Sri Lanka: Slaying the Bogey of Inflation

This article appeared in the January 2008 issue of Globe Asia.

Sri lanka started the year with an unwelcome butnot totally unexpected bang. The country's long-runningcivil war erupted with troops from the governmentand the Liberation Tigers of Tamil Eelam taking off theirgloves.

In consequence of multiple violations of the ceasefire of February2002, that truce became a bloody victim as the Norwegian-ledSri Lanka Monitoring Mission began winding down.

If the civil war flair-up wasn't bad enough, Sri Lanka's othermajor problem - the bogey of inflation - remains alive and kicking.As Chart 1 indicates, inflation has been spiraling up since the startof 2006. Last year ended with a disturbing 18.8 % year-over-yearincrease for the month of December. The specter of unanchoredinflation haunts the Sri Lanka economy.

Those unanchored expectations throw into doubt the centralbank's 2008 inflation target of 10% to 11%. Indeed, in light of thehuge fiscal deficits that have been recorded year-after-year (seeTable 1) and with the civil war heating up, it will be very difficultto control inflation and sustain strong growth with Sri Lanka's currentmonetary set-up. To slay the inflation bogey, Sri Lanka needsnew institutions that will deliver discipline.

Monetary discipline (and ultimately fiscal discipline) can bedelivered if a monetary authority has either a credible internal orexternal anchor. It must be stressed that these anchors are mutuallyexclusive: one or the other, but not both. An internal anchorrequires a monetary authority to have a well-defined monetarypolicy. For example, this could be an inflation target or a target formoney supply growth.

With an external target, a monetary authority does not haveits own monetary policy. Instead, it links its currency to an anchorcurrency of a fixed exchange rate. In consequence, it importsthe monetary policy and the inflation rate (roughly) of the anchorcurrency country. In this way many developing nations have beenpegged against the US dollar.

At the end of the day, inflation is always a monetary phenomenon.This is, of course, the case in Sri Lanka. The problem residesat the central bank. It doesn't have a credible anchor. In consequence,it lacks the discipline to control inflation and contain inflationexpectations.

Sri Lankan Inflation, 2004-2007

Let's take a closer look. According to the International MonetaryFund's Annual Report on Exchange Arrangements and ExchangeRestriction (2007), exchange-rate regime is classified as"managed floating with no predetermined path for exchange rate."Therefore, we know that the Sri Lankan Rupee is not linked to ananchor currency at a fixed rate and that the central bank does notemploy a pure external anchor. We also know that the rupee doesnot freely float.

Instead, the rupee's exchange rate is managed via the centralbank's intervention in foreign exchange markets. This means thatSri Lanka's central bank has a mixed system of anchors: the exchangerate is used to some undefined degree (an extended externalanchor) and there is also an internal anchor (inflation target).

There is a straight forward way to show, with publicly availabledata, that Sri Lanka's central bank relies on a mixed-anchor system.For a central bank with a pure external anchor (fixed exchangerate), its net foreign reserves (foreign assets minus foreign liabilities)should be close to 100% of the monetary base (also called reservemoney).

Sri Lanka: CPI Pont to Point% Changes

Moreover, the reserve pass-through (the change in the monetarybase divided by the change in net foreign reserves over theperiod in question) should be close to 100%. For acentral bank with a free floating exchange rate, thereserve pass-through should be close to 0%, becauseit rarely has reason to buy or sell its currency for foreignreserves.

As Chart 2 shows, Sri Lanka's central bank doesnot have a fixed exchange rate which would delivera 100% reserve pass-through. Nor does it have afree-floating exchange rate which would be accompaniedby a reserve pass-through of 0%. Sri Lanka'ssystem is neither fish nor fowl.

To introduce more discipline and inflationfightingcredibility into Sri Lanka's monetary setup,an exchange-rate system must be adopted. Andas Professor Ronald McKinnon from Stanford Universityconcluded in Exchange Rates Under the EastAsian Dollar Standard (2005), for a country likeSri Lanka "a satisfactory free float is impossible."Therefore, the establishment of a credible internalanchor is not feasible. This is not the case for a Sri-Lankan external anchor.

By establishing an orthodox currency board, SriLanka could gain a secure external anchor.

Just what is a currency board?

It is a monetary authority that issues notesand coins convertible on demand into a foreignanchor currency at a fixed rate of exchange. Asreserves, it holds low-risk, interest-bearing bondsdenominated in the anchor currency and typicallysome gold. The reserve levels are set by law and areequal to 100%, or slightly more, of its monetary liabilities(notes, coins, and if permitted, deposits).

By design, a currency board has no discretionarymonetary powers and cannot engage in the fiduciaryissue of money. Its operations are passiveand automatic. The sole function of a currencyboard is to exchange the domestic currency it issuesfor an anchor currency at a fixed rate. Consequently,the quantity of domestic currency in circulationis determined solely by market forces, namely thedemand for domestic currency.

Over 70 countries, including Sri Lanka, haveemployed currency boards. Contrary to much thathas been written about Argentina's convertibilitysystem of the 1990's, that system was not a currencyboard. All real currency boards have acted toenforce both monetary and fiscal discipline.

Sri Lanka – or Ceylon as it was once called - establisheda currency board in accordance with thePaper Currency Ordinance (No. 32 of 1884) on December10, 1884. It was modeled after the Mauritiuscurrency board. On January 1, 1885, the board beganissuing rupee notes redeemable at a fixed rate of(1) Ceylon rupee per (1) Indian silver rupee. Sweptup by the fashion of the time, the currency boardwas replaced by the central bank in 1950.

If Sri Lanka wishes to slay its inflation bogey, itmust enforce monetary and fiscal discipline. Theonly way to do that is to install a currency boardwith a strong external anchor.

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute.