ECONOMYNEXT – Sri Lanka should set up a currency board to stop further currency falls, US economist Steve Hanke has said as the island’s currency collapsed from 203 to 290 to the US dollar in an attempt to float the currency which has not yet succeeded.

“Since January 1st 2022, the Sri Lankan rupee has depreciated ~26% against the USD. #SriLanka’s severe balance of payments crisis and recent fuel price hikes are sinking LKA,” Hanke, who is professor of Applied Economics at Johns Hopkins University in Baltimore, said in a twitter.com message.

“To ease the crisis, LKA needs to install a currency board, like the one it had from 1884 until 1950.”

Sri Lanka – then Ceylon – set up the currency board after the Ceylon Rupee issued by the Oriental Bank Corporation stopped exchanging silver for rupee notes, technically called a suspension of convertibility.

A modern day central bank attempts a float also in a similar fashion, though the bank is not closed.

A currency board is easy to set up and will end balance of payments trouble for ever, insulating the public and also politicians from Keynesians who print money to manipulate interest rates.

Currency boards have very low interest rates just about 50 basis points higher than the anchor currency by automatic tightening to prevent imbalances from building up.

The anchor currency for the currency board can be the US dollar, Euro, Swiss Franc, Swedish Kroner or Singapore dollar, which is among countries with the best monetary policy in the world.

Hanke has prepared a handbook on how to set up a currency including measures for war torn countries where the monetary authority could be incorporated abroad to prevent any warlord from getting hold of reserves.

In 2018 Sri Lanka was put on the extraordinarily situation of a ruling politician, then-Minister Harsha de Silva, pleading with central bank in public, to raise rates in a bid stop money printing, after giving it full operational independence to inject liquidity.

At the time taxes raised taxes to reduce the deficit and a political costly price formula or fuel was set up, but money was printed to create balance of payments trouble by so-called ‘call money rate targeting’.

Money was also injected through dollar rupee swaps of the style used to bust East Asian pegs during the crisis by speculators (Soros style swaps). Speculators could not break the Hong Kong currency board during the East Asian currency board, but instead mad massive losses on swap costs.

In 2020 the policy was taken several steps ahead by crippling bill and bond auctions with price controls. Now the rupee has been hit by a surrender rule, analysts have warned.

Analysts have called for strict laws to block the ‘domestic operations’ of the central bank through which balance of payments troubles are created, or set up an orthodox currency board.

When the Oriental Bank Corporation shut its doors in 19th century Ceylon, the Mercantile Bank which also issued notes provided convertibility at par.

Oriental Bank Corporation ran out of silver reserves following bad loans. A modern day central bank runs out of dollar reserves due to direct government financing of deficits, re-financed credit schemes and sterilized interventions or giving reserves for imports.

The central bank of Sri Lanka today holds over two trillion in Treasury bills a part of which was taken back from banks in the course of private sector finance to maintain a policy rate or price controls of bond auctions.

Sri Lanka’s currency board, which had kept the island safe through two World Wars and a Great Depression was replaced with a Latin America style central bank under US technical advice in 1950.

Almost all such central bank by Fed experts have led to social unrest and some central banks have collapsed and led to spontaneous dollarization.

Analysts have warned it may happen in Sri Lanka as well if the float is not established.

Currencies are depreciated by Keynesian interventionists for ‘competitive exchange rates’, which critics say is a merciless a zero-sum policy of transferring wealth from the working class to shareholders of export or import substitution companies by destroying real wages.

The advantage remains until workers go on strike demanding higher wages and until utility prices such as electricity, power or water rates are raised.

Knowledge of currency boards have been lost to most post World War II ‘economists’ who relentlessly favour depreciating currency central banks, through which they try to boost growth with ‘stimulus’ create balance of payments trouble, starve the poor, create social unrest, boat people, and bring down governments.

The rising world food and commodity prices hurting the poor around the world while strengthening the hands of authoritarian leaders of natural-resource rich countries after the US and ECB printed vast amount of money is the latest example analysts say.

Steve Hanke was one of the few economists in the world who correctly warned that Fed’s Jerome Powell would set off an inflationary spiral.

Hanke has helped set up several currency boards including in Eastern Europe.

Currency boards have neutral policy and are still in use in East Asia. However most East Asian pegs including Vietnam are tighter than currency boards and collect forex reserves exceeding the monetary base.

Sri Lanka used to have a 1 to 1 currency boar with the Indian rupee (which was originally silver) along with Mauritius and other South Asian nations.

Before the Reserve Bank of India was nationalised to print money for Nehru’s Gosplan style programs, the Indian rupee was also used in the Middle East countries like Dubai.

The only economist who opposed Nehrus economists was a lone classical economist, BR Shenoy who issued a note of dissent on the plans which were to be financed with central bank credit.

Bhutan still retains it one to one peg with the India rupee which has been unbroken for decades. Nepal has also kept a 1.6 peg with the Indian rupee for more around 40 years. The Indian rupee is however a depreciating currency and neither country benefits much except avoiding currency crises.

The IMF supports Maldives peg with the US dollar but encourages stimulus, open market operations and depreciation in larger countries like Sri Lanka which is believed to due to a mis-understanding about pegs held in the US Treasury.