Towards a well-planned economy

The lender of last resort, the Central Bank of Sri Lanka, is under heavy fire now, due to the release of extracts of the report on the Bond Commission appointed by the Head of State. The report submitted by the commission is expected to come before the Parliament.

Therefore, it is our duty, as students of economics and political science, to evaluate scientifically the origin of the Central Bank of Sri Lanka, its gradual evolution, varied functions and performance, lapses and also to arrive at a judgment whether it has fulfilled the expectations of its founding fathers and the high degree of faith kept in/on it by the people of Sri Lanka.

A Central Bank is an independent national authority that conducts monetary policy, regulates banks and provides financial services, including economic research, covering every aspect and wide corners of an economy. For performing all these assignments, it has earned the prestigious name, The Banker’s Bank. A Central Bank is expected to stabilize the nation’s currency, keep unemployment low and prevent inflation.

Central Banks stimulates economic growth by controlling the liquidity of the financial system. To control this liquidity they are fully armed with three sharp weapons. First and foremost, a Central Bank can set a reserve system/a reserve requirement. It has the legal authority to tell the network of commercial banks, how much cash they can possess each night. This ceiling can put a limit to a bank’s lending.

The second strategy of Central Banks is to use the open market operations to buy and sell securities from member banks. It changes the amount of cash in hand, without changing the reserve requirement. It is said that the European Banks manipulated this tool during the 2008 financial crisis. Further, it is pointed by financial experts that private and commercial banks bought government bonds and mortgage-back securities to stabilize the banking system. The third strategy used by the Central Banks is to set up definite targets on interest rates they charge from their member banks. By using this method, they guide rates for loans, mortgages and bonds. It is well understood, that raising interest rates slows growth, preventing inflation. This theory is well known as contractionary monetary mechanism.

Sweden, established the first Central Bank –THE RISKS-in 1668. The Bank of England, came next in 1694. Napoleon created the Banquet de France in 1800. Congress, opened the Federal Reserve in 1913. In Canada, the Bank of Canada entered the banking field in 1935 and the German Bundesbank, joined the queue later.

Active, robust monetary policy

After gaining political Independence from the British Raj in 1948, The Central Bank of Ceylon was set up in Sri Lanka by the post independence government, taking into consideration the importance of an active, robust monetary policy and a dynamic monetary sector to support, enhance and promote economic growth in all spheres of economic life.

The Currency Board System that came into being, under the Paper Currency Ordinance No: 32 of 1884, looked after the functions of banking prior to the inauguration of the Central Bank in Sri Lanka. On setting up of a Central Bank in Sri Lanka, the then Government of Ceylon requested the services of the United States Government for technical, structural and financial advice. As a result of this request, the US Government appointed John Exter, a reputed economist of the Federal Reserve Board of the U.S.A. to shoulder these responsibilities and assignments for the government of Sri Lanka.

After studying the financial sector in Sri Lanka and her responsibilities towards achieving sustainable development, John Exter submitted a very comprehensive report to the government in November 1949. Based on the recommendations of this report, The Central Bank of Ceylon was established by the Monetary Law Act of (MLA) of No: 58 of 1949 and commenced operations on August 28, 1950.

It was renamed the Central Bank of Sri Lanka in 1985.

The main objectives of the Central Bank were enumerated as follows by the MLA of 1949.

01. Maintenance of Price Stability(Stabilization of domestic monetary values)

02. The preservation of the par value or the stability of the exchange rate of the Sri Lankan Rupee(sustainable maintenance of exchange rate- stability)

03. The promotion and maintenance of a high level of production, employment and real income in Sri Lanka.

When analyzing the different tasks of the Central Bank and its relevance to the Sri Lankan economy, it is our duty as students of economics to turn to the pages of the doctoral theses submitted by Prof. H A de S Gunasekara to the London School of Economics on the subject of ‘From Dependent Currency to Central Banking in Ceylon-An analysis of Monetary Experience 1825-1957’. In his well-researched thesis, Professor Gunasekara has underlined the fact, that the Central Bank’s performance during the first years of its existence has not been fully successful to prevent the volatility of money supply originating from fiscal deficits and export fluctuations.

Even the present day economists who have done in-depth studies of Central Banking performance from 1949 to date vindicates Professor Gunasekara’s findings and is of the opinion, that the analysis outlined by Professor Gunasekara that the limitations of the Central Bank in a developing economy, saddled with the twin objectives of economic development and stabilization, still remain valid.

Economic or social targets

In a planned economy or when there is a definite economic plan for a country, the tasks of a Central Bank is much smoother than in an unplanned economy. In a well planned economy, the economic or social targets are well set for a definite period, for five-seven years. A Central Bank operating within this set course, knows the ambitions and objectives of the government in power and the welfare options it intends to undertake within this period. But in a market orientated economy this ‘assurance’ is absent.

Therefore, in a market orientated economy, where the demand and supply theory dominates the relationship between the government and the Central Bank varies from a country to country.

There is a general consensus, that the Central Bank in a country should be allowed to handle its affairs completely free, without any kind of impediments blocking its freedom. The rationale behind this argument is that when there is direct or indirect political interference, the Central Bank will fail to conduct sound monetary policies aiming at price stability. There is another point of view, which elaborates that the Central Bank should be under the control of the government.

However, in practice Central Banks in market orientated economies operate between these two extremes and it is observed that they enjoy different layers of independence in different countries.

In parliamentary democracies, where the voice of the people is given priority consideration to satisfy the political constituency, the general tendency is to incur government expenditure for various populist welfare measures such as handouts, subsidies, and income transfers to households. Without pragmatic plans in store, ‘job creation’ will also be undertaken in certain sectors and the final result will be surplus of employees, hindering the economic performance of the particular institution.

Economists who have researched this aspect of financing, point out, that this is one of the main reason for the prevailing and on-going budgets deficits. To finance these ongoing deficits, borrowing is the only alternative. In situations like this, the government in power expects the Central Bank to come into its rescue and the Central Bank will have to ‘print’ money to uphold the unfinanced portion of the deficit. Further, there will be budgets and interim budgets.

In a situation like this, only an independent Central Bank can advice the government in power to refrain from ‘power-hungry’ solutions. The function of price stability should be the prerogative of the Central Bank.

The yahapalanaya government which took over the political administration of the country in 2015, decided to transfer the subject of Central Banking and monetary policy from the Finance Ministry to the National Policies and Economic Affairs Ministry, headed by the Prime Minister.

During the last regime, an outsider who did not posses any Central Banking experience was appointed as its Governor, although there were several Deputy Governors rich in experience and sterling qualities. Arbitrarily, their due promotions were neglected and suppressed. A former Governor is also alleged to have been involved in bidding for the commonwealth games and lobbying for his political masters lavishly spending ratepayers’ money. The bond scandals that have come up reveal that there had been ‘established precedents’ from 2008 and the present regime also followed the same course by appointing a foreigner to the top position of the CBSL and allowed him to use its position lavishly for the benefit of the kith and kin, ignoring the long-term national interests.