A child’s guide to currency board systems – Part II: The performance of Ceylon’s currency board

The central bank can make a huge seigniorage, have a lavish expenditure pattern, and even contributes to the government coffers in a big way. That is how central banks are able to offer lavish perks to its officers and become an important source of revenue for the government. Currency boards, to the contrary, are not big money makers, and hence, must keep their expenditure as frugally as possible. Since the earnings on the investment reserve is not that high, they are not big contributors to the government as well

Economics whiz kid Aseni and her Guru Grandpa Sarath Mahatthaya have been examining the current debate on whether Sri Lanka should go for a currency board system to cure its present monetary sector ailments. Sarath Mahatthaya, a former employee of the Ministry of Finance has led the discussion. 

He has told her that currency boards are not alien to Ceylon because the British colonial masters had established a currency board in the country when the currency issue was monopolised by the government in 1884. Prior to that currency had been issued by private banks by issuing their own notes by accepting specie, silver coins that represent foreign exchange today, when the colony imported specie through exports and foreign direct investments and exported the same through imports and outward remittances. 

Banks were required to maintain a minimum balance of specie equal to a third of the notes issued. However, in practice, banks had issued notes in excess, a practice similar to currency printing by a central bank without reference to any internal reserves within the bank. The first currency and monetary crisis was faced by the colony when in 1884, the main note issuing bank, Orient Bank, suspended the conversion of its notes to specie due to an acute liquidity problem.

The currency system collapsed, and the colonial government intervened in the system by establishing a currency board that was required to maintain a 100% reserve against the notes it would issue. A half of the reserve should be in specie, while the balance half in securities issued by the British or other colonial governments, specifically prohibiting it to buy securities to be issued by the Ceylon government. This system prevailed till 1950 when the independent Ceylon decided to replace it with a central bank.

The first conversation can be found here: https://www.ft.lk/columns/A-child-s-guide-to-currency-board-systems-Part-I-How-colonial-Ceylon-did-it/4-734214. 

The conversation continues. 

Aseni: Wonderful! The Currency Board of the colonial Ceylon had survived nearly seven decades until it was replaced by a Central Bank in 1950. But many writers have branded it as a rigid system because currency issue had been linked to the acquisition of specie by the Board. As a result, they have argued that the Currency Board did not have the flexibility to expand the currency issue when it was necessary to pump liquidity to the system in an economic downturn or natural disaster. Was it a fair criticism, Grandpa?

Sarath: That rigid system was also one of its virtues. That is because it could not expand the currency issue, an important component of the money stock of the country, at its will arbitrarily. If it acquired foreign reserves, in this case, Indian silver coins, it could expand the currency issue. If it did not, it was prevented from doing so. 

As a result, the colonial government in Ceylon could not finance its expenditure programs by getting the Currency Board to print currency and supply to it. Consequently, the colonial government was forced to raise revenue through taxation or acquire funds by borrowing, if it wished to increase its expenditure programs. This is called practicing fiscal discipline at the highest level. Because of the resource limitations, the government could not go for extravagant projects simply to boost the personal egos of those in power. 

But because of two reasons, the system was not rigid as the critics had claimed. 

Aseni: What were those two reasons?

Sarath: One is that at that time money stock consisted of another important component called demand deposits created by commercial banks in their day-to-day business. The other is that even the Currency Board enjoyed a certain degree of flexibility if it wanted to increase the currency issue, marginally of course, above the total reserves it was holding. 

Aseni: How could this demand deposit factor help relax the rigidity of the currency board system?

Sarath: Money stock at that time consisted of all currencies and demand deposits held by public. The public for this purpose, as it is today, was made up of all individuals, businesses, corporations, cooperatives excepting the government entities or commercial banks. The Central Bank’s annual report for 1950 has published the money supply figures from 1942 to 1950 during which the Currency Board was in operation. 

Commercial banks also create money in a financial system by way of lending to customers in numerous forms. They do so by keeping a minimum cash balance as a reserve of the deposit liabilities and lending the excess reserves to customers. This is being done by just making a book entry by debiting a loan account and crediting the customer’s deposit account. That deposit, which has not been made from the real earnings of the customer, is a creation of the commercial bank. But it increases the buying power of the customer in the same way as a currency note issued by the Currency Board.  

According to the Central Bank data about which I talked earlier, the currency held by public in 1942 had amounted to Rs. 164 million. At end 1950, this figure had nearly doubled to Rs 325 million. But the demand deposits held by the public had increased much faster during this period by about 119% from Rs. 267 million to Rs. 585. As a result, the demand deposit component in the money stock has increased from 62% in 1942 to 64% in 1950. What this means is that the Currency Board’s so-called rigidity has been more than compensated by the free action of commercial banks by creating multiple deposits and credit during this period. This is seen from the dramatic increase in loans and advances of commercial banks. 

In 1943, they had amounted to Rs. 124 million. At end 1950, they had amounted to Rs. 399 million, recording an increase of more than 2 times. Hence, if the system demanded, there was the possibility of providing more liquidity to the economy. This is important because it has happened in the economic slump during the war and the post-war period. 

Aseni: You said that the Currency Board also enjoyed a certain degree of flexibility in increasing the note issue above the 100% reserve requirement. This is puzzling to me. Can you explain this?

Sarath: Gunasekera also has referred to this in his doctoral thesis. As I told you, the Currency Board was required to keep a 100% reserve of the notes it has issued, a half in the form of Indian silver rupees known as the cash reserve and the balance in the form of investment in securities. In the case of the cash reserve, it could go down to a minimum of a third without violating the statutory requirement. This leeway allows the Board to issue notes in excess of 100% of the total reserve subject to two restrictions. One is that it cannot be practiced continuously as a permanent strategy. The other is that such issues are only marginal and should be in small doses. 

Take a hypothetical example that the cash reserve is above the minimum threshold of a third of the note issue. Theoretically, the Board can go down to this minimum level without violating the statutory requirement. Suppose that the balance sheet of the Board has Rs. 100 as the note issue on its liability side. On the asset side, suppose the cash reserve is Rs. 43 and securities investment is Rs. 57. Now the Board can reduce its cash reserve to Rs. 33, use the excess Rs. 10 to buy Indian silver rupees from commercial banks and issue notes to a value of Rs. 10. Now reserves will go up to Rs. 53, investments to Rs. 57, and the total note issue to Rs. 110. 

It is still short of Rs. 2 to satisfy the cash reserve requirement of a half of the note issue amounting to Rs 55. If it buys additional 3 Indian silver rupees from commercial banks, the note issue will go up to Rs. 113, the cash reserve Rs. 56, and investment portfolio Rs. 57. In this way, if the cash reserve falls below the minimum 50%, the Board can increase the note issue by recouping the shortfall reserves till it reaches the minimum level. 

Though this is a theoretical possibility, there is no evidence that the Board has actually done it. 

Aseni: So, the system has not been that rigid as the critics have said. But the Currency Board has to incur expenditure to issue notes, replace them when they become unserviceable, and meet its own operational expenditure. How did it meet these expenditure items? Was it given a subsidy by the colonial government?

Sarath: That is a good question. In the case of a central bank, the expenditure can be met out of the profits it makes by issuing currency. Those profits are called ‘seigniorage’, a French term meaning the profits earned by a Lord by issuing coins. A central bank earns seigniorage on currency issues without spending an equal amount of real resources. For instance, when the central bank issues a 5,000 rupee note, its real sacrifice is the printing cost of that note and the operational expenditure it incurs to run the bank. This is a fraction of the face value of the note issued. 

Since all central banks are in the practice of issuing paper money or digital money today, the cost is a negligible amount. Hence, the central bank makes enormous amount of profits, meets its own expenditure on note issue and its replacement, and the operational expenditure of the bank as well. The remaining huge amount of profits is transferred to the Treasury which in Sri Lanka’s case has been the largest component of the non-tax revenue of the Government. 

In the case of a currency board, the sacrifice of the board is the same as the note issue because it has to buy specie from commercial banks to do so. So, on the liability side, the board has note issues and on the asset side, it has the specie holdings. There is no profit made. However, in terms of the statutes, a half of the specie can be used to buy securities issued by the British government or any colonial government other than the colonial government of Ceylon. These investments earn a return, and the board can meet its expenditure from that income. Any remaining surplus after meeting the expenditure can be transferred as revenue of the colonial government. 

This is the fundamental difference between a central bank and a currency board. The central bank can make a huge seigniorage, have a lavish expenditure pattern, and even contributes to the government coffers in a big way. That is how central banks are able to offer lavish perks to its officers and become an important source of revenue for the government. Currency boards, to the contrary, are not big money makers, and hence, must keep their expenditure as frugally as possible. Since the earnings on the investment reserve is not that high, they are not big contributors to the government as well. 

Aseni: Great! Has the currency board in Ceylon kept the needed reserves to back the notes it has issued?

Sarath: Yes, of course. According to the data published by the Central Bank in its first annual report, during 1938 to July 1950, the total reserves have always been above 100% of the notes issued by it. Remember this is the war period during which the economy of Ceylon had gone into a slump. Even during that period, the average reserve position has been 109% with 123% in some years. Hence, the Currency Board has been up to its job as envisaged. This led H.N.S. Karunatilake, a former Governor of the Central Bank, to give a good certificate to the currency board in his assessment of the operations of the Central Bank of Sri Lanka titled ‘Fifty Years of Central Banking in Sri Lanka: 1950-2000’. 

I will quote Karunatilake for you: “As the foreign exchange reserve under the System was always at a minimum of 100 percent, the actual reserve often exceeded this figure. There was no danger that the money supply would increase by some multiple of the foreign currency that was deposited with the Currency Board. In practice, the Currency Board maintained a reserve of more than 100 percent which meant that very often for foreign exchange received, it issued a Ceylon currency in much lower proportion. Thus, by maintaining a reserve of more than 100 percent, the Currency Board mechanism actually exerted a general contractive effect on the money supply. Therefore, the full effect of a surplus in the balance of payments did not always operate on the money supply. By this means, the system of currency issue minimised monetary disturbances in the pre-war economy.”

This observation is important because it has come from a former Governor of the Central Bank who has critically assessed the performance of the Bank in its first 50 years. 

Aseni: The currency board system was a great stabiliser of the economy because surpluses did not force it to issue more currency than necessary, and deficits did not lead to monetary contraction because commercial banks issued their own money by creating demand deposits. This is the discipline which we lack today. But isn’t it akin to the ‘constant money growth rule’ proposed by Nobel Laureate Milton Friedman for central banks if they are interested in avoiding inflation?

Sarath: In a way, yes. Friedman said that central banks can avoid inflation if they allow the money supply to grow at the same rate as the real economic growth. What he said was that central banks should avoid excessive increases in money supply. When people have money in their hands above their needs, they will use that money to buy goods and services causing the aggregate demand to increase. Since the aggregate supply is determined by real forces like capital stock, technology, and human capital, the excess demand will push the prices up. 

Hence, money is neutral on the real economic activities. Therefore, the central bank should just do its duty by providing liquidity to the economy and nothing more. This can be done by allowing money supply to rise at a constant growth rate. The mistake is done when this rule is violated. We expect the central bank management to use its prudence and wisdom to avoid it. But very often, they fail in their duty. 

A currency board will force authorities to follow this rule and therefore, they do not cause inflation or currency depreciation to happen through arbitrary increases in money supply. Those who object to currency boards will say that it is a loss monetary independence in which they can respond to economic slumps by providing a stimulus to the economy through expansion of money supply. This was what all central banks had done in response to the COVID-19 pandemic. But the results have been disastrous as revealed by the rising inflation from USA, to India, to Sri Lanka, just a few examples. Hence, this monetary independence should also be exercised cautiously. 

If it is mishandled, the whole nation will have to pay through its nose. To its credit, the Currency Board by following the Friedman rule long before it was pronounced by him had effectively handled the economic slumps in Ceylon caused by the coffee blight in 1880s and global economic depression in 1930s. It did not provide a stimulus, followed its rule, and got the real sector to come out of its ailment on its own within a short period of time. 

Aseni: Thanks Grandpa for clarifying it for me. 

Sarath: Let’s continue this discussion. 

(To be continued)

Part I of this article was published in the Daily FT on 2 May and can be seen at https://www.ft.lk/columns/A-child-s-guide-to-currency-board-systems-Part-I-How-colonial-Ceylon-did-it/4-734214

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected])