Import spending exceeds USD 1 billion for the eighth consecutive month – The Island

By Dr Asanka Wijesinghe

On March 8, Sri Lanka devalued the rupee against the US dollar, entering a floating exchange rate regime. The Central Bank of Sri Lanka had to abandon the pegged exchange rate because it was impossible to defend the rupiah with declining reserves. The interbank exchange rate soared once banks were assured that the exchange rate was floating. The initial surge was followed by a further rally in the US Dollar reaching close to Rs. 300 per USD. With the gradual weakening of the rupee, inflation is also reaching worrying levels calling for radical changes, including the adoption of a currency board. This article discusses the effectiveness and relevance of a currency board for Sri Lanka in the current macroeconomic environment.

Weakening rupiah, rising inflation and

Currency Board Solution

A currency board is a system that issues domestic banknotes in exchange for a specific foreign currency – an anchor currency like the USD that is used for trade with partner countries – at a constant rate. One of the cornerstones of the currency board mechanism is the ability of the authority to respond to any demand for foreign exchange by holders of the national currency.

In Sri Lanka, even after the floating of the rupee, reports suggest that there is an active curb market with a significant premium above the interbank rate. While such market behavior indicates an acute shortage of dollars in the market and the equilibrium rate is further away, no official data exists on the curb market currency exchange. However, cryptocurrency platforms provide essential information. The Tether (USDT) coin, which is closely pegged to the US dollar on a one-to-one basis, is traded for rupees on peer-to-peer (P2P) platforms as USDT is used as a way to buy other crypto -currencies, including Bitcoin.

Data extracted from the P2P platform support of Binance – a popular cryptocurrency exchange among Sri Lankans – shows evidence supporting the ever-widening discrepancy between official and informal rates. Significantly, the premium over the official rate fell once the rupee was floating, but it gradually recovered until the pre-floating period (Panels A and B in Figure 1). The number of sellers and volume of USDT available for sale also increased, but returned to pre-float period levels (Panels C and D in Figure 1).

Inflationary pressure also shows no signs of ending, further eroding people’s purchasing power. These developments encourage the adoption of a currency board as a currency board is seen as a solution to rising inflation. By the internal mechanics of the currency boards, the independence of discretionary monetary policy is removed, in favor of a disciplined monetary policy – ​​a gold standard without gold – which eliminates the inflationary bias. Indeed, there is empirical evidence in favor of the anti-inflationary effect of currency boards. The inflation rate is lower under currency boards than under fixed or floating rate regimes. Moreover, economies subject to currency boards have grown faster than the average for countries with indexed regimes. However, empirically disentangling the multiple influences to identify low inflation on the currency board is a daunting task.

Another selling point of the currency board is fiscal discipline, as currency board regulations prohibit direct monetary financing of government spending. A high budget deficit in Sri Lanka and excessive government borrowing from the Central Bank make the fiscal discipline effect of currency boards much more attractive. Empirical evidence points to low budget deficits or larger surpluses under currency board regimes.

Source: Author’s illustration using data from Binance

Challenges in Adopting a Currency Board

A major disadvantage of a currency board is the need to give up the independence of monetary policy needed to manage asymmetric shocks. Such a loss is costly when the anchor currency country reacts to cyclical conditions, which are different from the conditions prevailing in the country that operates the currency board. For example, the Hong Kong currency board imported low interest rates from the United States in the early 1990s. Such monetary easing was appropriate for the United States, but Hong Kong faced a surge asset prices that necessitated monetary tightening. A counter-argument against the negative impact of the loss of monetary policy is the availability of fiscal policy at the disposal of the exploiting country. However, the maneuverability of fiscal policy is determined by fiscal and debt positions. In the Sri Lankan context, the high debt-to-GDP ratio and budget deficits could restrict the use of fiscal policy to revive the economy – to stimulate the economy during a recession – due to fears of losing confidence investors in debt sustainability. Thus, international evidence shows that countries with highly pegged exchange rate regimes typically tighten fiscal policy during recessions. Argentina’s attempts to reduce the deficit during a recession in 2000 proved disastrous.

Sri Lanka’s high indebtedness will also make it difficult to set up a currency board. As soon as a threat of default looms, interest rates soar and debt refinancing becomes increasingly difficult. In addition, the mining country needs reserves to support the monetary base in a currency board. In a currency board, the fund must continually convert the domestic currency to the anchor currency at a constant rate. It should be noted that Sri Lanka’s reserve level has been declining over time in the recent past. Another disadvantage of currency boards is the requirement for real sector changes to compensate for exchange rate differentials. For example, if the anchor currency appreciates against Sri Lanka’s major trading partners, wages should fall to offset rising consumer prices abroad, thereby restoring competitiveness. Such an exercise requires greater flexibility in labor markets. Thus, flexible labor markets are essential to the sustainability of currency boards. The political feasibility of institutional attempts to relax labor market regulations is highly questionable.

In this context, the decision to install a currency board should be taken after a thorough cost-benefit analysis. A currency board will be helpful in stabilizing inflation in the short term, but in the long term Sri Lanka will be better off with a more flexible exchange rate regime. Moreover, the benefits of a currency board are not mutually exclusive. For example, fiscal discipline should be stronger in flexible exchange rate regimes because the effects of fiscal policy are passed through immediately and more transparently. Thus, if Sri Lanka enters a currency board to stabilize inflation and the national currency, it must consider an exit strategy. Generally, it is advisable to leave a currency board when the economy recovers. The obligation to give up monetary independence and the inability to finance public spending under a currency board could reduce the political preference for such a system.

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