By Hema Senanayake –

Dr. Hema Senanayake

Ditwah hit Sri Lanka badly. It was the most disastrous cyclone Sri Lanka had ever experienced in recent history. Ditwah killed more than 160 people, another 214 people disappeared and nearly eight hundred thousand people were displaced at the time of writing this article.  Just Rs. 32 billion in disaster relief funds would be quite inadequate compared to the damage done by Ditwah. It might require trillions of rupees for the recovery. This is why I argue that Sri Lanka is in exact situation where we need to increase both foreign reserves and money supply. Here, increase in money supply means the issuing of a portion of the money supply directly by the central bank (“sovereign money”) debt free.

The current money system is called “Fractional Reserve Banking” or “debt money” system. In this system most of the money is created by designated commercial banks not by CBSL. Technically, most of the money is created when commercial banks make loans. This system is highly flexible, even though it tends to create debt bubbles. There is another system of banking called “Full Reserve Banking”. In this system, all money in circulation is created by the Central Bank (or the Government) debt free. In this system commercial banks function as intermediaries only, without creating any money.

Immediately after the new Central Bank Act (CBA) was enacted  I argued, “… it is important to explore as to how both money systems could be used alternatively, when necessary, in confronting major debt crises and pandemics like COVID-19. It would be a hybrid money system for open emerging markets consisting of Public Money Administration and Fractional Reserve System. The idea is to create a certain amount of money debt free while maintaining the flexibility of the economy allowing commercial banks creating a certain amount of “debt money” under the CBSL’s overall policy for total monetary growth… The new Central Bank Act should be amended significantly to facilitate an advanced hybrid monetary system” (Daily Ft. 12 Dec. 2023).  This situation has come now with the massive disaster of Ditwah.

Printing money is not always bad idea, if it can be done responsibly subject to a certain monetary rule.

Printing new money (sovereign money)

If Sri Lanka receives foreign currency inflows such as increased remittances, donations, disaster-relief grants, etc. the Central Bank gets an opportunity to create near equivalent amount of rupees  to be used in disaster recovery while keeping foreign currencies to increase foreign reserves. Printing money against U.S. dollar inflows is not generally inflationary. This increases both foreign reserves and money supply.

But is it safe?

Yes, it is safe under certain conditions. Printing money against USD inflows is generally not inflationary. But the Central Bank must fully absorb the foreign exchange and in turn this will increase foreign reserves. In a positive move, the government has requested from Sri Lankan diaspora to remit donations direct to CBSL’s account at Federal Reserve Bank in New York. If this is true CBSL would be able to issue sovereign money equivalent to USD inflows.

Inflow of USD represents new resources, not borrowed for consumption. When foreign reserves rise, the newly printed rupees are properly backed, so inflationary pressure is contained.

However, CBSL should be ready to contain excess liquidity if needed.

However, if the government uses the inflow of USD as justification to print more than the actual dollars entering  or if printed rupees to finance the fiscal deficit or if the dollars do not actually remain in reserves, the central bank cannot sterilize the liquidity due to fiscal pressures and in the event, it reduces import capacity possibly creating inflation and currency depreciation.

According to some economists Sri Lanka’s 2020 – 2022 crisis was driven by exactly this mismatch: money printing far exceeding real foreign inflows, causing imbalances.

Special Situation

However, we are in a special situation. That means we are receiving disaster relief donations/ grants. These are pure inflows not loans.

Therefore, if the government raises U.S. dollar 1 billion the central bank can print equivalent amount of rupees and the dollars remain in reserves or are used only for imports related to relief, the recovery would be fast and stable.

In such a situation, inflation impacts are relatively small because real resources are entering the economy, but mismanagement can still cause problems.

Key principle

Money creation must match real resource inflows. A country can print domestic currency when real external resources come in aligning the Balance of Payment consistency and monetary sovereignty but only if the printed rupees reflect genuine foreign exchange inflows, productive use and  disciplined monetary operations.

Conclusion

Sri Lanka can print money equal to disaster relief dollar inflows, but it must do so only to the extent  of actual USD received with proper reserve management avoiding fiscal misuse and being ready to prevent excess liquidity. If done correctly, this approach may actually support recovery but if it is done incorrectly, it could repeat the 2020 – 2022 disastrous inflationary cycle.