Sri Lanka. Another sorry chapter in the story of failed money.
Good news is hard to come by these days, but sometimes you can spin good from bad. The travel section of the weekend Financial Times tackles the thorny (and somewhat morally dubious) question of whether tourists should go to Sri Lanka for a good time when the people are starting to starve and to run out of fuel (‘Sri Lanka needs tourists - but should they go?’, Weekend FT, 09/07/2022).
To do the FT journalist (Tabby Kinder) some justice, the premise of the article is that tourism pre-Covid used to comprise 6% of GDP, and with the Sri Lankan rupee in free fall, the country desperately needs inflows of foreign cash. The moral dilemma is whether tourists, in return for their dollars (or other forex) deserve first dibs at fuel and food when the local population is not just slipping below the poverty line but struggling with subsistence itself. That is a tough one to call.
While the proximate causes of Sri Lanka’s misfortunes are the disruption caused by Covid, inflation due to various aspects of the Ukrainian war (sanctions affecting the supply of commodities), and more generally US Federal Reserve hawkishness causing the dollar to rise (thus sinking all other foreign-exchange crosses around the world), the real cause is poor governance, particularly with respect to agricultural policy. The country is indebted to the tune of $50 billion, of which $7 billion is due this year 1. It defaulted on its US dollar-denominated debt in May2. The currency has been weakening at an alarming rate - the Sri Lanka rupee or LKR has fallen from around 196 to 360 against the US dollar in 2022.
The story of poor governance is not a new one for Sri Lanka, nor is Sri Lanka unique amongst developing countries with respect to having a currency crisis caused by poor fiscal policy. Since 1950, Sri Lanka has had 16 IMF interventions, clearly none of which have worked in stabilising the country’s economy3. The build-up of debt and the financial instability it has caused has now reached a critical juncture.
What happened in 1950? As part of the effort to replace the pound sterling with the dollar as the world’s reserve currency, the US encouraged Sri Lanka to ditch the currency board which linked its currency to India’s silver rupee, thus ending ‘imperial preference’, the policy adopted by Britain to ensure that trade within the empire and Commonwealth had to occur in sterling or a sterling-linked currency. The pound was fixed to the US dollar, which in turn was pegged to gold at $35 per ounce.
What is a currency board? It is a fixed exchange-rate system which forces a country to back all of its monetary base with a foreign currency. This means that a country forgoes a monetary policy (usually the purview of the central bank) in favour of an exchange-rate policy, and by eliminating the role of the central bank, fiscal discipline is enforced. Central bank discounting of government bills is the method by which profligate governments finance their deficit spending.
By eliminating the role of the central bank through a currency board and implementing a fixed exchange rate, governments can’t spend willy-nilly. Excessive debt, either in the public or private sector, can cause an imbalance between investment and saving in an economy which then causes a current account deficit, and if the balancing inflows in the capital account fall (this is where tourism comes in - creating demand for Sri Lankan Rupees), then the currency starts to tumble, which is highly inflationary.
Venezuela has had in recent years the dubious honour of being the most inflationary country in the world, but Sri Lanka is sadly making a charge up the leader board. The central bank of Sri Lanka estimates May inflation to be 54.6% but Steve Hanke, professor of applied economics at John Hopkins University and an expert in currency boards (having implemented four in Eastern Europe in the 1990s) suggests that the real number is nearer 113%. Hence the protests and the news on 9th of July of rioters occupying the Presidential Palace in Columbo, forcing President Rajapaksa to flee.
A currency board which fixes the monetary base in another country’s currency means you can’t have a money-printing fest, and this enforces fiscal responsibility on the government through the balancing of fiscal expenditure with taxation.
A currency board is thus essentially a sound-money policy. It eliminates the government’s ability to run a deficit, stabilises the currency (thus eliminating the principal source of inflation), allowing the private sector to save, and these savings can then be recycled into constructive lending allowing ‘good’ economic growth through sensible private-sector investment. The turnaround in countries such as Estonia and Bulgaria in the post-Soviet 1990s following the implementation of currency boards is testament to the beneficial effects of the approach.
Sound money isn’t just a discussion for emerging markets though. The excessive deficit spending of the past few years in the developed world is the key cause of the current bout of inflation. The dubious wisdom in the Eurozone of governments borrowing to finance energy subsidies or to bail out or nationalise energy suppliers (Uniper in Germany and EDF in France) are identical in form to the fiscal profligacy which has got Sri Lanka into its current pickle, only in Europe it is about hydro-carbons while in Sri Lanka it is about carbohydrates. You can print money, but you can’t print energy. If you try, you just get inflation.
In June 2022, Germany recorded its first current-account deficit for over thirty years, a sign of a growing instability in Europe’s economic engine-room and a key contributor to the tumbling euro as inflation rages while the European Central Bank dithers over rate hikes. Sri Lanka may seem a long way away but excessive debt, fiscal deficits and a feeble monetary response to sharply-higher inflation are realities which are much closer to home. An impending developed-world currency crisis? There but for the grace of God go I.
R.M. Mannivan, Sri Lanka needs a currency board, 22/05/2022, Project Syndicate.
Udithe Jayasinghe and Alasdair Pal, Sri Lanka to default on debt, no money for fuel, minster says, 18/05/2022, Reuters.
Sri Lanka monetary meltdown: Steve Hanke on currency boards and flawed pegs, 24/06/2022, economynext.com