its deficits by borrowing from the market. That’s a much better way of doing it. Let the exchange rate go where it wants to go, where the market wants to go. That will keep your balance of payments in equilibrium. Stay out of the bond market.

So just sit on your hands and do nothing, and effectively let the market work things out. It is the road to peace and bliss as far as I am concerned in terms of the life of a central banker.


Sri Lanka had a currency board from 1885 to about 1950. Th e British set it up. Why don’t people set up currency boards any more? Is there any technical or economic reason behind that?

Well, it’s partly politics. Politicians in the government and the central bank like to be able to intervene. If you have a currency board, there is no intervention, as you know. A currency board simply means you have a bunch of people who buy and sell foreign exchange for a fixed rate on demand. If there is demand for foreign exchange, you sell it to them. If there is a supply, you buy it from them, always at the fixed rate.

There is no discretion. There’s no intervention in anything. You are just doing something very mechanical. Politicians don’t like that kind of situation because they want to say to people; ‘Well we can intervene in markets on your behalf.’

It’s never on behalf of the people as a whole. They will pretend that it is, but the fact of the matter is, when the government intervenes in the market, it’s to benefit one party at the expense of the rest of society. So the politicians like to have something like a central bank because then they can be seen to be doing something. They can actually do things to benefit particular parties and get the support of whatever nature from those parties.

At the same time, you have the economics profession. I am an economist. Th e problem with economics is that, if we really believe in markets, then there is nothing very much for economists to do. We trust the invisible hand to organize all production and distribution of goods and services. What does the economist do? Not very much. And so we do see ourselves out of a job.

If we want to create a job for ourselves, then we have to persuade people. ‘There is a market failure here, there is a market failure there, I’m the guy who can fix this market failure for you.’ That is just another way to intervene in markets. You always pretend that it is for the benefit of the people as a whole. That’s almost never the case.

Almost all intervention is to help one party at the expense of another. So I am afraid the economists’ profession has much to answer for in that sense. In the case of the currency board as you just mentioned, Sri Lanka used to have a currency board in the beginning and then based on foreign advisors as I understand it was decided we needed a central bank.

You told me the person who became the first Governor of the Central Bank was one of the people who had advised to set up a central bank. Th is to me is a perfect example of economists persuading governments that there’s a market failure here that I can fix. Let’s have some intervention and, by the way, I am happy to do the intervention on your behalf.

I believe he was invited by Sri Lanka’s government to take the job because we did not have experienced people at the time.

Well I wasn’t there at the time, so I don’t know anything about this history, but you can say as a representative of the economic profession, he was advising the Sri Lankan government at their request, that you needed a central bank.

You need a bunch of economists with all of this market failures, and us economists as a profession know how to fix market failures. So in that sense, he was generating jobs for economists, doing something completely unnecessary.

As you said, when you had the currency board, the economy operated just fine. I don’t think you had inflation. So you didn’t have balance of payment problems because the market automatically dealt with those by changing the money supply in accordance with the condition of the external accounts.

So to take it one further step, some countries neither have a central bank nor currency board. They use some other country’s currency. So this is the ultimate in no jobs for economists’ in the field of monetary policy. If you talk about a country like Panama, which uses the US dollar, a small country call Kiribati in the Pacific Ocean uses the Australian dollar, East Timor uses the US dollar. They don’t need any economists, they don’t employ any economists to run monetary policy because they don’t have their own money and yet the economy functions just fine.


We have seen some reports recently in the press about dollarization in Ecuador and about how inflation collapsed and GDP went up.

Yes, the overall experience is that the dollarization, if you call it that, or adopting another country’s currency, in a way it works pretty well if the initial problem was very high inflation and you knock that on the head straightaway. So I think there is plenty of experience, not a large number, but enough countries to say – yes, this works. Interestingly enough, I will give you an anecdote from Indonesia. You know Steve Hanke, who is the world’s guru on currency boards and dollarization. You remember, Indonesia in 1998 had a terrible monetary crisis. Just before that, as I mentioned before, the economy was in excellent shape. Robust growth, low inflation, stable exchange rate, fairly stable exchange rates.

Then this Asian Financial Crisis comes along, and because of the way it was handled, money supply went out of control.

Indonesia was quite unique among Asian financial crisis countries at the time because all others didn’t have this enormous burst of inflation that Indonesia experienced.

The reason was that the Central Bank abandoned its policy of depreciating the currency at 3-5%, which had been the nominal anchor, but it didn’t replace it with another nominal anchor.

Now the Central Bank must use its policies to control one nominal variable. The Indonesians neglected to do that. For 8 or 9 months from August of 1997, base money supply ran out of control. The reason was the Central Bank doing a lot of last-resort lending to the banking system. Well, that’s all very fine, but it (the central bank) wasn’t sterilizing that, and that base money was growing very, very, rapidly. It doubled in the space of about eight months. Very predictably, as a consequence of that, prices and nominal interest rates rose enormously during that time. This caused chaos for the economy. The rate of real economic growth in 1998 fell to minus 13 or 14 percent. So, in other words, awful monetary policy during that period caused the Indonesian economy to suffer greatly.

We were talking about Steve Hanke and the Asian Financial Crisis in Indonesia. As you may know, he became the advisor to the President (Suharto) at that time. And so, when he came to Indonesia, as I said, money supply was out of control.

The IMF had set targets for it, but Indonesians had basically ignored those targets. The IMF said okay, let’s revise the target upwards, and there were several months where the base money was targeted but ignored, and the base continued to increase rapidly. So you get this high inflation and interest rates are going up, and there is large currency depreciation. So the president asked Hanke what can we do about it, and Hanke said ‘I guess two possibilities, one is Currency Board, one is Dollarization’.

Well, dollarization is a bigger fence against the economists’ nationalist feelings than I suppose the Currency Board that the president actually accepted at one stage. As we mentioned, currency boards implemented in various other countries had the impact of stopping inflation in its tracks, so the president accepted the proposal from Hanke. But then the whole international community came down on him and said ‘No you can’t do this. You can’t have a currency board in Indonesia.’

So Suharto was getting pressured from the United States in particular, from the Western world in general, from the IMF, from the World Bank. And unfortunately, he bowed to that pressure saying, ‘Oh well, if everybody is against this idea then let’s not do it’. By not doing it, inflation continued to be very high for several more months. The president had fallen from office in May that year, and was replaced by President Habibi, and shortly after that the monetary policy was changed to get the money supply under control. Inflation disappeared very rapidly after that. If Hanke’s proposal had been accepte, the same thing would have happened, the rapid expansion of the money supply, which was the underlying cause of the problem that time, that problem would have gone away instantaneously.

Even the announcement that Indonesia was going to go for the currency board was sufficient to stabilize the exchange rate, in fact, to improve the exchange rate. But as I said, it didn’t go ahead. But of course, a lot of the opposition was from the economics profession in Indonesia. It goes back to the idea that the Currency Board doesn’t generate jobs for economists. The Currency Board doesn’t need economists. But central banks do.

So trust the central bank. Trust that all the economists in the central bank will fix the problem. Well, it was the Central Bank that was the cause of the issue at that time because it didn’t have any monetary policy. It had abandoned its exchange rate policy, the fixed rate of depreciating policy, but hadn’t replaced it with anything else. There is this idea that I have come across when I talk with some economists that you can’t do a Currency Board unless there was a service economy. You cannot do it for a manufacturing economy. Then when Hong Kong is mentioned, they say it is a service economy. Or they say you need large labour movements for a currency board, so you cannot do a currency board for Sri Lanka.


Some of these people do not know that we had a currency board at that time. Is the activity that you do a requirement for the monetary arrangement?

I don’t think so. I think those kinds of arguments are bogus. All we are talking about is the value of the monetary unit. As I said earlier, the value of anything is a question of the balance between supply and demand.

So it doesn’t matter what your country is producing. People can wave their hands and say ‘Oh, it will only work if you are an agricultural economy. Oh, it will work only if you are a service economy’. To me, that’s just nonsense. It doesn’t matter what you are producing; there is demand for money, and the central bank determines to supply that money. It has to keep the supply in balance. So if we go to a currency board, then it’s all automatic. There is supply and demand for foreign exchange. The currency board meets that by increasing or decreasing the money supply, and that will simply adjust your prices to be consistence with the rest of the world. So I don’t see any value in those arguments, as it depends on what your economy produces.

When we had a currency board, we must have been getting along pretty well, as you said. There is a story that economists repeat here that, when we got independence from Britain, we had the highest living standards after Japan. In fact, Malaysian companies used to raise capital in Colombo, and we had free movement of capital; some of those plantations are still listed here. But exchange controls came soon after independence. It does not seem to have happened over there?

I think Indonesia had a reasonable rate of growth for an extended period, apart from the Asian Financial Crisis period, and that is because its macroeconomic policy has been reasonably good. I don’t think it was perfect by any means, but it was reasonably good.

You can create reasonably stable macroeconomic conditions that give you a good base for reasonably robust economic growth. But the minute you start badly managing your macroeconomic policy that you have to impose exchange controls, or if you think you have to impose exchange controls, then people lose confidence in the economy. If I am the foreigner and I am interested in investing in Sri Lanka, then I worry about whether I can get my money out later when I want to or whether it’s likely there is going to be a new policy that prevents me from doing so.

So it stands through reason that interest on the part of foreigners investing in Sri Lanka would’ve been falling and that’s going to reduce the growth rate that you can achieve over time. People are going to spend more time finding ways around exchange control, and there are always ways to beat that, and they are going to be more interested in that than being in the business and driving the economy forward.