The best way to save Sri Lanka from hyperinflation is to mothball its central bank and establish a currency board.
Over the weekend, Sri Lanka collapsed into chaos. Sri Lankans had finally had enough. Among other things, since Gotabaya Rajapaksa was elected president in November 2019, the rupee has shed 54 percent of its value against the U.S. dollar as of July 13, and inflation is roaring at 112 percent per year by my measure. For months, protestors had demanded the resignation of Rajapaksa. On Sunday, they got their man, when Rajapaksa threw in the towel.
Sri Lanka is an example of how easily ill-advised economic policies can turn a fairly prosperous country — one that the World Bank had moved up to the rank of “upper-middle-income” only three short years ago — into one that is literally out of gas. But Sri Lanka could also become an example of how a sound currency reform can turn things around immediately.
Just how did the wheels come off the Sri Lankan rupee and its economy? Because of its political shrewdness, one family, the Rajapaksas, became Sri Lanka’s ruling clan. Gotabaya Rajapaksa was elected president in 2019, after having served as defense secretary when the Sri Lankan armed forces won the civil war against Tamil separatists in the north of the country in 2009. His older brother Mahinda was president during the civil war and became prime minister during Gotabaya’s presidency. Two of their brothers and one of Mahinda’s sons were also cabinet ministers.
As so often happens, clannishness begat insularity. The Rajapaksas’ government spent freely, running large deficits and piling up government debt. The Central Bank of Sri Lanka (CBSL) became a great facilitator. Indeed, in 2020, the bank’s governor, W. D. Lakshman, said, “The fears around debt sustainability appear to be unfounded. As rupee-denominated bonds were within the ‘sovereign power,’ money could be printed to repay them as indicated by ideas like Modern Monetary Theory.”
So, there you have it. For the first time, a governor of a central bank publicly and explicitly embraced Modern Monetary Theory. With that, the rupee sank like a stone and Sri Lanka hemorrhaged foreign-exchange reserves. The CBSL attempted to stem the flow with ever-tighter exchange controls, but to no avail.
The Rajapaksas stubbornly pressed on. Sri Lanka’s economic plight became more and more dire. The CBSL blew through all of the country’s foreign exchange. And without foreign exchange, Sri Lanka wasn’t able to import essentials, such as gasoline. Economic desperation begat fury at the Rajapaksas, and the final curtain came down on Sunday, July 9.
What is to be done? The experience of many other countries, and of Sri Lanka itself, shows that a credible currency reform can immediately stop the bleeding and restart the economy. To be credible, a currency reform must discard the institutions and monetary modus operandi that were the sources of a currency’s unreliability and instability and replace them with institutions that have proven sound-money track records. In Sri Lanka’s case, a credible currency reform will require the replacement of the CBSL, which, like central banks in many emerging market countries, is subservient to the politicians.
As it turns out, Sri Lanka has been through an edifying currency crisis before. In 1884, the London-based Oriental Bank Corporation failed. As was common in those days, the bank had issued its own notes — paper money exchangeable into silver. Because that bank was dominant in Ceylon, as Sri Lanka was then called, its failure threatened to make trade grind to a halt by rendering a large part of the island’s currency unusable. The government quickly guaranteed the notes and soon established a currency board. The crisis passed and the currency board provided a credible, reliable currency. The system remained in place until Sri Lanka established the CBSL in 1950.
Fast-forward to 2022. The Rajapaksa government dithered while Sri Lanka slid further and further into trouble. The government pinned its hopes on a loan from the International Monetary Fund. But, for a small country in the grip of a currency crisis, the IMF’s bureaucratic pace is often too slow to “save” the patient. This was Sri Lanka’s fate. For some time, the government and the IMF have embraced the notion that the CBSL, with all its discretionary powers, must be retained, despite the economic chaos that it has created. If only the culprit, the CBSL, was mothballed and put in a museum, a credible currency reform that would ensure sustained stability could be implemented immediately. The centerpiece of the reform should be a currency board, like the one Ceylon employed for 66 years.
So, just what is a currency board? A currency board issues notes and coins convertible on demand into a foreign anchor currency at a fixed rate of exchange. It is required to hold anchor-currency reserves equal to 100 percent of its monetary liabilities.
A currency board has no discretionary monetary powers and cannot issue credit. Its sole function is to exchange the domestic currency it issues for an anchor currency at a fixed rate. A currency board’s currency is a clone of its anchor currency.
A currency board requires no preconditions and can be installed rapidly. Currency boards have existed in some 70 countries. None has failed.
The most notable modern currency board is Hong Kong’s, installed in 1983 to reduce exchange-rate instability. After the fourth round of Sino-British talks on Hong Kong’s future, market volatility reached epic proportions. Between July and September 24, known as Black Saturday, the Hong Kong dollar shed 24 percent of its value against the greenback. The chaos ended abruptly on October 15 with the establishment of its currency board.
Estonia is also notable. It took less than a month to establish its currency board in June 1992. At that time, Estonia’s currency was the hyperinflating Russian ruble. With the installation of the Estonian currency board, the Estonian kroon replaced the ruble, and stability was established. After expressing initial skepticism, the IMF heaped praise on Estonia’s currency board.
In 1994, neighboring Lithuania adopted a currency board to cut off the central bank’s funding of government expenditures. Subsequently, the IMF praised Lithuania’s turnaround and economic performance as one of the best in the European Union, which Lithuania joined in 2004.
In 1997, Bulgaria faced raging hyperinflation and a banking crisis. With the installation of its currency board in July, hyperinflation stopped immediately. By 1998, the banking system was solvent, money-market interest rates had plunged from triple digits to an average of 2.4 percent, a massive fiscal deficit turned into a surplus, a deep depression became economic growth, and Bulgaria’s foreign-exchange reserves more than tripled. The IMF gave the currency board rave reviews.
Bosnia and Herzegovina installed a currency board in 1997, as mandated by the Dayton Agreement ending the civil war. In the middle of ethnic strife and economic ruin, the currency board did what currency boards do: It established stability, a prerequisite for rebuilding.
It’s important to note that Argentina’s Convertibility System (1991–2001) was not a currency board. Although this system, which revolved around the maintenance of a one-to-one dollar/peso peg, had some superficial similarities with currency boards, it allowed for the Banco Central de la República Argentina to engage in financial engineering and discretionary monetary policy, both of which are prohibited under a currency-board arrangement.
The only way to end Sri Lanka’s economic nightmare is to establish a currency board rapidly, as Estonia did. While currency stability might not be everything, nothing can be achieved without it.