Can Sri Lanka beat inflation before being swallowed by hyperinflation?

While not everyone likes the move, the taxes, both direct and indirect, should rise. More than that, there should be means to bring everyone entitled within the tax nets – private or public sector; COPE proceedings repeatedly reveal how some government entities absorb the PAYE tax components of their own employees. These are luxuries we no more could afford. Unless these holes in the wall are fixed there is a serious danger of the entire wall falling

The moment I stepped out of the currency exchange counter at Jakarta Airport I had this bizarre sensation of being a millionaire. There were 3 million Indonesian Rupiahs in my pocket. I negotiated a taxi for a fare of IDR 500,000 to my modest hotel. The additional zeros on the bank notes have already started making me uncomfortable. They reminded me of Zimbabwe and Venezuela. I kept reassuring myself this wasn’t exactly hyperinflation, but the outcome of several phases of inflation since the 1950s culminating with the East Asian Financial Crisis which raised the US Dollar from IDR 2,500 to nearly IDR 15,000 within a period of a year. After that, IDR stayed almost stable. I didn’t have to change the local currency in my hands to USD every evening so I do not have less money than I had in the morning. 

This was exactly what Zimbabwe bus conductors did. Bus tickets were issued for local currency, but at increasing rates throughout the day. The evening commute became the highest-priced ride. All drivers had to exchange money three times a day, not in banks but in back office rooms and parking lots. Shops and restaurants that quoted prices in Zimbabwean dollars, adjusted them several times a day. Otherwise, they would have been worse off. That was not inflation, but hyperinflation – defined as a situation where the prices of goods and services rise uncontrollably over a defined period. In general, the term is used when the rate of inflation increases at more than 50% a month. So officially, Sri Lanka right now is facing a hyperinflationary phase, though short-term.

Hyperinflation is perhaps the nastiest situation that can happen within an economy. Entering into such a situation is no joke. Controlling that bull in a china shop is perhaps far more important than even solving the political puzzle. This piece attempts to analyse the present situation and the strategies to come out of the danger zone.

Inflation: What it means to Sri Lanka

“Inflation,” said Milton Friedman famously in one of the speeches he gave in India in 1963, “… is always and everywhere a monetary phenomenon.” Hardly anybody could doubt that. Inflation, by definition, is the loss of purchasing power of a currency, so it had to be a monetary phenomenon. Still, Friedman meant much more. After having defined inflation, in that same talk, as a “steady and sustained rise in prices,” Friedman argued that one could not find evidence of inflation anywhere in the world that was not caused by a prior increase in the supply of money (read ‘money printing’) faster than they were being absorbed by the system with the increased supply of goods and services. Oversimplified, he meant if central banks stopped printing money above a sustainable limit, there would be no inflation. 

Let me make another observation specific to Sri Lanka, and maybe to other similar economies. Just like Friedman saw money printing precedes inflation we see LKR losing its value with respect to USD and other hard currencies always precedes it. How? Simple. The “steady and sustained rise in prices” happens as we import a sizable section of our consumer goods. If we double the value of USD more than half of the goods in our Consumer Price Index basket will double their prices. (As someone noted on social media one item that stays at the same price following recent inflation is rambutan. This is possible because it uses no imported goods as raw materials in production.) This may not necessarily make Friedman wrong; one can argue LKR always loses its value following excess money printing, but we now have a better co-relation. This leads to an interesting deduction: To control inflation one must control the LKR value falling against hard currencies. 

Hard currencies and weak currencies

Who decides that I get this many Indonesian Rupiahs for a USD and based on what? Well, determining currency values is an intricate subject. Textbook stuff, first. Currency is “representative money” – money that lacks any intrinsic value (like in salt or gold that has been used as currency once) but is backed by its ability to be traded for a physical commodity. First, they were valued under the gold standard, where each country’s currency was tied to a fixed amount of gold. Then some currency became fixed in value, while others remained ‘floating’. The value of the former is determined by governments and central banks of the respective countries, but the same of the latter is decided by the market. Aggregate demand and supply, in economic terms. If IDR gradually loses its value against USD, it means USD is more in demand than IDR. How much more in demand is determined by the rate – or in other words, inflation. This is what any Economics textbook says.

Going beyond, we know much more than this, thanks to the advent of cryptocurrencies. They do not care about aggregate demands and supplies. Only in some cases do we have an idea about the supply. Absolutely no idea about the demand. Cryptocurrencies are not backed by central banks and their values do not depend on the behaviours of the governments. What determines their value, and probably the value of the ‘other currencies’ – fiat currencies – to some extent, is speculation. This is common for any other commodity. The more market thinks the value of a currency would go up, it will and vice versa.

What made LKR drop: Money printing or speculation?

Equipped with this knowledge and connecting dots backward we can analyse what happened to LKR. Mainstream economists have already inferred it lost value only because of the overprinting of money. Did it? Let’s look at the timeline. LKR was fairly stable at 0.64 US¢ in June 2017. There was a slight drop around September 2018 but even around April 2020, it was around 0.5 US¢. Probably then it started sliding (but not correctly shown in the charts as it was not allowed to float). The drop was complete by February 2022, with LKR sliding to an ever-low 0.28 US¢. If money printing were the only cause the drop would have happened earlier. We were always printing money. 

By mid-2020 the debt issue and pending default were well known. Undial/Hawala networks, anticipated LKR to lose value. When the rate was fixed at an artificial value, the demand for USD immediately shot up with black marketers taking the best advantage. They bought USD at a higher rate (One USD was bought for Rs. 300 while commercial banks offered only Rs. 250-260) and sold even higher. 

While the evidence is inadequate to academically prove it, this indicates speculation has played a role in LKR losing its value – a role perhaps equally important as that of money printing. Please also note the Central Bank’s stern (but unsuccessful) attempts to curb the black market. That would not have happened if the black market played no role. The black market, as many believe, does not give a commodity its market value. Riding on the speculation it gives an artificially high value. For example, during 1970-77 times a pound of sugar, sold at 75 cents at co-operative shops was priced at Rs. 12.50 in the black market. A litre of 92 octane petrol sold at Rs. 470 at petrol stations was anywhere between Rs. 1,000-2,500 in the black market. The same is true for currency. Black market artificially pushes up the price far above market value. This is what had happened to all hard currencies for the last few months. 

Weak currencies too have their own advantages

Is currency becoming weak that bad? Well, not necessarily. Sometimes weak currencies can be helpful. They are so useful that countries go the extra mile to maintain them weaker. China, for example, keeps its currency Chinese Yuan (CNY) weak by continuously buying USD on the open market and keeping demand for the latter high. China can afford to buy and hold USD en masse due to its huge trade surplus with America. It buys USD roughly equal to this surplus. The boosting of the USD in turn makes CNY weak. For the last few years, China has maintained the value of CNY at just under 7:1. The undervalued CNY gives China an unfair advantage in the export market, encouraging the United States’ growing trade deficit with China and keeping goods in markets like India from locally competing.

So why not Sri Lanka take this advantage? Perhaps it cannot in the same manner. Like in China, our production is not large. Also, we do not produce all raw materials. It does not make sense to purposely undervalue a currency if half of the raw materials are imported. Still, in an entirely different manner, Sri Lanka can exploit the opportunity. With a weaker LKR, Ukrainian tourists might find it cheaper to stay a week here. Apparel goods of ours too can be more competitive in the international market, with cheaper labour. Given that INR: LKR ratio has dropped to 1:4 from the customary 1:2.5, it also would be, at least theoretically, more advantageous for an Indian business magnate to open a factory in Sri Lanka than in South India. Still, these are not enough reasons to let LKR fall further as the gains hardly justify the losses. Riding on a wave is no harm, but creating a wave is an entirely different thing. 

Under the guidance of the Central Bank of Sri Lanka, interest rates have already been increased, perhaps with the speculation that it would be a critical condition to be imposed by IMF. This is traditionally one of the bitter medicines IMF prescribes. The thinking may be better to get used to inevitables rather than avoiding them

Taking the inflation by horns

The correlation between the LKR value and inflation is so complicated that it is difficult to figure out the dependent variable from the independent variable. For our convenience let’s make the LKR value the independent variable. Will it further drop? The answer depends on multiple factors.

Money printing is one. That certainly has an impact – may be a delayed one – on LKR value. Still, money printing is one thing we cannot stop. Few weeks back we printed Rs. 107 billion to purchase fuel; then another Rs. 29 billion to pay public sector salaries for July. We can only lessen the amount we print; either by cutting costs drastically or finding new sources of revenue. Both are not easy, but possible. Some of the measures are already on the way. 

First, cutting costs. So much has been written on making massively loss-making State Owned Enterprises (SOE) at least breakeven; preferably profitable. SriLankan Airlines, a profit-making entity when operated by Emirates recorded a loss of Rs. 170 billion in 2021, accumulating its cumulative losses to Rs. 540 billion. The decision to stop bridging this gap with public money, is still being delayed. Petroleum, CEB, Railway, and CTB too are making losses, though not to that extent. Government employees nearly 1.5 million bearing the burden of their salaries. Certainly, the country has to take a few unpopular decisions soon. That will partially reduce the burden of printing money.

Then increasing government revenue. While not everyone likes the move, the taxes, both direct and indirect, should rise. More than that, there should be means to bring everyone entitled within the tax nets – private or public sector; COPE proceedings repeatedly reveal how some government entities absorb the PAYE tax components of their own employees. These are luxuries we no more could afford. Unless these holes in the wall are fixed there is a serious danger of the entire wall falling.

Interest rate hike: Is that a solution?

Under the guidance of the Central Bank of Sri Lanka, interest rates have already been increased, perhaps with the speculation that it would be a critical condition to be imposed by IMF. This is traditionally one of the bitter medicines IMF prescribes. The thinking may be better to get used to inevitables rather than avoiding them.

Will this move be useful in restraining inflation? Alone, No. Still, there can be an impact as higher interest rates encourage the public to keep their money in banks rather than on their own. Nonetheless, previous examples indicate adverse externalities. 

Turn to Korea, for a case study. What is known as the ‘East Asian Financial Crisis’ elsewhere, is called the ‘IMF Crisis’ in Korea – because of the supposed issues created by the prolonged increased interest rates there. Facing the 1997 regional financial crisis the Korean won (KRW) fell by more than 50% against the USD in the first few months alone. Then naturally, Korea called the IMF for rescue. In late 1997, an IMF team was brought to Seoul to discuss a “bailout package” of $ 60 billion. Consequently, as part of the IMF adjustment program, the Bank of Korea had to raise the base interest rates from approximately 12% to almost 30%. 

The objective of this move was to induce the investors to keep their savings in KRW and additionally to attract foreign investment in the hope of stabilising the value of the same. High-interest rates, it was argued, would not only attract capital inflow but also crumple aggregate demand, which was said to improve the country’s trade balance. It stabilises the value of KRW, no doubt, but failed to achieve its primary objective of inducing net capital inflows. Then contrary to expectations, the move diminished investors’ confidence in the economy as they were concerned that excessively high rates could push Korea’s corporate sector into insolvency. In general, the IMF program had hurt Korea’s macroeconomy; it triggered stagflation in which consumer price inflation continued in an environment of rising unemployment. During the first half of 1998 alone consumer spending fell by 12% with investment dropping by 40%. Korea’s real GDP contracted by 5.3% while the unemployment rate soared to a 7% high. Eight of the top 30 chaebols – the Korean conglomerates – went bankrupt.

Sri Lanka’s base interest rate is still not as high as 30% yet, but it could be, subsequent to a possible IMF bailout. Given the Korean example, this is a move we must take with extra caution.  

Hyperinflation: Not necessarily inevitable

Is hyperinflation inevitable? The answer to this question depends on whom you would ask. “The official inflation rate in Sri Lanka is 21.5% per year (sic) and the accurate inflation is the one I’m measuring that’s 132%. So the real inflation rate is 6 times higher than the official inflation rate,” said, early May 2022, Steve Hanke of Johns Hopkins University, a leading international economist. “It looks to me like everything in Sri Lanka is going to come to a stop.” He adds. I am not sure from where he obtained these ‘accurate figures’. Were they accurate – probably he is right. Sri Lanka will be hit by an express train. We need not even talk about the debris.

On the other hand, presuming Hanke’s figures and assumptions are not fully accurate, we can have a balanced look at Sri Lanka’s economy. Let’s start with facts. We are not in the best shape. Our report card is so bad that Shekhar Gupta, an Indian journalist calls India’s low-performing states ‘future Sri Lankas’. We have defaulted on our debt. We have been rated at the very bottom by all rating agencies; Moody’s, S&P, and Fitch Group. No attempts to deny any of these. Still, the countries that have entered long-term hyperinflation phases look too different. 

The five worst cases of hyperinflation in world history, in the order of severity, are Greece (1944), Weimar Germany (1923), Yugoslavia (1994), Zimbabwe (2008), and Hungary (1946). Other than Zimbabwe the rest were the outcomes of serious political and military battles. In Greece, it happened during the German and Italian Axis occupation during WWII. The response to the rapid increase of agricultural, mineral, and industrial products was printing currency without limits. The problem with the Weimar Republic, officially named the German Reich (Deutsches Reich) was that it had to print money to pay colossal amounts of borrowings previously Germany took with the hope of winning WWI. 

Hyperinflation in Yugoslavia happened immediately before, during, and immediately after the period of breakup of the country, from 1989 to 1991. Hungary’s case – the worst hyperinflation we have seen so far too can be attributed to WWII. Only in Zimbabwe, it happened following the economic disruption caused by failed land reform agreements and rampant government corruption resulted in reductions in food production and the decline of foreign investment. Argentina, Bolivia, Brazil, Nicaragua, and Peru in the 1980s and 1990s, and Venezuela in the mid-2010s reported hyperinflation episodes but the backgrounds were very different from that of Sri Lanka now. So it is not likely that Sri Lanka follow suit. However, still, it would be overly optimistic to rule out the possibility.

Conclusion: Need for a national plan

Sri Lanka’s foremost challenge at this point is to work out a detailed national plan to revitalise the service sector (particularly tourism) and launch a rapid industrialisation program. Sri Lanka is no more a poor country. We have the infrastructure in place. In two previous articles (Sri Lanka needs a rapid economic transformation, not global sympathy – FT, June 3, 2022, and Dollars or brains: What will solve Lanka’s debt puzzle? – FT June 22, 2022) I have detailed how this may be done. Not that one has to follow the same paths, but having a plan is essential. Whatever said and done, finally it would be that plan which may decide whether Sri Lanka would end another Zimbabwe or not. 

(The writer is a policy researcher. He can be reached via [email protected]. Views expressed here are personal.)