Under an orthodox currency board, bureaucrats cannot print money either to finance the deficit under political pressure or artificially depress rates on their own volition, when credit demand spikes and trigger currency collapses.
A floating interest rates create is an automatic mechanism to balance external payments, links the monetary base to the balance of payment and the fixed exchange rate.
There is no sterilization (offsetting) of either inflows or outflows to go against the balance of payments to build large volumes of fore reserves at a rate faster than the growth of base money, or attempt to slow the contraction of base money with printed money to and trigger a currency crisis and credit downgrades.
Countries like Singapore and Malaysia resisted the creation of discretionary central banks.
Sally said for rules to work, there had to be consensus among the elite, that rules mattered over discretion.
“That said, something as strictly rule oriented as a currency board cannot be seen in isolation,” Sally said.
“This is where the political economy is really important.
Sally said successful currency boards set up recently in Hong Kong since 1983 and the Baltic States in the 1990s, where he had personal experience worked partly because there was a respect for rules.
“They worked because that rule, discipline in monetary policy and exchange rate policy had a corresponding rule discipline in fiscal policy,” Sally observed.
“And if you like a generalized consensus among the elite, underpinned by popular legitimacy, not to tamper with independent institutions, and to privilege rules at the discretion.”
He said he doubted whether an orthodox currency board could be set up for political and technical reasons and in currency board in isolation may not work, and the experience in Argentina was a case in point where there was fiscal indiscipline.
An attempt to set up a currency board in Argentina, had failed with the peg breaking after a few years. Argentina did not set up a separate agency, but some rules were brought via a ‘convertibility law’ to the Banco Central de la República Argentina (BCRA).
Classical economists who had looked at Argentina’s convertibility law, found that central bankers who operated the peg could sterilized up to 33.33 percent of the monetary base allowing it to buy up government bonds when bureaucrats wanted, and as well as other lender of last resort facilities.
Between 2000 and 2001 alone BCRA’ holdings of government bonds varied had varied from 20 percent of assets to 50 percent, researchers who analyzed the BRCA, something a currency board should not have been able to do.
Sally said a currency board would not solve all of Sri Lanka’s economic problems.