Why was a central bank established in Sri Lanka in 1950? Could the government achieve its national objectives?

Article's purpose and background

The present central bank which was established on 14 September 2023 as a part of economic management package set out in the 2023 IMF Accord has recently released a press notice to inform the public of the closure of its Public Debt Department (PDD) effective from January 01, 2026 (Read the notice here). The PDD is one of few Departments established under the Monetary Law Act (MLA) at the inception of the central bank on 28 August 1950. This news motivated me to write this short article in the national interest on the following background.

• The PDD served as the bread and butter for the implementation of the fiscal policy of the government and monetary policy of the central bank as set out in the MLA in the national interest during the past 76 years, given the fact that the Sri Lankan monetary system that was established by the MLA in 1950 was built on sovereign currency (Sri Lankan Rupee) supplied by the government through its fiscal spending and debt. 

• Therefore, the public debt management through the PDD was the cornerstone for the conduct of both monetary policy and fiscal policy in a coordinated environment as both policies were ultimate public responsibilities of the government.

• How the PDD was operationally driven by the relevant managers of the central bank from time to time is a different subject. As stated in the press notice, the view taken for the closure of the PDD is to strengthen the institutional accountability and enhance the efficiency and transparency of Sri Lanka’s debt management framework. This implies that the central bank's debt management for the past 76 years is not up to the quality. Any comment on this view has to wait for several years ahead until the performance of the new framework and the resulting economy is reported because government debt is the bread and butter of modern monetary economies.

• However, those who were hastily brave to close down the PDD and public debt management function of the central bank don't seem to have understood what they were under the MLA for the national economy and living standards of Sri Lanka. The non-availability of a publicly inquired report on the stated closure other than IMF austerity conditions also is a significant lapse of the government.

Therefore, the purpose of this article is to shed some light on the national macroeconomic role entrusted by the MLA with the former central bank in Sri Lanka where the public debt management was an integral instrument that strengthened the management of the new monetary system of the country established in 1950 for the objects stipulated in the MLA. 

Relevant materials for the article are gathered from the Exter Report dated 4 November 1949. This is the report that was submitted by John Exter to the Minister of Finance on establishment of the central bank. John Exter is the economist released from the US central bank (Federal Reserve System established in 1913) on the request of the Sri Lankan government to advise on establishment of a central bank in Sri Lanka. He also served as the first Governor of the central bank so established. This central bank was terminated on 14 September 2023 and its assets and liabilities were transferred to the new central bank incorporated by the Central Bank of Sri Lanka Act of 2023.

In that context, some may tend to question whether Sri Lankan economy needs a central bank of the current sort to deal with economic crises ongoing and envisaged. If the government can assure the public of its ability to deal with such crises without the support of the country's sovereign currency-based monetary system unlike in other countries, nobody needs to worry. However, this article does not touch on this technical subject.

What was the Sri Lankan monetary system prior to 1950?

It was the Currency Board system which issued Sri Lankan currency notes, Rupees, with 100% convertibility for Indian Rupees. Therefore, the country's money supply was automatic on its balance of payments position as the Currency Board did not have any discretionary powers to print or create Sri Lankan Rupee currency to facilitate the mobilization of domestic resources for the growth of employment, income and living standards. 

• Instead, the Currency Board issued currency in exchange of Indian currency at the par value and invested its Indian currency reserve in Indian money market. In times of balance of payments surpluses, banks sold Indian Rupees to the Currency Board in exchange of Sri Lankan Rupees and money supply expanded. In contrast, in times of balance of payments deficits, the Currency Board had to sell Indian Rupees to banks who demanded Indian Rupees to finance the foreign trade deficits of bank customers where money supply contracted as some of Sri Lankan currency flew back to the Currency Board and extinguished. The Currency Board carried out this currency trade with banks to keep the par value between Sri Lankan currency and Indian currency.

• As such, the country could not have a national monetary policy. The government spending was largely limited to tax revenue and grants received from the British government as the monetary system was not ready for the creation of money to fund the government. Therefore, the country could not have an active fiscal policy.

• Accordingly, the economy, employment, real income and living standards were passively dependent on production and export of few plantation crops which determined the country's balance of payments and money supply connected to Indian Rupee. Therefore, John Exter questioned the rationale for dependence of the independent Sri Lanka's economy on the policies of the Indian central bank.

John Exter in his report articulated so elegantly why the Currency Board monetary system was not suitable for the under-developed Sri Lanka with abundant natural resources and growing population. He wrote as follows. 

"Finally, such a system may be expected to impart a consistently deflationary bias to a growing economy. As Ceylon’s population increases and its domestic trade expands, it will naturally require an ever-increasing money supply. In the absence of a highly developed banking system, under which a significant expansion of bank credit would be possible, an increased money supply can be achieved only through a persistently active balance of payments on current account, or by borrowing abroad without using the proceeds to import goods. An active balance of payments is a costly luxury for an under-developed country, and as for borrowing abroad, it neither makes economic sense to incur foreign indebtedness in order to finance domestic expenditures in a country’s own currency, nor in such practice on any significant scale likely to be possible in the present-day world."

Therefore, his recommendation was to establish a sovereign monetary system and a central bank which would be able to create a flow of credit and money in sovereign currency for the fuller use of the country's human and material resources and raising living standards.

• However, the manner in which the monetary system and central bank were operated in the latter part of its existence was nothing but a de-facto Currency Board system that persistently exposed the country to macroeconomic risks of active balance of payments through foreign indebtedness as alerted by John Exter as above in 1950. 

• Therefore, the sovereign currency so created by the MLA could not prevail for the development of the economy and living standards as expected. This is the persistent trap that has spiraled around the economy and living standards during the most part of post-independence up to the present as evident from the acute syndrome of heavy dollar dependence, foreign borrowing and IMF austerity programmes.

Remarks

• Therefore, carefully designed technical studies are necessary to understand why the government had to close down the central bank and monetary system hastily on 14 September 2023 and why they ultimately failed in securing their objectives and national duties as set out in the MLA. 

• Such studies may also cover whether the new monetary system and central bank now in operation since 14 September 2023 would be capable of navigating the economy and living standards from the present crisis status and systemic vulnerabilities in line with global literature of central banking responsibilities and performances.

Why a sovereign currency-based new monetary system was created in 1950?

Under the Currency Board, creation of currency, money supply, banking and foreign exchange were separate monetary or economic activities that were not regulated for a central purpose of development of the economy and living standards. 

 John Exter narrated the importance of money and credit in modern economic system to justify the macroeconomic ideology of the proposed monetary system as follows.

"It has been the endeavour of this report to propose a type of central bank which, with proper skill and understanding in its management, will establish monetary conditions in Ceylon that may make possible, as never before, the fuller use of the nation’s human and material resources and a rising standard of comfort for all. The importance of money and credit in a modern economic system hardly needs to be argued. Perhaps no single factor can do more to influence the welfare and growth of a community than the flow of money. It is the mechanism by which the resources of a country can be mobilised for production. It plays a dominant role in the determination of prices and wages, of income and employment. Stable money is essential to performance under contracts and to the equitable liquidation of debt; it is the lifeblood of foreign trade."

Therefore, modern money is an active factor of production that can serve people through both demand side and supply side of the economy in contrast to the old monetary belief of money only being a price setter through the demand side.

Therefore, the MLA consolidated above stated monetary activities as ingredients of the new monetary system which was built upon Sri Lankan rupee as the standard unit of monetary value to be used for all transactions and contracts for the country's broader development objectives. Key elements of the new monetary system were as follows.

• Sri Lankan rupee designated as the legal standard unit of monetary value.

• The par value of the Rupee was linked to gold in line with the global practice followed at that time. Later, this was amended to follow a par value or leave it as determined by the Minister of Finance.

• The means of payment were defined as the currency notes and coins or legal tender issued by the central bank on behalf of the government and demand deposits which are the liabilities of the central bank and commercial banks denominated in the Rupee and are subject to withdrawal in legal tender upon demand by cheque, draft, or order.

• Commercial banks were taken under the regulation and supervision on both monetary (lending and deposit-taking) and prudential (governance and business stability) grounds to be the major conduit for the operation of the new monetary system.

• The central bank was established as the authority responsible for the administration and regulation of the monetary and banking system.

• The Monetary Board was established as the body corporate for the overall responsibility for the management, operation and administration of the central bank and specific monetary and banking policies as set out in the MLA. In fact, the Monetary Board was a government agency responsible for the determination of monetary policy and the regulation of economic activity on money, banking and credit. While the central bank was to operate on specific statutory duties, it functioned as the secretariat for the Monetary Board, given the Board's overall responsibilities.

Operation of the monetary system, its policies, principles and objectives were set out in detail by the provisions of the MLA.

Overall, the new monetary system was designed to monetize economy with a sovereign currency as the mechanism for developing the country and its living standards from their under-development. 

• Accordingly, the system was to be driven by the central bank/Monetary Board consciously to influence the supply, availability, cost and international exchange of the money to achieve specific macroeconomic development goals. 

• The underlying monetary mechanism consisted primarily of two types of monetary operations of the central bank. First, voluntary domestic credit operations with the government and banks in order to meet the credit needs of the economy. Second, compulsory foreign exchange operations to buy and sell foreign exchange on the demand of commercial banks, similar to the previous Currency Board, in order to maintain the par value and free convertibility of the rupee for current account transactions.

• Accordingly, the central bank's domestic credit operations were discretionary to augment or offset on the economy of its foreign exchange operations.

• Therefore, the central bank had a significant macroeconomic balancing role through the wider monetary system and monetary conditions, irrespective of government policies.

Although the new monetary system was to operate under the fixed exchange rate mechanism, later amendments to the MLA provided for flexible exchange rates in line with global practices where the flexibility started in November 1977 under the crawling peg mechanism as decided by the government.

Authority and objectives of the central bank

 As set out in the MLA, the central bank's authority and objectives were as follows.

The central bank was established as the authority responsible for the administration and regulation of the monetary and banking system of Ceylon; and, without prejudice to the other provisions of the Act, the central bank was charged with the duty of so regulating the supply, availability, cost and international exchange of money as to secure, so far as possible by action authorised by this Act, the following objects.

• the stabilisation of domestic monetary values,

• the preservation of the par value of the Ceylon rupee and the free use of the rupee for current international transactions,

• the promotion and maintenance of a high level of production, employment and real income in Ceylon, and

• the encouragement and promotion of the full development of the productive resources of Ceylon.

Accordingly, the central bank was given a wide mandate for the development and stabilization of the economy and livings standards by regulating the supply, distribution, interest rate and exchange rate of Sri Lankan currency. This has been the model of central banking pursued even in developed countries in the recent past.

These objects were reworded by subsequent amendments to the MLA in view of new developments such as adoption of flexible exchange rates and financial stability frameworks. However, central bank's overall macroeconomic role prevailed in tact.

In addition, public powers vested in the central bank later by the Exchange Control Act of 1953 and Employees Provident Fund Act of 1958 significantly widened the space of the central bank to operate the monetary system for its objectives, given their impact on the country's monetary conditions and economy. In fact, the central bank was blessed with a large number of additional policy instruments that strengthened its hand on the country's monetary management. For example, investments of funds under the Employees Provident Fund Act helped management the domestic money market and interest rates while exchange controls helped management of the foreign currency market to balance the country's monetary conditions.

It is interesting to see that John Exter recognized the economic impact of policies of other state institutions on the country's monetary conditions. Therefore, the central bank was designed as the single or central authority for regulating and operating of the monetary conditions of the country for specified macroeconomic objectives, irrespective of other policies of the government. He wrote as follows.

"Under the draft law, the Central Bank will be the principal monetary authority, but it is obvious that it cannot exercise its authority in the monetary field as in a water-tight compartment from which the various ministries and other agencies of the Government are excluded. There is no fine line separating monetary policy, from other policies, such as fiscal and trade policies. The Minister of Finance through his fiscal policy or the Minister of Commerce and Trade through his authority to control imports and exports, can exert a powerful influence upon monetary conditions in Ceylon. But it is the clear intent of the Bill to concentrate, in so far as it is considered practicable and constitutional to do, as much monetary authority and responsibility as possible in a single regulatory and operating agency — the Central Bank."

Accordingly, John Exter in his report emphasized the extent of macroeconomic powers of the central bank as he proposed in the MLA as follows.

"A central bank thus undertakes a great responsibility, and the broad powers given to the Central Bank of Ceylon under the draft bill in Part II of this report are commensurate with the magnitude of this responsibility. The Bank should not be hampered by rigid limitations which might prevent it from fulfilling its purpose. When a new central bank is being established, it is impossible to predict the course of its development. This will depend upon the environment within which it works and upon those who, determine its policies. Many of its powers may go unused for long periods, because they are designed for particular situations, some of which may never arise. Others are intended for use only in crises or to forestall a crisis, but prudence dictates that they be included now, so that they will be at hand in case of need. It would be foolhardy to assume, with the record of the war—and depression—induced economic crises of the last 30 years plainly before us, that the Ceylon economy will somehow escape such crises in the future. The safer assumption is the one underlying the drafting of the present bill: it is better in an uncertain economic world to be prepared for any eventuality."

Remarks

Therefore, it is worthwhile to assess whether relevant managers of the central bank were able to trace and use such powers of the central bank to forestall crises or resolve crises from time to time as envisaged in 1950, especially, during the global corona pandemic-induced economic crisis in 2020/23 as compared to central banks in other countries. The reason is because the crisis emanated directly from monetary operations of the central bank on the management of foreign currency reserve, exchange rate and public debt.

Why public debt management powers were vested with the central bank?

John Exter knew that the Sri Lankan monetary system was built on sovereign currency in line with contemporary monetary systems in the world where the source of the supply of the currency was the fiscal deficit and debt. Therefore, the government was blessed with an active fiscal policy funded through the creation of the sovereign currency and debt, unlike in the private bank currency systems that prevailed before. 

In that context, the only conduit to balance the monetary system with the fiscal policy operations  was to empower the central bank with duties as the government's fiscal agent, banker and debt manager. Accordingly, a large number of monetary powers were vested with the central bank to intervene in fiscal policy and debt to ensure that the central bank had strings and safeguards to protect the official monetary system for its macroeconomic objectives set out in the MLA. Therefore, this subject was a double-edged sword as the monetary system was built on sovereign currency whose supply was dependent on fiscal deficits and debt while the central bank had its independent macroeconomic objectives to be achieved through the monetary system.

Remarks

Therefore, the closure of the public debt management function of the central bank could be an indication of a shameful failure of those who governed the central bank under the MLA. This could also be a source where the new central bank also will be vulnerable in the near future, given the nature of sovereign currency-based modern monetary systems and their dependence on fiscal spending and debt. This would be another subject for technical studies outside the underlying politics.

Central bank governance in the MLA

In view of the dynamism and urgency required in policy actions connected with monetary matters, John Exter recommended a small Monetary Board of three members consisting of the Governor of the central bank, Secretary to the Ministry of Finance and one appointed member from the public. The Secretary to the Ministry of Finance was the conduit for coordination and co-operation between the central bank and the government, given the close connection between the monetary system and fiscal operations.

The post of the central bank Governor was designed to dominate the Monetary Board and to have the full control over the management of central bank and its policies. Accordingly, the regulation and operation of the monetary system was largely at the hand of one individual, the Governor of the central bank.

Therefore, John Exter described the quality of the character expected from an individual to be appointed as the Governor as follows.

"Since the other two members of the Monetary Board will be part-time members and because the problems facing central bankers are frequently complex and technical, it is to be expected that the full-time Governor will ordinarily be the most influential member of the Board and will tend to dominate it. Accordingly, the Governor should be a man of recognized and outstanding competence in and understanding of the economic and financial problems of Ceylon, and of unquestioned integrity and responsibility. In order to attract such a man it is recommended that his salary be set at the highest possible level not inconsistent with remuneration in top-ranking posts elsewhere in the Government and its agencies."

The Governor's dominance over operations of the central bank as part of his statutory duties was provided for in the MLA as follows.

 "The execution of policies and measures approved by the Monetary Board and, subject to any such policies and measures as may be applicable, the direction, supervision, and control of the operations of the Central Bank and its internal management and administration."

John Exter also elaborated the need for the continuous and constructive co-operation between the Monetary Board and the Government and its dependence on persons in the Monetary Board and the government from time to time.

"The ideal which it is hoped that the proposed law will achieve is one in which there will be continuous and constructive co-operation between the Monetary Board and the Government. The principal instrument for achieving this co-operation should be the Permanent Secretary to the Ministry of Finance whose membership on the Board will ensure at all times that his Minister’s views will be made known to the other members of the Board. The effectiveness of this co operation and co-ordination between the Board and the Government will depend more upon the men occupying the key positions at particular times than upon any legal formula, no matter how carefully or elaborately it might be worked out. A relationship as complex, and sometimes as delicate, as this one is certain to be, cannot be established full-blown by a piece of legislation. It must be the result, as in other countries, of years of experience and the slow growth of political conventions." 

Remarks

Therefore, any assessment of the central bank's effectiveness in the development of the economy and living standards as provided for in the MLA has to be connected primarily with the characters of individuals who held the position of the Governor from time to time.

Concluding Remarks

• The current crisis status of the Sri Lankan economy is a clear indication of the failure of implementation of the monetary system that was established consciously in 1950 to drive the real economy and living standards of Sri Lanka to modern levels.

• However, those who managed the monetary system have consciously trapped the country in active balance of payments through foreign indebtedness which is the risk alerted by John Exter far back in 1949. In fact, new monetary system established in 1950 was intended to prevent this risk. Therefore, the collapse of the foreign currency reserve, steep currency depreciation and default of foreign debt in 2022 were miserable failures of the central bank in regulating the sovereign monetary system for mandated real economic objectives.

• The ideological bias towards old money-induced inflation rhetoric adhered to by key managers of the central bank during later decades prevented the use of the sovereign currency for the country's development as set out by the MLA. In contrast, the central bank chose the route of the active balance of payments to fix a set of monetary numbers to show its performance. It is pathetic to see the political ideology that has been created in the minds of the general public on money and government debt as public enemies. This baseless ideology has prevented the government from fiscal spending to rebuild the economy and living standards devastated by Ditwah cyclone where donor funds have are planned as the preferred option. It is hard to think of public powers of a government with sovereign currency powers that runs after donor funds to serve its public duties.

• The current monetary mechanism being operated on the overnight policy interest rates linked to the consumer price index monthly announced by the government and the foreign currency reserve funded by the government's foreign borrowings (active balance of payments) has become a day-to-day speculative financial business with money dealers that has no benefits to the real economy and living standards in the medium and long-term. 

• It is hard to visualize the nature of the present monetary system where the new Public Debt Management Law provides for the government to issue debt securities to support the implementation of the monetary policy objectives and to borrow from foreign markets to support the balance of payments by replenishing of the foreign currency reserve of the central bank.

• Therefore, it is fearful to think of the country's real economy and living standards even falling on day-to-day-basis, not to mention the near-term or long-term status, under the economic governance system being implemented by the IMF at present. The recent statement made by a consortium of 121 global economists on risks to which the country is acutely exposed and immediate solutions required (Read the statement here) to deal with such economic model risks is an useful piece of forensic evidence for the country's macroeconomic plight prevailing at present.

• There is no doubt that the current economic management model of active balance of payments through foreign indebtedness and austerity dictated by the IMF will also fail as it does not have a targeted flow of domestic currency to fund the real economy to generate a foreign currency surplus. This requires major surgeries to both the economic structure and the economic governance system.

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public. All contents in the article are based on the author's research and views on the subject which have no intension to personally discredit characters of any individuals.)

P Samarasiri

Former Deputy Governor, First Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 13 Economics and Banking Books and a large number of articles published.)