ECONOMYNEXT – Sri Lanka’s central bank ended price controls on bond auctions, an absolute requirement to end a currency crisis and possible external default, but the rate rises have been slow and insufficient to end money printing so far.

Before exploring policy options, it is important to understand what Sri Lanka is doing wrong now, what it has been doing wrong for the last 70 years, why these actions make the country go into an external crisis every time there is an economic or credit recovery.

It is also important to know why ‘flexible exchange rates’ fail, as they do in Sri Lanka, what a floating and fixed exchange rate is and also why going to the IMF has been only a temporary solution as evidenced by the multiple trips to that organization.

This FAQ attempts to explain the key misconceptions that drive wrong policy and also give the historical background on why some countries with a particular ideology keeps get into trouble, while others do not.

What is a central bank? And what is a bank note?

A central bank is a bank which can create paper notes which are exchangeable for goods and foreign currency. Any number of banks can create these notes in a given territory – and in the free banking era they did – but later governments limited this ability to one bank, giving it a note-issue monopoly. In connection with Sri Lanka this happened with the Bank Charter Act of 1844 in the UK, which limited the ability of banks to create money, to Bank of England in the UK and later in the Empire.

In Ceylon there was Ordinance No 23 of 1844. In Ceylon such regulated money was first created by the Oriental Bank Corporation which was a chartered bank and the Chartered Mercantile Bank of India, London and China. In many areas of the British Empire, the Standard Chartered Bank and its affiliates issued money which was very much more stable that those issued by the later state central banks. Standard Chartered still issues money in Hong Kong, subject to the rules of the Hong Kong Monetary Authority.

The power – and the problem – of central banking comes from its ability to issue these notes which people exchange for goods domestically and abroad by exchanging with foreign currency. These notes are an interest free liability of the central bank like an IOU or a bearer cheque. In fact for all intents and purposes rupee notes are bearer cheques.

The monetary base of a country is a whole bunch of bearer cheques, which are cashed at the central bank for dollars if there is a fixed or pegged exchange rate and not cashed of there is a floating exchange rate.

Are fixed or pegged exchange rates artificial? Are they inherently unstable?

Not at all. Fixed exchange rates are not artificial or unviable or unstable. That fixed exchange rates are unstable seems to be a myth spread by Keynesians and other Mercantilists who are unaware of banking in general and monetary history in particular after Keynesian stimulus shattered pegs wholesale.

A fixed exchange rate is simply a type of monetary system with a particular type of anchor.

Mercantilists have used false econometrics like the real effective exchange rates (REER) to attempt to link currency to trade. That such ideas are misguided can be readily seen in the ‘undervalued’ exchange rates of Sri Lanka and the supposedly ‘overvalued’ exchange rates of currency boards and almost all East Asian nations.

A fixed exchange rate is so-called because it is fixed or anchored to some asset or currency which does not inflate fast and preserves its value.

Throughout history, sound paper money had been pegged to a valuable non-inflating (relatively rare) asset and the asset itself has been circulated in parallel. The best one found so far in human history seems to be gold, but silver has also been successfully used.

The India and Ceylon Rupees were originally silver or pegged to silver, which is another way of saying that paper money has been issued like a cheque against a bank account balance of silver or gold, just as a person in the present day may issue a cheque against the current account balance.

What is the connection between the exchange rate (parity of the note issue of one central bank with another) and the economic performance of a country?

Strictly speaking there is none. Until 1971 (or the 1934 Gold Reserve Act) when US citizens were banned from holding the metal) gold was money. But gold is just something dug up from the ground.

Under the classical gold standard all countries had a fixed exchange rate, all money had the same anchor – gold.

Under the classical gold standard therefore exchange rates did not change. The parity between Sterling and the US dollar was unchanged unless there was a policy error. Therefore all countries had an unchanging ‘exchange rate’ one can argue. Though the units may have been labelled differently based on the gold returnable (the rupee was supposed to be worte 2.88 grains of gold when the central bank was set up in 1950) and the US dollar one 35th of a troy ounce or 13.71 grains. The parity remained the same among all currencies. Parity was maintained through the ‘specie flow mechanism.’ (see David Hume)

A country can use multiple types of money if there is no prohibition against it. Many countries in the past have done so. Before the renewed economic troubles in Zimbabwe with the new RTGS dollar, the country had stability under multiple currencies, including the US dollar and the South African Rand.

The Colombo Port City area can use dollars, Pounds, Yuan, Euros and so on. That area will have currency competition where businesses and people can choose which currency to use. Businesses can agree with workers to pay salaries (denominate the salary) in a currency and people can use the strongest currency they want to keep bank deposits. Or have deposits in two or three two currencies if they want to.

Other multiple or dual currency areas such as Cambodia, which is becoming an export powerhouse shows that the belief that the strength (or weakness) of a currency circulated in a given area has something to do with the real economy or trade is a delusion spread by academic Mercantilists.

The Port City will not be tied to the fortunes of one central bank. It will also not have currency crises, because there is no bank there that can create money. In the rest of the country the Central Bank of Sri Lanka has a note issue monopoly. Unfortunately therefore the fortunes of its residents are tied to the value maintained by the central bank. The value will decrease if a large amount of notes are issued and it will be strong if a lower amount of money is issued.

The depreciation ideology developed in some English speaking countries in the 1930s after the US Fed created the Great Depression, and was spread by J M Keynes at Cambridge. It later to other Universities like Oxford and Harvard, using old discredited ideas of classical Mercantilists like John Law and others. Competitive devaluation, stimulus and anchor conflicts have brought destruction to vast areas, and make people think that the value of money has something to with the broader economy and not the actions the bank that issues it.

According to Friedrich A Hayek, who tried to counter these ideas in the 1930s, and later won a Nobel after the Bretton Woods collapsed in 1971 generating high inflation and high unemployment, Keynes was was not familiar with the monetary history of his own country and thought his stimulus ideas were original.

In Britain the bullionist debates at the turn of the 19th century involving David Ricardo, Henry Thornton and others were among the most in depth ever to take place in the English language.

Other Nobel Prize winners like Bertil Ohlin also tried to argue with Keynes, but since Keynes could speak English well, edited an influential economic publication and taught at Cambridge little Keynesians were created and they went around the world spreading these ideas which caused immense hardships to the UK and many newly independent states.

Countries that used the opposite philosophy, such as West Germany (and nearby nations with large German speaking populations), Japan, Sweden and Singapore prospered after World War II while the UK went from one Sterling crisis to another, like Sri Lanka does today.

Germany realized the problem with un-anchored paper money after the 1920s hyperinflation and money printing under Hitler. Singapore’s economic architect Goh Keng Swee had said that he was paid with Japanese Banana money under occupation. Plus he studied at London School of Economics where Hayek taught and could not be deceived. That is why Singapore resurrected the pre-war Straits currency board and created one for its own after separating from Malaysia.

These people believed that stable or sound money is required to protect the poor. It is the best protection also for businesses and provides a strong foundation for anyone in making hard goods, providing a service, like a person doing a job to build their lives.

The IMF was also created by a type of Keynesians called New Dealers of the US, so their grasp of note – issue banks is not that firm either. That is why IMF programs do not provide lasting solutions to monetary problems of a country.

So no, exchange rates are determined by an anchor, not the economic prowess of a country or inflation differentials.

What is a hard pegged exchange rate? What is a currency board?

A hard pegged exchange rate is the simplest form of monetary system that one can imagine. This is where some institution takes a foreign currency or gold and issues paper in exact proportions. This is like writing cheques against a current account.

As long as cheques are written with a balance the cheques always realize (can be exchanged for dollars). This is a currency board and they never depreciate and are never dishonored. This is because the owner of the cheque book is prohibited in the first instance by law from writing cheques which bounce.

This is called a monetary anchor. The cheques are firmly anchored to the available balance of the account or reserves of a bank. As long as what is the reserve does not inflate, the cheque also will not inflate.

Digressing a little, this is why central banks generally discourage undated cheques from passing from hand to hand.

If the Federal Reserve does not inflate the dollar, Hong Kong dollar issued under currency board principles will not inflate and certainly the parity will not change. If Singapore dollar does not inflate, Brunei currency board dollars will not inflate. And Singapore dollars will exchange in parallel.

Thomas Cook traveller’s cheques are currency board like notes. Amex traveller’s cheques are also currency board notes. They never defaulted and broke the one-to-one parity like the central bank depreciates the currency.

As many readers may be aware there used to be unsigned travellers cheques that used to circulate like money, especially when there were tight exchange controls.

Amex and Thomas Cooke never broke the parity but they also replaced stolen travellers cheques. This was done using the invested returns of deposits taken from Amex customers to issue the travellers cheque, which is like the interest earned from foreign reserves of a currency board or central bank.

The Tether cryptocurrency (a so-called stable coin) is supposed to operate like a hard pegged exchange rate to the US dollar. Whether the promise will be kept no-one knows. A currency board will transparently publish its balance sheet every month to back up the promise.

When people with fixed exchange rate paper use it for imports, the total outstanding (reserve money) reduces as the monetary authority exchanges the bills for dollars.

That automatically stops further imports. If a system of banks uses this money, interest rates in all the banks will go up and credit will contract. In practice these changes are very small.

That is how the Ceylon rupee held a one-for-one parity with the Indian rupee until 1950 the Latin America style central bank was set up, and Bhutan still does.

Under such a system, the rupee notes outstanding also called the reserve money or monetary base is fully CONVERTIBLE to the foreign reserves.

Maintaining the exchange rate limits money issue and it is the ‘anchor’ that preserves the value of the currency. There is absolutely no problem with maintaining a fixed exchange rate as long monetary policy – the rule for printing money – supports it.

What is a soft-pegged central bank?

A soft pegged central bank is like a conventional bank where a customer (The Monetary Board) can write cheques without having the required full cash balance in the bank in the hope that it will not be presented for redemption. However as soon as credit picks up these notes come up for redemption creating forex shortages.

The old gold standard central banks were also soft-pegged central banks. They could issue notes or interest free cheques without having gold in the bank. This phenomenon is also called fractional reserve banking.

However if large volumes of notes were issued without taking in gold in the economy into the bank, the value of the notes depreciated (gold price went up). Because Sri Lanka is supposed to issue dollars against foreign reserves, if money is issued against Treasury bills, the value of dollars will go up.

This in fact is what has happened to Sri Lanka now. In fact it has happened to many other countries. It does not happen to Bhutan or Singapore because there is a law which says money cannot be issued against Treasury bills.

The original Monetary Law Act of Ceylon in 1950 contained elaborate measures to stop the over-issue of money except for short periods – usually about 270 days – which was expected to keep the peg intact.

The IMF is trying to ‘modernize’ monetary policy in many countries which have good central banks. When it succeeds, these countries will have severe social unrest. They are trying harm Vietnam and Cambodia with the same ideology that destroyed Sri Lanka. These two countries will become like Laos if they follow the IMF.

Why do soft-pegged central banks run into currency crises?

Soft pegged central banks run into currency crises because when notes are first exchanged for dollars in the reserves, the outstanding note issue does not contract unlike in a fixed exchange rate and rates do not rise. Reserve money is re-expanded by injecting money through standing lending facilities, overnight reverse repo auctions and term reserve repo auctions to stop rates falling. This prevents reserve money from adjusting to the outflow or transfer of wealth and the currency collapses.

The value of the note does not collapse due to ‘overvaluation,’ or the real effective exchange rate, due to the lack of tourism revenues or other myths.

The currency collapses due to liquidity injected to sterilize or fill the rupees lost due to the intervention. If the intervention was unsterilized and rates were allowed to go up – even partly – it is possible to hold the currency. This is what Dubai, Qatar, Saudi Arabia and Oman do.

Is it possible to run a monetary system where money is created against something like Treasury bills which has no inherent value?

Yes. To a great extent. That is exactly what a floating exchange rate is. In a floating exchange rate reserve money is not convertible. This is called inconvertible paper money. The central bank is not obliged to give dollars in exchange for inconvertible paper money.

People exchange these money among themselves like undated cheques.

Because no dollars are sold to defend the exchange rate, no rupees have to be injected to stop the rates from going up.

When we say the Bretton Woods collapsed, President Nixon closed the gold window, the Bank of England suspended gold convertibility, or the Sri Lanka rupee floated, what we actually mean is the convertibility has been suspended.

Therefore outflows of foreign exchange matches inflows, just like a hard pegged exchange rate system.

But under this system, there has to be a rule also to limit the creation of money to make the floating exchange rate strong.

In the short term therefore note issue does not grow or contract due to foreign exchange defence or purchases, it can go out of ATM withdrawals and banks may also be tempted to get money from the central bank window and lend.

The notes outstanding will also change when pull money out of ATMs which will also be filled by the central bank to keep rates fixed. However they may come back to the banking system in a day or two.

The danger is that money reserve money will grow simply through open market operations to maintain the interest rate as happened in the Greenspan-Bernanke bubble and the current Powell bubble with asset price bubbles and commodity bubbles.

If there is no external anchor to control reserve money in a floating rate, and there is no gold as an anchor, what keeps a floating reserve money in check?

To limit the growth of reserve money in a floating rate also an anchor is needed. Margaret Thatcher and Alan Walters first tamed the floating rate Bank of England with money supply targets. In 2008/2009 Sri Lanka also did that when Deputy Governor W A Wijewardene devised such a program. IMF programs in the past typically used to have them. Bangladesh still does it. But it also intervenes in the forex market and collects reserves.

One consistent system developed by Sweden and New Zealand independently was to target inflation directly with interest rates, ignoring money supply changes in a pure floating exchange regime. A low inflation target of around 2.0 percent has been shown to work.

That is to say when inflation goes up, regardless of what reserve money or broad money or any other indicators such as economic growth or jobs is, rates are raised to slow the growth of reserve money and credit and which in turn tends to strengthen the currency. The US Fed fails due to its dual mandate as well as Mercantilist (John Law style) ideology which resurface like a bad penny.

Floating exchange rates are extremely strong. As a last resort when soft pegs collapse, a float will stabilize the system following a bungee jump.

Has Sri Lanka had a floating exchange rate?

No. Sri Lanka has had very short periods of floating when foreign reserves had run out and the credibility of the peg has been completely lost. But these periods can probably be measured in days or weeks. Sri Lanka then goes back to a dollar buying peg.

What is the problem with ‘flexible’ exchange rates?

A flexible exchange is just a new IMF term for a collapsing soft-peg or managed float without consistent rules. It is an intermediate regime that is neither a hard peg (currency board) nor a floating rate that can be properly controlled with an inflation target.

A ‘flexible’ exchange rate is a non-regime that switches from being a peg (convertible reserve money) when the central bank defends the currency and becomes a floating (non-convertible reserve money) regime when it stops. This can happen several times in the same day.

The IMF also gives a panic button called DMC rule to switch back and forth.

In a flexible exchange rate episode with panicky defence and a collapsing currency such as in late 2015 or 2018 or in March 2020, this switching happens rapidly. There is no clean independent float.

One downgrade was given during the 2018 ‘flexible exchange rate’ episode and another came after the 2020 ‘flexible exchange rate’ episode.

This inconsistent switching makes it collapse continuously without stabilizing. A currency can collapse to any level under a ‘flexible’ exchange rate with partial interventions. It happened to Argentina during its last IMF program.

A float on the other hand is like bungee jump. As long as no intervention is done and therefore no money is printed to make outflows exceed inflows, the exchange rate will stabilize after a fall and sometimes bounce back a little.

What is the connection between the budget deficit and depreciation or inflation?

There is no connection unless there is a central bank willing to finance the deficit with printed money. The central bank depreciates the currency in the process of trying to finance it with printed money or trying to control interest rates. Therefore it is important to keep the deficit down, if rates are not to go up to very high levels.

Regardless of the deficit, a high interest rate, which channels money to the deficit through bond auctions by crowding out private investment and consumption can keep monetary stability and protect the poor.

But a lower budget deficit will not just reduce the borrowing volume and rates, but it will also increase the confidence of rupee bond investors, dollar bond investors and the IMF because they can now believe that there is some light at the end of the tunnel.

A debt restructuring will also help. In any case an IMF sign-off will unlock World Bank, ADB budget support loans.

What is the importance of confidence?

Confidence is needed for people to invest in bonds denominated by the central bank’s rupees. When confidence is low investors will demand a high rate to compensate. The bond auctions were crippled by the central bank from around April 2020 with price controls and now investors will buy bills and bonds factoring some rate hikes into the rate.

That is why Treasury bill rates have to go up. Already rates have started to go up and a more realistic and steeper yield curve is appearing. The so-called ramrod rate anomaly where different maturities have the same rate across time is being removed.

From the foregoing it can be seen that it is important not to print money, and bond markets have to raise real resources either to hold a peg, a fixed rate or operate a stable floating rate after a fall.

Like the bond market the central bank has also crippled the foreign exchange market. Just like bond investors are unwilling to buy bonds denominated in rupees at low rates, people who bring dollars to the country are also unwilling to convert them and hold rupees.

What about a float?

Yes. A float will work in a severe loss of confidence. Floats work every time, unless there is a DMC (a Disorderly Markets Conditions rule where the central bank is allowed to intervene) as in IMF programs. Then the float can fail as it did in Argentina. That is why the 2012 float failed until the currency fell to 131 before stabilizing as opposed to a quick fall to 120 in 2009 followed by a rebound, which is a classic float of a peg. Large volumes of dollars were given for petroleum bills in 2012 and liquidity was injected to sterilize them.

However, for a float to stabilize the exchange rate, interest rates have to be sufficiently high for bond auctions to work and prevent further money printing to pay the salaries of state workers. At the moment deposit rates have not adjusted.

Floats also have the advantage that interest rates will not shoot up unlike in unsterilized sales in a situation of weak confidence. The currency can be re-pegged at a weaker rate later, but for there to be credibility all interventions have to be unsterilized after that.

What is the difference between sovereign default and currency crisis? Where is the sickness?

A currency crisis is essentially a run on the central bank. The central bank defaults on the value of the domestic note issue by devaluing. The holders of rupee notes demand dollars, so it is a run on reserves.

Sovereign dollar default is also a run on the Treasury. So they are similar in nature. When there is a run on the central bank the Treasury suffers as there are no dollars to buy.

Sri Lanka’s economy is doing as well as can be expected given the pandemic. There is nothing much wrong with the economy made up of private companies and private citizens that is also not wrong in most other countries. But the government is sick with a massive salary bill, state enterprises are sick, any company subject to Consumer Affairs Authority price controls get sick fast,, state energy utilities are extremely sick due also to price controls and the central bank is very very sick.

Price controlled state energy enterprises which run massive losses with printed money and allocated foreign exchange have led to complete monetary meltdowns in Latin America.

This time the central bank is also very sick due to swaps and outstanding borrowings from the IMF and its dollar balance sheet is developing a very large hole as this column is being written. This type of hole can result in the complete collapse of the Central Bank and anyone using its money as it loses the ability to conduct monetary policy. In other words it loses the ability to enforce a consistent rule.

Has this happened before in Sri Lanka?

It happened in 1884 when the Oriental Bank Corporation which was issuing money, collapsed and suspended convertibility or payments, creating widespread disruptions. However at the time there were people with knowledge in the UK who could help.

And they set up a currency board, when Arthur Gordon was the Colonial Governor. He was a liberal and had studied at Cambridge before that great institution was corrupted by Keynes.

Governor Gordon decided not to allow a note issuing bank again but to set up a currency board, -which had been invented in Mauritius a short time earlier – with silver and the Indian rupee as the anchor, though gold was also accepted.

Since the Oriental Bank Corporation was private, it was not easy as now to deceive the people that the problem in the Central Bank of Sri Lanka is a problem with the broader economy.

It was clearly evident that the depreciation was a problem with the note-issuing bank.

The swift economic deterioration at the time, and suffering of the people and businesses immediately after the currency collapsed imposed upon the users of that currency, should be a warning to those in authority now.

The following extract from Ceylon Currency British Period by Benjamin Walter Fernando outlining comments by then Governor Arthur Gordon is illustrative.

There is no ‘Ceylon Government or an Empire to back the rupee notes now. After hiring hundreds of thousands of unemployed graduates into the work force, engaging in stimulus and REER targeting, borrowing to consume through credit lines and adding to the national debt, the government itself is in a precarious position.

In fact the opposite is happening. The note issue bank is acquiring liabilities through swaps and issuing forex guarantees to rupee debt of the government.

One way to soften the blow is to allow parallel dollarization. In 1884, the Mercantile Bank was still alive. Now some exporters have dollars. To cushion the blow, parallel dollarization should be allowed to seep into the economy through remittances, exports and hotels.

Why can’t present day people in authority understand this?

It seems that these concepts of note-issue banking, monetary stability or currency boards are impossible for anyone who had studied at a Keynesian University to grasp. In fact based on their writings they seem to be frightened of currency boards. But they have used travelers’ cheques without any problem.

In 1884 Sri Lanka or in 1800 in the UK, there was no such broad, academic brainwashing to battle and to restore critical thinking. Any country that figures this out can end inflation and currency depreciation, as East Asian nations did and Britain itself did. After the failed soft-pegs of the ERM, UK learned from its former colony New Zealand and adopted inflation targeting, which is not the best system, but is better than most.

From the ‘flexible exchange rate’ and flexible inflation targeting fiasco in Sri Lanka it seems that inflation targeting itself is mis-understood in this country.

Keynes did not appear to understand banking. As a result any country that does not understand banking will have BOP trouble.

Keynesians and what is generally called Cambridge economists (Anglo-Saxon or English speakers ideology) seem to think that the value of the money is determined by trade, imports and current account deficits and not the rules of the note-issuing authority (the anchor). It must be said that even Thornton was partly seduced by this idea.

Money printers are taking refuge under a tourism fall and current account deficits today, it was a drought then.

So economics in the present day is not one philosophy. There is classical economics, which you can argue based on logic and reason and refute, and there is Mercantilism which is like a religion based on unreason. Adam Smith’s Wealth of Nations was essentially a treatise against Mercantilism. But mercantilism is running high, a few import substitutors are amassing unimaginable wealth, and the rupee denominated masses are being dragged into a meat grinder.

No amount of logical reasoning, or Amex paper or Thomas Cooke paper analogies or what happened to the Oriental Bank Corporation will ever convince someone who had studied at a Keynesian university about the value of stable exchange rates. These people believe in monetary protectionism and the REER.

It is not without reason that classical economists say that Keynesianism spread like a new religion.

In fact Hayek jokingly said that Keynes was elevated to Sainthood after his death, while he himself discredited himself by writing the Road to Serfdom. This book described what happened to a country like Sri Lanka, and how citizens are reduced to playthings of the rulers and bureaucracy with great accuracy. He wrote it to stop the UK going down that path. He failed and the UK had social unrest and went to the IMF eleven times until Thatcher, who was a great fan of Hayek was elected and her advisor Alan Walters and Chancellor of the Exchequer Geoffrey Howe – who was a lawyer – fixed the Bank of England and ended 40 years of exchange controls. In fact 300 economists or Mercantilists wrote to Thatcher to change tack.

She did not do it and said the now famous words – “This lady is not for turning”. Because once the note issue banking and its dangers are understood well by an adult or child, stimulus mania is defeated forever and the poor wins.

That is to say poverty goes down, provided of course private property is respected, there is free trade and business owners are not favoured against consumers.

As can be imagined Keynes was an articulate English speaker. On the opposing side were Germans and Swedes with accents. However in the early 19th century in the bullionists debate, the public and British parliament accepted the arguments presented by David Ricardo, Henry Thornton and others contained in the Bullion Report supporting the restoration of convertibility.

In that case it was English speakers against English speakers, not some foreigners. The Bank Restriction Act which allowed the float in 1797 eventually ended in 1821.

The Sterling then became the strongest currency, a position which it held until August 1914, when the UK entered World War I, and started printing money. Since banking knowledge was there at the time, the Pound was floated.

Modern day academics and central bankers however appear to be clueless about banking in sharp contrast to the likes of Ricardo and Thornton knew banking very well. As a result mis-steps and misery galore. Sri Lanka is also in a dangerous situation with policy makers with little banking knowledge trying to fight a fire with tools that add to the flames.

How does all this affect the moves announced by Governor Cabraal in October?

Governor Cabraal lifted import controls on LCs. That was correct. From the foregoing it can be seen that import controls are a waste of time. If credit is moving, it will go to a sector which is not controlled. This is why imports soared to levels not even seen in 2019 despite the fall in tourism revenues. What happens is credit will move from highly taxed areas like cars to low tax areas, which people do not want as much as such will fill a less important need for holders of money.

The exporter conversion rules can backfire. Like remittances which went off the radar after the 203 decree, it can push money off the legal channels. Instead of bringing dollars here, which banks can use to settle their external liabilities or buy SLDBs, a part of the export proceeds will be parked outside.

Controlling service exports like IT is even more difficult.

The forced conversion also does not address the problem with remittances.

Higher interest rates can partly address the problem. But like in the case of bonds, the weaker confidence requires a higher rate to incentivize people to part with dollars.

But selling land and getting foreign resources to the budget is a good move, though it is out of the control of the central bank. Foreign investors are also unlikely to come to rupee bonds at these rates.

Governor Cabraal has only allocated 300 million dollars for defending the currency. From the foregoing it can be seen that a pegged exchange rate at 200 can only be enforced through convertibility and higher rates. Forced conversions are a gamble that can be easily lost.

What are the problems with the current policy measures and controls?

Newly appointed central bank Governor Nivard Cabraal also rightly lifted some controls on electronic and other imports which had no relevance to external troubles.

Import controls have no bearing on forex shortages or balance of payments crises, which are caused by excess creation of rupees in a soft-pegged exchange rate regime.

Despite price controls being lifted bond markets are still limping and forex markets are crippled.

The central bank’s six month roadmap, which is an attempt at cohesive solution including fiscal measures also has some contradictions, chief among them a forced conversion of export proceeds to maintain an exchange rate peg around 200 to 203 the US dollar, which can divert more inflows into unofficial channels.

A surrender rule when a peg is under pressure creates money (inserts rupee reserves into banks) at zero interest rates.

A maintaining a credible fixed exchange rate is a fairly straight forward activity which this country as Ceylon under British rule did very well until the establishment of a money printing central bank in 1950.

However once the credibility of the peg has been lost, re-stablishing credibility requires very high interest rates.

The cascading fiscal and monetary policy errors made in 2020 and 2021 are unprecedented and their impact on the central bank balance sheet has been devastating.

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This will not get better until monetary policy is corrected.