Stability has a price

The recent debate over reserve accumulation, money creation and exchange rate pressures has revived an old question in economic policy: would the country be better served by a currency board than by a central bank?

The discussion is often framed in simplistic terms. Critics point to reserve purchases by the Central Bank and argue that any resulting increase in liquidity amounts to money printing. Supporters of the current framework respond that reserve accumulation is essential after sovereign default and the depletion of foreign exchange buffers. Both observations are correct, but neither resolves the underlying issue.

The distinction that matters is not whether money is created, but how it is created and what constraints exist on its creation.

Sri Lanka’s monetary framework today differs fundamentally from the one that existed before the 2022 crisis. The Central Bank is no longer financing Government expenditure. Fiscal deficits are funded through taxation, domestic debt markets and external financing rather than direct monetary financing.

When the Central Bank purchases foreign exchange to build reserves, it creates rupee liquidity in exchange for a foreign asset. Such operations strengthen reserve buffers and improve resilience to external shocks. They are not equivalent to creating money to finance public spending.

Critics are nevertheless correct to observe that reserve accumulation can increase domestic liquidity. If credit growth accelerates too rapidly and domestic demand expands faster than the economy’s capacity to earn foreign exchange, pressure can emerge on imports, inflation and the exchange rate. The question is whether liquidity growth remains consistent with broader macroeconomic objectives.

The recent volatility in the rupee illustrates the point. The Middle East conflict raised concerns about higher fuel costs, rising shipping expenses and weaker tourism inflows. Importers rushed to secure foreign currency while some exporters delayed conversions. Such behaviour would have created pressure under almost any monetary regime.

A currency board would not have prevented higher fuel prices, weaker tourism inflows or increased demand for foreign exchange. External shocks do not disappear because a country adopts a different monetary framework. Its proponents argue, however, that a currency board would have prevented balance-of-payments pressures from being accommodated through discretionary monetary expansion.

The difference would lie in the adjustment process.

Under a currency board, demand for foreign exchange would automatically reduce domestic liquidity as reserves left the system. Interest rates would rise, credit conditions would tighten and domestic demand would weaken. Rather than relying on exchange-rate flexibility or discretionary monetary policy, a larger share of the adjustment would occur through tighter financial conditions and weaker domestic demand.

This is the principal attraction of a currency board. By limiting discretion, it reduces the scope for policy errors, constraints monetary expansion that is not supported by reserve growth and anchors confidence through reserve backing. Its supporters argue that the framework prevents balance-of-payments pressures from becoming currency crises through discretionary monetary intervention.

Yet the same mechanism can prove politically difficult during periods of stress. When external shocks occur, the scope for monetary accommodation is sharply constrained and a greater share of the adjustment falls on interest rates, credit conditions and economic activity.

A currency board may produce greater monetary and exchange-rate stability by limiting policy discretion and tying monetary conditions more closely to the country’s external position. But the stability it offers comes at a price. Governments must accept harder budget constraints, banks must operate with less liquidity support and businesses and households must absorb a larger share of external shocks through higher interest rates and tighter credit conditions.

The question is not whether a currency board can deliver greater stability. It can. The question is whether we are prepared to accept the costs and constraints that such stability demands.