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Closing the Sri Lanka - Singapore monetary gap with currency board: fuss-budget
13 Oct, 2008 19:02:18
By Fuss-Budget
Oct 13, 2008 (LBO) – With the Sri Lanka rupee peg with the US dollar once again pressured by sterilized intervention activities of the central bank, exporters may be hoping for a more realistic exchange rate.
The monetary system seems to be hit by an emerging deep crisis in the fiscal affairs of the government.

The call for a new 300 million dollar syndicated loan is just one outward sign of this fiscal morass.

Fiscal Crisis

In Sri Lanka, all inflation or currency pressure is fiscally triggered, by false budgets with over-estimated revenues and under-estimated expenses driven by mentally-challenged economic policies.

The sudden jump of 32 billion rupees worth of Treasury bills in the central bank's stock in October is an outward sign of this problem.

The Ceylon Petroleum Corporation also seems to have compounded the problem by borrowing millions of short-term dollars from Iran and creating a dangerous risk to the country's economic and monetary stability.

If petroleum was fully in private hands this problem would not have arisen. If Lanka IOC was not there the risk overhang to the country would have been 30 percent greater. CPC is now externally leveraged by around 500 million dollars, according to official statements. That is equivalent to a significant chunk of the country's foreign reserves.

No private sector entity could have run that kind of debt in the space of four or five months, due to the credit risk. Only state and political power can create that type of dangerous overhang. The sooner CPC is privatized the better, for the stability of this country.

When market fundamentals finally override state control, just like global markets are now crashing from sustained paper money central banking also helped by the manipulation of housing interest rates in the US by state sponsored Freddie Mac and Fannie Mae, the chickens come home to roost.


But this column is not about Mercantilist state controls. This column is about Singapore's monetary policy and exchange rate and the lessons Sri Lanka can draw from it. Singapore is a country that is run like a private corporation mostly on Classical principles.

Fuss-budget has mentioned several times that Singapore operates a very complicated system very similar to a currency board but which seems to outperform a hard peg in practice.

A strict currency board has a 100 percent foreign reserve backed currency, no lender of last resort facility, no open market operations to maintain a policy rate, no statutory reserves and free capital mobility.

For more information on currency boards and how central banks create currency crises read The Thrift Column – Currency Crisis, and The Thrift Column – Regime Conflict.

Singapore has provision for an intra-day liquidity facility (even a standing facility from June 2006) and a reserve requirement of 3 to 4 percent. However its 100 percent foreign currency backing of reserve money is sacrosanct.

Also because interest rates are market determined (like in a currency board) there cannot be 100 percent sterilization like in an ordinary policy rate framework when the Monetary Authority of Singapore (MAS) intervenes in the forex market. The Singapore standing facility for example, is on a premium to the interbank offered rate.

Which means, even if day-to-day forex interventions are automatically (if not partially) sterilized by existing mechanisms, any aggressive currency defence is unsterilized. Interest rates can rocket up at those times.

Reserve money is ruthlessly shrunk when MAS goes on the offensive against currency speculation. In 1985 September, rates rose to 100 percent when MAS fought off a speculative attack.

A currency board engages in unsterilized intervention everyday. That is why its peg is 'hard' or 'credible' versus a 'soft' or 'non-credible' peg of a sterilizing central bank.

During the Asian currency crisis, Hong Kong, which maintains a more orthodox currency board (hard peg), allowed overnight rates to go to 200 percent. Nobody, not even George Soros, can break Hong Kong and Singapore currencies.

It is sad to see both the Central Bank of Sri Lanka and the Reserve Bank of India committing soft-pegged currency suicide. But that may well be a good thing for exporters within the context of an emerging slowdown in external demand.

The Indian rupee would have fallen anyway because it was floating when the dollar appreciated. By intervening, the RBI brought more grief for itself.

Sri Lanka's central bank is better placed to defend the currency due to a partially closed discount window but the capacity for full sterilization of outflows, makes it vulnerable to collapse just like the so-called 'currency board' of Argentina was.

Productivity Hocus Pocus

This column is not a fan of exchange rate devaluation. That is why it has always urged the central bank not to engage in mis-guided sterilized intervention and push the rupee down. Devaluation destroys living standards, especially of the poor.

Having said that however, when inflation goes up due to domestic money printing, and the exchange rate is overvalued and the country's manufacturing industry is hit badly, a devaluation is needed for survival. When non-tradables and wages rise, export and domestic industry is made uncompetitive.

The emerging opposition to an Indian free trade deal, as well as the mass lay-offs at top end apparel firms is a sign of this very real problem.

Central bankers often claim that 'productivity increases' in one country pushes up the exchange rate against another. This is one of a series of dastardly mercantilist central banking lies, as John Exter is reputed to have told Paul Samuelson (read answer to question 03 in interview with Exter).

Productivity increases will help sustain economic activity (what people call growth) in the context of a stronger exchange rate, but it is monetary policy (money printing or lack of it) that determines the exchange rate in the first place.

Loosely speaking there are three categories of goods and services in an inflation index.

The prices of traded commodities, (like oil, precious metals, base metals, foods) are usually externally driven by reserve currency money printing (Fed and ECB) and can be countered by a floating exchange rate, domestically.

Non-traded goods and services are most influenced by domestic money printing. Thirdly, manufactured goods. Manufactured goods prices can be driven down by productivity growth and will almost always push an inflation index down.

If productivity rises (even in non-traded areas) and prices fall, a central bank - let's say an inflation targeting central bank - will print more money, finance government, push inflation up and bring the exchange rate down.

This is partly why a 'supply shock' can be countered by tightening policy. The central bank will print little less money and allow the 'space' from productivity increases to go to the people.

So productivity growth will never, ever, strengthen the exchange rate, unless the central bank tightens policy or it has a superior inflation index or domestic anchor. The current global bubble and meltdown is also related to this phenomenon, but that is another story altogether.

By keeping inflation 'positive' a government prints money and creams off any productivity growth. That is why the central bankers' oft repeated claim that "productivity growth strengthens the exchange rate" is a blatant lie. The cause and effect runs in the opposite direction.

Central bankers tell all kinds of lies, including stories of 'supply shocks', 'cost push' and such drivel, as part of a repertoire of monetary policy hocus pocus that is doled out to justify central banking, deceive the common man and steal from them.

Sterilized intervention, policy rates, reserve ratios

Any exchange rate appreciation then, must come from the central bank. When a central bank raises policy rates, it will destroy liquidity in the interbank market through open market operations and the exchange rate will appreciate.

If a central bank wants to strengthen the exchange rate all it has to do is raise rates. But forex market interventions are immediate, and will hold up, if backed up by a rate hike. But the monetary authority will lose reserves.

But by the same token an intervention that is sterilized will result in a loss of reserves immediately, and in the context of a peg more reserves will be lost when the newly injected cash works its way through the banking system and hits the forex markets again.

By sterilizing, and buying back treasury securities or adding new cash from banks, the central bank will substitute loans for treasury securities or simply increase loans in banks. In addition to losing more reserves when these loans hit the forex market the central bank could also worsen the the loan-to-deposit ratios of banks in the process.

This is part of the reason banking collapses follow heavy central bank currency defence, like in East Asia.

Through sterilized intervention, a pegged exchange rate central bank loses twice the amount of foreign reserves it would have lost if it simply printed money and financed the government. Unlike a floating rate central bank, it is committed to the peg, when the injected liquidity comes and hits forex markets again. This double whammy is what makes currency crises escalate so frighteningly fast.

If a central bank increases the reserve ratio, the exchange rate will also tend to appreciate by withdrawing liquidity from banks. But to maintain it, rates have to rise.

If not, through off-setting open market operations, and policy rates, sterilization in other words, a central bank will cancel at least part of the effect.

That is why modern central banks do not use reserve ratios as monetary policy tools. Sri Lanka's central bank is way ahead in not using reserves ratios to achieve monetary policy objectives.

The Reserve Bank of India is still in the dark ages and is engaging in such activity. When it cut reserve ratios last week, it spelled death to the exchange rate, subject to any recouping through policy rates.

That said, cutting reserve ratios is a good idea, (when there is no exchange rate pressure) because high reserve ratios keep nominal interest rates artificially high.

Most advanced central banks have trimmed reserve ratios to very low levels to create a level playing field between commercial banks and other financial players.

Adjustable Currency Board

A central bank which does not have a policy rate, and is committed to 100 backing of money supply by a foreign currency, can therefore manipulate the exchange rate at will. Essentially this is an adjustable currency board.

There is only one such 'central bank'. That is the Singapore Monetary Authority (MAS). China is also doing this, but its system is different.

MAS pushes up the exchange rate not only by selling Sing dollars against forex but also by dumping provident fund balances in the MAS, which shrinks reserve money. Cool huh?

Singapore originally had a currency board or hard peg with Sterling, but after the break-up of the Bretton Woods it flirted with floating for a while and shifted to a US dollar peg.

From 1980 Singapore appreciated the currency to keep inflation down. Then it followed a policy of continuously appreciating the Singapore dollar.

In the process MAS has outperformed developed inflation-targeting central banks in price stability.

No cry baby whining in Singapore that there was a type of inflation that MAS could not counter. No, Sir. No attempts also to make itself an international laughing stock saying that MAS could only act against 'demand driven inflation'. Where do people get these from anyway?

There is a world of difference in the way Singapore gently pushes its currency up and the way our central bank did recently. Also pure floating countries behave differently and can survive large swings in exchange rates.

Singapore kept inflation down and slowly and deliberately appreciated its currency, giving time for economic players to re-engineer their businesses and even close down low value added industries.

To quote MAS; "The real appreciation of the SGD (Singapore dollar) has also provided the impetus to continuously move up the value chain, in order to remain competitive."

That is economic policy making par excellence.

Not like our central bank which prints money like there is no tomorrow, engages in sterilized intervention like a jack-in-the-box, drives inflation to 20 percent, creams off all productivity gains by the private sector, and then tells exporters to increase productivity some more.

Bull-in-the-china-shop policy making,par excellence.

Leaning against the wind

In the same way, when external demand weakened, Singapore has moved the exchange rate down.

During the East Asian crisis, Singapore pushed the exchange rate down to help domestic industry as competitor's exchange rates fell, and the world deflated.

In the first part of 2008 MAS pushed the exchange rate up as US money printing fired a commodity bubble. Vietnam, which tried to follow Singapore, ended up in a currency crisis because the country did not have the institutional framework to manipulate the exchange rate.

Last Friday MAS said it will no longer appreciate the Sing dollar with the economy shrinking. If conditions become worse, and deflationary conditions persist, MAS may depreciate the currency as it did during the Asian crisis.

But in Sri Lanka we have blistering growth never seen before in our history. This is the danger of manipulating economic statistics. We simply do not have reliable information to make policy decisions.

MAS has also outperformed developed countries in keeping nominal interest rates low.

Developed countries print like there was no tomorrow to keep rates down and 'stimulate' economic activity. But without printing money, Singapore has had lower interest rates and much higher growth, by simply maintaining low inflation and budget surpluses.

Since the yield on a currency is a function of the exchange rate and interest rates, an appreciating currency would keep rates down.

MAS manages the rate on an undisclosed basket. But in practice it uses the exchange rate – which is the policy instrument – to counter reserve currency generated inflation or external shocks to growth, like a collapse in external demand.

The beauty of the system is it is very people friendly. The founding fathers of Singapore, were socialist members of the Peoples' Action Party.

An exchange rate depreciation can always be reversed. But domestic inflation cannot be reversed easily. Domestic inflation does lasting damage to people, especially savings accumulated through decades by old people and pension funds.

The MAS has a specific policy of protecting the value of the country's Central Provident Fund (CPF).

"A basic philosophy underlying Singapore's exchange rate policy is to preserve the purchasing power of the SGD (Singapore Dollar), in order to maintain the confidence in the currency and preserve the value of workers savings especially their CPF balances," says the MAS.

Makes you cry, doesn't it?

Compare that with the white-collar plunderers that 'manage' our Employees Provident Fund while conspiring with the Treasury to steal from it and manipulate interest rates, while getting inflation protected pensions, topped up with public money, themselves.

Monetary Stimulus

The problem of Keynesian monetary stimulus (or even Friedmanite) is that it boosts activity by giving profits to businesses via cutting real wages of workers through inflation. But the accompanying erosion of past savings and the loss of purchasing power of salaries is permanent.

In countries like Sri Lanka house and land prices also cannot be reversed once they are inflated by the central bank.

If wages could be cut temporarily, growth could be stimulated without causing permanent damage to workers. But with so-called 'leftist' trade unions, wage cuts are out of the question here. Singapore does this by cutting employer contributions to the CPF temporarily, effectively giving more profits to firms.

The Singapore government also has bonus based salaries, which could be cut. Not like our greedy state workers who demand more and more every year.

Singapore cut salaries during Asian currency crisis.

Our labour minister, who is part of the inflationary economic framework that is destroying the EPF, is now calling for higher EPF contributions when the productive sectors and export industries are already hit.

Can you imagine how weak our economic policy making is? The mental status of our politicians? It is so sad.

What can we do? All we can do is cry.

Cry for our people. Cry for our country which is being destroyed by various vote hungry Chinthanayas and politicians. Cry for our workers whose EPF and salaries are destroyed by the central bank and the government.

Cry for our thrifty older people whose lifetime savings are destroyed. And also cry for our children who will have to bear the burden and resulting poverty of all the policy mistakes and deficits incurred by this generation of politicians.

Or we can reform the central bank, make a currency board with the Singapore dollar and put the EPF under an independent commission.

A currency board can close the yawning monetary policy gap between Sri Lanka and Singapore. A currency board will also force fiscal prudence, because there would be no money printing.

But the productive sectors should also speak up against mentally challenged economic policies. It is true that rich businessmen can survive crazy economic policies of the type we have had since the 2004 Rata Perata madness. If they have limited liability companies they can close down firms and still survive.

But even rich businessmen owe a duty to their workers. Remember, it is the workers that kept keep factories going and allowed the rich businessman to make money in previous years.

To protect workers from inflationary economic policies and bad budgets the productive sectors must speak up against the cunning and treacherous so-called 'socialist' politicians who prey on innocent workers and steal their salaries and EPF through inflation and fraudulent budgets.

If not, the devious politicians, after driving up inflation, will ultimately turn workers against their employers and cause labour unrest, which may result in job losses.


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2. fuss-budget Oct 13
The world needs a new monetary architecture. Pure paper money central banking has led us to this situation. This time central bankers may not be able to bluff their way out of the crisis. The world also need inflation index reform.

Gold standard would be the best. But the problem is we cannot have the gold standard in isolation. If we do, our exporters will not be able to compete. We will have to constantly cut salaries to survive. Bonds will have to have negative rates, because prices would be deflating everyday. That is a very complicated way of running an economy.

Our policymakers would simply not be up to it. If the world returns to gold - as they had in earlier episodes of paper money - then we can also go back to gold - or target gold at least.

The advantage of pegging to the Sing dollar is that Singapore would do most of the analysis needed to counter inflationary pressures.

Except for our agricultural exports, we are also small, trade heavily with USA and EU and import practically everything.

But the biggest advantage would be that the massive monetary shocks that we get from the central bank would disappear. That will counter the dis-advantages. A currency board also automatically forces fiscal prudence. Privatization etc, is not needed. Loss making institutions would be automatically closed.

1. Johan Oct 13
Thank you so much for the enlightening article. Rather than a currency board pegged to a basket of currencies, why not move to a gold standard?

It seems to make sense especially in these turbulent times when faith in most global currencies is waning (with huge money printing happening in the US and EU as we speak).

Also, our Sri Lankan culture is one that places value in gold (savings are usually turned into a gold chain that is then pawned when cash is needed, assets are often passed on to the next generation in gold jewelery). We might even attract investment as the only currency backed by gold. What do you think?