Sri Lanka Crisis: What’s this currency board the economists want?

Food is kept on a placard as Muslim protestors Iftar (breaking of fast) during the holy month of Ramadan while they protest against Sri Lanka's President Gotabaya Rajapaksa near the Presidential Secretariat, amid the country's economic crisis in Colombo, Sri Lanka, April 9, 2022. REUTERS/Dinuka Liyanawatte - RC2OJT9KAKFK

Is Sri Lanka firing its central bank? What?! Where did you hear that?

Isn’t it setting up something else? Like an alternative? Oh, the currency board. It needn’t replace the central bank. In theory, both can work in parallel. Though, for all practical purposes, the central bank will function as an administrative office at best… if a currency board is set up. 

So, will Sri Lanka be getting one? A currency board? There are economists suggesting that a currency board will ensure better discipline in the country’s monetary policy… that the currency board cannot be influenced by the government to increase money supply, unlike a central bank that can be arm twisted.

And CBSL was supposed to… do what? According to former Deputy Governor of CBSL, Dr WA Wijewardena, when the government went to borrow from the banking system… the CBSL and the banks lent generously, when the CBSL should have pushed back and asked the government to raise taxes and increase revenue. Be more fiscally prudent. Instead, its generous lending increased the money supply by 40%! 

Is that a lot? According to him, central banks usually allow money supply equal to real economic growth, plus another 5 to 6% to facilitate transactions. But, this time, when real economic growth was nearly zero in the country, the money supply went up by 40%. It fed into the unprecedented inflation levels being seen in the country now.

Why will the currency board behave more independently? Hmmm. Actually, central banks and currency boards can issue currency. The difference is in the discretionary power, which central banks have and currency boards don’t. While central banks can issue currency whenever it thinks there is a need–even printing money to fund a massive government borrowing or to save a troubled bank–currency boards can issue notes or coins only based on the foreign reserves it holds. Currency boards have to follow that discipline. In fact, the value of the forex reserves the currency board holds will be equal to or more than the value of the domestic currency the board will issue. So, if investors have lost faith in the local currency, they can take heart from the fact that the local currency can be converted into the reserve currency whenever needed. Also, currency boards will not set policy rates…

Like repo, reverse repo and all of that? Yes, like that. Those are the lending rates that the central bank uses as levers to control money supply. If it wants to increase the money supply it will lower the repo rate, or if it wants to decrease the money supply, it will increase the reverse repo rate etc… According to Dr Niranjan Shastri, Associate Professor (Finance) at NMIMS Indore, the policy rates will become defunct with the setting up of a currency board. 

How can an economy function without policy rates? Don’t banks make money on that? Yes! Impressive. Banks do. One of their main sources of revenue comes from the difference in interest rates–between the rates at which they borrow and the rates at which they lend. Dr Shastri explains: “Without the policy rates, the banks will begin to earn from the transaction fees”.

That seems like a big loss for the banks! Why do away with the policy rates? For one, they are irrelevant, since the currency in circulation is entirely decided based on forex reserves. For another, policy rates can be used as levers by the political class, to ‘guide’ the monetary policy. For example, the government could ask the central bank to set repo rates lower if the government wants to fuel growth… even when there are concerns about inflation. 

Can’t all of this be done by the central bank? Yes, says Dr Shastri. It can be. “But the currency board is a massive brand-building exercise for the country’s currency. When the currency board is set up, it is sending a message to the world about the government’s intention to set things right,” he says. Also, as Dr Shastri says, the government cannot afford to let the currency board fail. He says, “A democracy is run on public confidence. A currency board is usually set up after the central bank is seen to have failed. It would be suicidal for the government to let a second regulatory body (the currency board) fail.” 

Are there other currency boards in the world? Yes, famously, Hong Kong’s. They began it in the early eighties, when the Hong Kong Dollar (HKD) fell by 15% in two days. Today, the Hong Kong Monetary Authority (HKMA) manages the region’s Linked Exchange System, through a currency-board system, with the dollar as the reserve currency. Here is how it works: if a lot of funds start flowing into the HKD, then demand for HKD goes up and there is more buying of HKD, and then HKD starts becoming scarce and becoming expensive. That’s when the HKMA steps in and sells HKD at a pre-set price (HKD7.75/$1). Now there is more HKD in the market, it starts becoming cheaper and the exchange rate is maintained, or the value of the currency is managed. If people suddenly lose confidence in HKD or if funds find a more attractive currency investment, and funds start moving away from HKD, the reverse happens. In this case, HKMA steps in and buys the Hong Kong Dollar ($7.85/$1). 

This currency board looks faultless… Hmmm. It isn’t that. The reason why people shifted away from currency boards is that it made a country’s monetary supply dependent on another country’s monetary policy. If the reserve currency experienced a sudden devaluation, the domestic currency would get pulled down too. On the other hand, if the reserve currency shoots up in value, then the domestic currency does too and it makes the domestic economy’s exports less attractive. Usually a reserve currency is chosen based on its stability and its economy’s inflation levels. Usually it is the dollar. But you know what is happening to the US economy now, with inflation hitting a 40-year-high of 7.9% early this March. 

Oh god, there are no easy answers. No, there’s only easy money.