Mobius is right. A central bank with discretion over national interest rates wields enormous power, but not everyone can wield it responsibly. If powerful politicians – like Sri Lankan President Gotabaya Rajapaksa and his brothers – are going to undermine fiscal management with disastrous tax cuts and ruin agriculture with a ban on fertilizers, and if the monetary authority is simply going to allow this recklessness in printing money, then the country might be better off ditching banking in favor of a set of rules.
Ultimately, that’s what a currency board is all about: a protocol. Anything that requires judgment – like fixing interest rates, bailing out troubled lenders, helping the government raise money on the cheap – goes out the window. The domestic currency is 100% (or more) backed by liquid, risk-free assets held in the anchor foreign currency. In other words, a pure currency board for Sri Lanka will not look like Argentina between 1991 and 2001: that system had too many cheat days in its regime. The correct model is the Hong Kong Monetary Authority.
Even in Hong Kong, which has operated a currency board since 1983, rumors of an impending demise of the peg begin to swirl whenever local interbank rates don’t match US rates – as they do now. . But these rumors are always exaggerated. Yes, the Federal Reserve has become hawkish and so Hong Kong should expect strong capital outflows in the coming months. But it does not matter. The HKMA will automatically sell US dollars to the banking system when the local currency falls to the weaker end of its convertibility commitment from HK$7.75 to HK$7.85, sucking up domestic liquidity so that, as the notes Bloomberg Intelligence strategist Stephen Chiu, “Local rates may also rise and catch up with US rates, supporting the Hong Kong dollar going forward.
Sri Lanka can also adopt such self-executing code, provided it can find the right anchor and an appropriate conversion value. Its rupee has been unofficially pegged to the US dollar since October 2021. However, after dwindling foreign currency reserves forced former central bank governor Ajith Nivard Cabraal to abandon the peg last month, the Sri- lankan collapsed – about 201 for the dollar. around 350. This volatility could be eliminated by giving the exchange rate a solid peg – the kind that existed in Sri Lanka’s past.
Before American economist John Exter came to Colombo to help create a central bank – he became its first governor in 1950 – Ceylon, as the country was then called, ran a hybrid currency board. Ceylon rupees were convertible 1:1 into Indian rupees, but were mostly backed by British pounds with some Indian currency reserves. This arrangement worked as long as the Indian currency was also tied to the pound. It began to crumble after World War II. Newly independent India imposed exchange controls on transactions within the so-called sterling area. A year later, Ceylon did the same. This created a paradox, as noted by Exter, since a currency board could not operate without free convertibility into its anchor currency.
The lack of convertibility of the Indian Rupee and the Chinese Yuan is the reason why neither can be the anchor of a Sri Lankan currency board even today. China and India are the island’s two main trading partners, and Beijing and New Delhi both have an interest in not letting Colombo lean too far to the other side. This makes the US dollar, the primary invoicing currency for global trade, the obvious choice.
But at what level? While the current exchange rate is a boon for the island’s garment and tea exporters, more expensive imports are fueling Asia’s fastest rate of inflation. Prices rose almost 19% year-on-year in March. The right level for a Sri Lankan currency board is perhaps between 200 and 350; but it will only be known when the contours of the rescue plan by the International Monetary Fund are clear and the uncertainty about the country’s future dissipates.
Currency boards are generally associated with lower inflation, higher economic growth, and lower fiscal deficits compared to hard pegs that are backed by promises rather than protocols. For small countries like Sri Lanka (population: 22 million), they present a legitimate alternative even to flexible exchange rates with monetary independence, which may not yield much anyway due to the political interference.
Yet life under a currency board is no picnic. Beginning in the late 1990s, Hong Kong faced excruciating deflation for several years. The city’s economy was still hemorrhaging after the 1997 Asian financial crisis, but the Fed raised US interest rates to as much as 6.5%. Hong Kong mortgages were underwater; unemployment was high. Until its 20th anniversary in 2003, the currency board was the subject of much criticism. Yet when asked what might happen if the Hong Kong dollar was allowed to float, Joseph Yam, then head of the HKMA, joked, “We don’t want to know.”
Sri Lankan technocrats must also be prepared to leave credit creation to commercial banks, growth and jobs to government, and interest rates to an algorithm. After all, a dollar-backed currency board is not much different from replacing the national currency with a stablecoin like Tether. But is that really what the island wants? This is the question he must first answer.
More from Bloomberg Opinion:
• The Great Chinese White Elephant of Sri Lanka: Andy Mukherjee
• Sri Lanka shows the madness of fringe economic theories: Mihir Sharma
• The street has spoken. Will strong men listen? : Ruth Pollard
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services. He was previously a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.
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