A child’s guide to currency board systems – Part I: How colonial Ceylon did it?

Aseni, the wiz kid in economics, has heard that there are many who have not been happy about the track record of the Central Bank of Sri Lanka during the last 72 years. As the solution to the problem, they are suggesting that Sri Lanka should go back to the currency board system which it had prior to the establishment of the Central Bank. She wanted to get the opinion of her grandfather, Sarath Mahatthaya, a former employee of the Ministry of Finance, on the subject. The following is the dialogue between the two:

 

Monday, 2 May 2022

Aseni: Grandpa, have you heard that there are many in the country now who advocate that Sri Lanka should reestablish a currency board system? Why has this become a hot topic today?

Sarath: Aseni, a currency board system is not an alien to Sri Lanka. During the British period of old Ceylon, the currency issue in the colony was handled by a currency board which the Britishers had established in 1884. This Board functioned well until the newly independent Ceylon decided to establish a central bank in 1950. The operation of the currency board has been well-analysed by H.A. de S. Gunasekera, a former professor of economics at the University of Ceylon, in his doctoral thesis submitted to the University of London titled ‘From Dependent Currency to Central Banking in Ceylon: An Analysis of Monetary Experience 1825-1957’. 

Gunasekera had done this research under the supervision of two well-known banking experts of the day, R.S. Sayers and J.S.G. Wilson. His thesis is the best source for anyone to learn of the working of the monetary system in Ceylon before the currency board was established, how the currency board had performed, and why Ceylon decided to replace the currency board with a central bank. 

Aseni: Wow! He has called the currency system before the establishment of the central bank ‘a dependent currency’. Why has he said so?

Sarath: That is because the currency issue in old Ceylon from 1825 had been linked to the colony’s acquisition of specie, another term for coins, from abroad through international trade. Therefore, it was dependent on the performance of international trade. The colonial economy was dependent on the exportation of commodities from Ceylon, first coffee, and then tea and rubber. The colony’s economy was therefore dependent on the markets outside the country. Since the currency issue was linked to the export performance, it was also dependent on what was happening outside the country. Hence, irrespective of whether the currency was issued by traders or banks or the currency board, it was dependent on the international trade. That was why the currency issue system was called a dependent currency. 

A criticism against this was that an economy had a domestic sector in addition to the external trade sector and the currency issue had not catered to the requirements of this domestic sector. A central bank was expected to cater to the requirements of both sectors and so, got itself freed from the dependency on what is happening outside the country. Therefore, a central bank could issue currency not only against the foreign assets it could acquire through international transactions, but also against the domestic assets it could create at its discretion. Hence, we can loosely call the currency system prior to the establishment of the central bank a ‘dependent currency system’ and the system that has been established after its establishment a ‘freed currency system’. 

Aseni: I now understand why it was called a dependent currency. And why did the colonial masters decide to establish a currency board? Couldn’t they continue with the system which the country had prior to that?

Sarath: Ceylon had its own currency throughout its recorded history spanning over three millennia. Old Lankan kings issued their own coins or coins issued by Roman emperors, Indian kings, and also the Chinese emperors. The good sign was that even private traders and high-class civil society leaders also issued their own coins of which the quality and the standard were assured by the king. All these coins were of precious metals and if these metals were not available, there was a limit to the issue of coins. 

During the colonial period, especially during the British period, trade between Ceylon and other countries expanded making it necessary for a convenient and safe currency system. There was a necessity for making payments for the labourers who had been hired from South India to work on upcountry plantations. When these labourers went back to India, they had to take their savings with them. Today, we get an inflow of remittances and at that time, it was an outflow of remittances. Currency was needed for this purpose and the job was done by banks which were called ‘exchange banks’ till 1884. Gunasekera has given a lucid description of how these exchange banks operated during that period. 

They were called ‘exchange banks’ because they exchanged local currency notes issued by them for specie or coins imported from India. This is like the foreign reserves which we have today. When Ceylon exported merchandise goods, it imported specie and those who earned specie could exchange them for local notes. Similarly, when Ceylon imported merchandise goods or Indian labourers took their savings back to India, Ceylon exported specie. So, the net balance of specie accumulating in Ceylon was equal to the surplus in the balance of payments. Similarly, if the export of specie was larger than the import of specie, there was a deficit in the balance of payments. 

According to the data presented by Gunasekera, in colonial Ceylon from 1856 to 1882, it was a surplus in the balance of payments because the import of specie was always in excess of their exports. For instance, during this period, import of specie representing the inflows on account of export of merchandise goods amounted to Sterling 28.6 million. The export of specie representing the outflows on account of import of merchandise goods and outward remittances amounted to Sterling 6 million. The net import or the surplus in the balance of payments amounted to Sterling 22.6 million. This was the case when the exports were down due to the coffee blight during 1870 to 1882. Therefore, the colonial Ceylon did not have a forex problem as we have it today.

The exchange banks did not hold a 100%-reserve of specie for the notes they had issued. The requirement was to keep only a minimum reserve of a third of the notes issued. Hence, they were able to issue multiple notes like the multiple deposit and credit creation being done by commercial banks today. This entailed a heavy risk on the solvency and liquidity of these exchange banks. That was because when the economy was in a downturn and more species were exported from the colony, they did not have sufficient cover to meet their obligations on the notes they had issued. In other words, when there was a continuous deficit in the balance of payments because exports were less than imports and outflow of remittances was high, naturally they went into trouble. 

The colonial Ceylon experienced its first banking and monetary crisis due to an acute liquidity shortage experienced by the biggest exchange bank, The Orient Bank. As a result, the orient Bank was forced to suspend the conversion of the notes it had issued on 3 May 1884. Pretty soon, there was a run on other two banks that had operated in Ceylon, Chartered Mercantile Bank and the Bank of Madras. This was a grave situation and the colonial government had to intervene to bring in a solution. That was to setup a currency board in Ceylon to issue government notes backed by a reserve of 100% so that no excess money was issued. 

Aseni: So, the issue at that time was same as today. You issue more currency than the reserves you have and continue to enjoy the fruits when the economy is doing well. But when the economy goes into a downswing causing a chronic balance of payments problem, you have to pay back all the joy you had had with extraordinarily high interest rates. This is exactly what Sri Lanka is facing today. You pay through your nose today for the past profligacy you had yesterday. Grandpa, how was the currency board set up in the colonial Ceylon?

Sarath: The colonial government went into fast action. But it could draw on the experiences of another colony, Mauritius, which had set up a currency board in 1849 after the failure of the note issuing exchange bank in that country, Mauritius Bank, in 1847. So, there was already a format of the law in the form the Mauritius Ordinance in 1876. What the colonial government in Ceylon did was simply an adaptation of that law with minor modifications to suit the time and specific conditions relating to Ceylon. That was how the Paper Currency Ordinance of 1884 was enacted paving way for the establishment of a currency board in Ceylon. History shows that all the new things are born out of crises, and this is a good example for it. 

Aseni: How was the currency board made of? How did it function, Grandpa?

Sarath: The currency system that was set up under the Ordinance was a ‘100% reserve system’. Under the Ordinance, a Board of Commissioners of Currency made up of three government officials, namely, the Colonial Secretary, the Treasurer, and the Auditor-General, was established. As Gunasekera has explained, the Board was empowered to issue currency notes in denominations of 5, 10, 50, 100, and 1000 rupee notes in exchange of silver rupees of India. These rupee notes which were legal tender were convertible on demand into Indian silver rupees at the office of the Board in Colombo. 

As an interim solution for the failed exchange bank, the Orient Bank, the notes issued by it were accepted for exchange for the new government notes issued by the Board till end of March 1885. Since then, the currency issue in colonial Ceylon was a monopoly of the government, but its freedom to issue currency was restricted by the need for having a 100% reserve. 

Aseni: That is a good safety clause because the commissioners could not issue currency notes just to please the colonial government as it is being done by central banks today. But how was the reserve made up, Grandpa?

Sarath: The Board was required to maintain at least a half of the notes it has issued in the form of silver rupee coins and the balance half in the form of investments in securities issued by Indian government, UK government, and any other colonial government except the government of Ceylon. As a result, the colonial government could not finance its expenditure by issuing a security to the Board and obtaining an equivalent amount of rupee notes. This is the main difference between the Currency Board that had existed prior to 1950 and the Central Bank that came to existence after that. If the colonial government had to incur any expenditure program, it had to either raise revenue through taxation or borrow funds from the market. Both will prevent the colonial government from undertaking extravagant expenditure programs just by relying on its money printing power. This was an extraordinary fiscal discipline that had been imposed on the colonial rulers. It is the same discipline which we do not have in the central banking system which we have today. 

Aseni: Great! But how did the Board acquire its reserves? By borrowing from outside sources as the modern-day central banks are doing?

Sarath: Ceylon acquired foreign reserves in its normal international transactions. Suppose it has exported goods worth of Rs. 100. This will result in the importation of an equivalent amount of silver coins by the country. If the country had imported goods worth of Rs. 50, silver coins have to be exported to its value and the relevant bank will meet the import bill out of its earnings. The balance Rs. 50 available with the bank can now be sold to the Board for local currency notes. So, one way to acquire reserves is to have a surplus in the balance of payments. 

Another is the direct investments by foreigners who bring in new capital. To get the local money, they have to sell their silver coins to banks. If the banks do not have money, they now have to sell those silver coins to the Board and get local money. If they do not have silver coins at all, they can borrow abroad and sell them to the Board for local notes. The same is relevant to government’s borrowings too. The proceeds of those loans will be sold to the Board for the local money. Therefore, the Board acquires its reserves not by borrowing, but by buying from the market. As a result, whenever there is a surplus in the balance of payments, the reserves as well as the rupee notes issued by the Board will go up. 

This will be automatically stabilised by an appreciation of the rupee. The opposite will happen when there is a deficit. In that case, the silver coins will go out of Ceylon. The system will be automatically stabilised by a fall in the value of the currency. But both appreciations and depreciations will cancel out making the currency stable. Any need for periodical change will be done the government by either revaluing or devaluing the exchange rate. 

Aseni: Grandpa, it is a wonderful system. It also imposes discipline on the central bank management too. They cannot borrow arbitrarily from abroad, build up reserves, and issue currency as the present central banks are doing. 

Sarath: Yes, there is a check on the arbitrary money printing, profligate funding of the government, and increasing the country’s foreign debt. 

(To be continued)

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(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com.)