Introduction
Throughout the British rule period Sri Lanka had an open and liberalised economy and even up to the point where exchange restrictions were imposed during the Second World War. Central Bank followed a loose monetary policy in the early 1950s. But here after it was focused on balance of payment and credit to priority areas with the purpose of controlling inflationary situations caused by high fiscal deficit. Though exchange controls were existed after 1955 the economy was virtually open. Since the liberalisation was introduced in 1977, there were several important reforms to the financial sector in Sri Lanka. Direct controls were used as monetary policy measures which includes control of interest rates, credit rationing, ceiling and exchange rate controls. During the period 1960s to early 1970s policy measures were a combination of the restrictions and concessions. The Bank Rate and the Statutory Reserve Requirement Rate were the major policy instrument of that period. Control of money supply is the major part of the monetary policy. Reserve money is the liability of the central bank basically determines the money supply .The effect of money supply often leads to the changes in general price level. Those are the money which is held by the hands of general public, not the money in the vaults of the central bank. The stock of money held by the public in purchasing goods and services is called money supply(Karunathilake, 2000).
Monetary policy is the actions of the financial authority of a country to change the factors which are affecting to the financial system. In Sri Lanka Central Bank(CBSL) is the financial authority which was established on 28th August 1950. The first governor of the central bank was Mr.John Exter and he was from the Federal Reserve Bank. Before the establishment of CBSL the monetary system of Sri Lanka was controlled by the currency board system since 1884, which the currency of the country was totally backed by foreign reserves with the Reserve bank of India. The only function of the currency board system was to issue new currencies. According to the Exter’s report there were some limitations in the currency board system such as lack of instruments to face an inflationary situation, limited activities and inability to control crisis situations etc. The monetary policy that applies for developed countries is not always suit for developing countries. Because the problems and objectives they are trying to achieve is different to each other. Monetary policy in developing countries should focus on effective stimulants for economic growth since they are trying to achieve a stage of self-sustained growth from the stage of under development.
Monetary Policy (1948-1959)
Monetary policy is the process by which the central bank of a country influences to the cost and the availability of money(Ms) which is linked to the price level. The Monetary Law Act No.58 of 1949 provided the legal framework to administer and regulate monetary system for the CBSL. After the establishment of the CBSL most of the commercial banks deposited some portion of their cash with the central bank to meet their reserve requirement. Those deposits were Rs.165.2 million as at December 1950. According to the monetary law act the effectiveness of monetary policy heavily depends on the monetary board and further it has mentioned there are four major objectives in CBSL under stabilization and development strategy before the amendment in 2002, those are stabilization of domestic monetary values, stability of the exchange rate and third one is to promote high level production, employment and real income, and to encourage productive resources. The principles clear objectives, systematic rules, open communication, and stable independence are determined the success of the monetary policy. The monetary policy actions of the central bank directly influence to the credit and money supply, and interest rates which have impacts on aggregate demand and inflation. When we consider about selective weapons or qualitative instruments of monetary policy Exter has categorized them as the methods of credit control. By fixing maximum maturity period for loans and investment central bank tried to monitor loans given to unsound business activities and not to curtail credit to productive purposes. Further, monitory board has the power to prevent the commercial banks by increasing the amount of loans and in section 104 of the Monetary low Act emphasizes the importance of the ceiling on interest rates.At the initial stage, the CBSL had to face a distinctive experience due to the export boom. Because, the Korean War boom resulted to increase in export prices especially rubber and coconut. The Korean War which was broke out in the period 1949-1950 led to the increase in export prices as a result of increasing the demand suddenly and the uncertainties generated by the war. This was also affected by the devaluation of Ceylon rupee in 1949 and a large accumulation of external assets threatened the stability of the price level. Hence maintaining the stability of the rupee was the main function of the monetary policy. In achieving a likely inflation, commercial banks were asked to invest their foreign reserves in abroad. By December 1951, the external assets were increased up to Rs.1185 million from Rs.934 million in 1949. There was an immediate increase in money supply from Rs.663 million to Rs.1106 million due to the monetization of exports. The increase in money supply led to the increase in purchasing power and it pushed up the general price level. Normally, when the money circulation in a particular country increases, it would positively affect to the interest rate movements(Kelegama, 2004).
In this era the government was encouraged to liberalized import controls for several countries; especially Dollar countries by the surplus in balance of payments and also middle income earners were able to consume luxury goods. But the banking system had to face many problems. Through them inflation was the major one and monetization of foreign exchange receipt put further pressure on it. CBSL aimed at to control increase in external assets due to favorable BOP. Further it managed the credit for non-essential purposes while increasing the domestic production of consumer goods and services by reducing the imports control in 1951 as a remedy for continuously rising prices. During this period commercial bank in Ceylon had more excess reserves due to the increase in money supply and exports by making traditional policy tools worthless. So, the Central Bank increased reserve ratio from 10% to 14%. In addition Central bank decided to engage with open market operations for the first time but it was not successful due to the smallness of the bank’s portfolio. After the end of the boom monetary authority had to adjust for new economic conditions due to the changes in certain key indexes such as Export Prices, BOP, Money Supply and External Assets. In this crisis situation CBSL had to finance a large budget deficit by using direct advances. Since the bank’s view was that it would be inappropriate to increase interest rate when there is an inflationary situation, bank rate was tried to be constant at 2.5%. Treasury bill rate increased up to 0.92% in 1952 from 0.4%. Further it increased up to 2.47% in 1953(Karunathilake, 1973). An important feature of that particular period was that heavy borrowings of the government from the banking sector which resulted in inflation. There was an improvement in 1954 after the recession in 1952 and 1953. Government had a budget surplus and external assets were at Rs.1135 million while trade surplus was Rs.412 million. The reason behind this situation is that the Tea Boom. The increase in money supply in 1954 was less than the increase in external assets compared to the Korean War Boom. The major task of the monetary authority was to increase money supply during that period. In here Treasury bill rate has declined to 1.65%. In 1955 government did not borrow from the Central Bank and it did not engage with open market operations. Interest rates declined moderately. The strategy used by the Central Bank is to ask the government to hold the budget deficit at a favorable stage. In 1958 monetary authority had to face three major problems. Those are high level of budget deficit, tight cash position of commercial banks and adverse BOP. To increase the cash base of the banks Central Bank discounted their Treasury bills and allowed to borrow at a moderate interest rate. During this period money supply increases due to the large increase in Central Bank’s assets.
Monetary Policy After 1960
There is a landmark in Ceylon monetary policy in 1960 due to the BOP problems which were prevailing over three years before. In here money supply rose by 3.5% and the value of imports declined by 13.1%. But in 1961 BOP was appeared to be favourable. Central bank introduced quantitative restrictions on imports while controlling bank credits in this year and ceiling rate was 6% on commercial banks. Further it obtained Rs.53.8 million from International Monetary Fund in April 1961. Commercial banks were permitted to hold a special reserve equal to 38% on demand deposits instead of 12% general reserve requirement. Due to the excess budget deficit government had to borrow money by issuing Treasury bills in 1962. As a result of following an expansionist fiscal policy the money supply was increased by Rs.54 million in this year and the liquidity assets that had a declined in 1958, rose again up to Rs.466 million(Cooray, 2003). Treasury bill was the only instrument to borrow money to the government to finance the budget. Monetary policy was directed towards controlling further expansion of bank credit and directing credit for essential purposes. In 1963 Ceylon had to face an inflationary situation and lack of certain imported goods. And also credits to the private sector from the commercial banks were the major factor of monetary expansion. And further they formulated a monetary policy in achieving a higher economic growth in the same year. Due to the higher prices in imported good Sri Lanka faced a severe balance of payment problem in 1964 and foreign exchange controls caused to the ability of achieving raw material, machinery and spares needs. Central bank report for this year has been mentioned that since the commercial bank did not make a proper investigation regarding the flow of credit, it had use further credit control and moral suasion was also successful in directing credit for productive purposes.
During this period the objective of monetary and fiscal policy was to restrain from monetary expansion by having a closer correspondence between aggregate demand and supply. In 1965 the performance of Ceylon became unfavorable due to low increase in GNP. In here the special case is that there was a contractionary effect on money supply by the Central bank credit to the government. By increasing Bank rate in to 5% and introducing special reserve requirement of 28% on the Peoples Bank, took further steps to control credit expansion. From 1966 to 1969, Ceylon experienced an improvement in economic condition as a result of increasing domestic production. In 1967 Sri Lanka rupee was devalued to provide an incentive to exporters by 20%. In 1970 bank rate was increased up to 6.5%. The minimum and maximum rates on advance were 7% and 9.5% respectively. Since Sri Lanka experienced a BOP deficit in 1972 due to the excess liquidity, a restrictive monetary policy was introduced and in achieving monetary stability there was a limited credit expansion to private sector. The ceiling on bank credit which had prevailed previous years was removed in 1972. However no changes were made to the SRR. So, commercial banks were informed that not to increase credit to non-essential purposes such as consumption and speculative stock building. Though these controls were existed up to 1974, the demand for bank credit was increased. When we consider about Ceylon monetary situation in 1976, the proportion of the reserve requirement was gradually decreased and a ceiling was imposed on bank credit on non-essential purposes(Central Bank of Sri Lanka, 1986). In 1977 there was a land mark in monetary policy due to the launching aggressive monetary measures. As a whole, during the period of 1960 to 1977 administrative type of monetary policy was pursued to face BOP difficulties and to have price stability. For that purpose traditional credit control and introduced selective controls to promote credit to the development of priority sectors.
References
Throughout the British rule period Sri Lanka had an open and liberalised economy and even up to the point where exchange restrictions were imposed during the Second World War. Central Bank followed a loose monetary policy in the early 1950s. But here after it was focused on balance of payment and credit to priority areas with the purpose of controlling inflationary situations caused by high fiscal deficit. Though exchange controls were existed after 1955 the economy was virtually open. Since the liberalisation was introduced in 1977, there were several important reforms to the financial sector in Sri Lanka. Direct controls were used as monetary policy measures which includes control of interest rates, credit rationing, ceiling and exchange rate controls. During the period 1960s to early 1970s policy measures were a combination of the restrictions and concessions. The Bank Rate and the Statutory Reserve Requirement Rate were the major policy instrument of that period. Control of money supply is the major part of the monetary policy. Reserve money is the liability of the central bank basically determines the money supply .The effect of money supply often leads to the changes in general price level. Those are the money which is held by the hands of general public, not the money in the vaults of the central bank. The stock of money held by the public in purchasing goods and services is called money supply(Karunathilake, 2000).
Monetary policy is the actions of the financial authority of a country to change the factors which are affecting to the financial system. In Sri Lanka Central Bank(CBSL) is the financial authority which was established on 28th August 1950. The first governor of the central bank was Mr.John Exter and he was from the Federal Reserve Bank. Before the establishment of CBSL the monetary system of Sri Lanka was controlled by the currency board system since 1884, which the currency of the country was totally backed by foreign reserves with the Reserve bank of India. The only function of the currency board system was to issue new currencies. According to the Exter’s report there were some limitations in the currency board system such as lack of instruments to face an inflationary situation, limited activities and inability to control crisis situations etc. The monetary policy that applies for developed countries is not always suit for developing countries. Because the problems and objectives they are trying to achieve is different to each other. Monetary policy in developing countries should focus on effective stimulants for economic growth since they are trying to achieve a stage of self-sustained growth from the stage of under development.
Monetary Policy (1948-1959)
Monetary policy is the process by which the central bank of a country influences to the cost and the availability of money(Ms) which is linked to the price level. The Monetary Law Act No.58 of 1949 provided the legal framework to administer and regulate monetary system for the CBSL. After the establishment of the CBSL most of the commercial banks deposited some portion of their cash with the central bank to meet their reserve requirement. Those deposits were Rs.165.2 million as at December 1950. According to the monetary law act the effectiveness of monetary policy heavily depends on the monetary board and further it has mentioned there are four major objectives in CBSL under stabilization and development strategy before the amendment in 2002, those are stabilization of domestic monetary values, stability of the exchange rate and third one is to promote high level production, employment and real income, and to encourage productive resources. The principles clear objectives, systematic rules, open communication, and stable independence are determined the success of the monetary policy. The monetary policy actions of the central bank directly influence to the credit and money supply, and interest rates which have impacts on aggregate demand and inflation. When we consider about selective weapons or qualitative instruments of monetary policy Exter has categorized them as the methods of credit control. By fixing maximum maturity period for loans and investment central bank tried to monitor loans given to unsound business activities and not to curtail credit to productive purposes. Further, monitory board has the power to prevent the commercial banks by increasing the amount of loans and in section 104 of the Monetary low Act emphasizes the importance of the ceiling on interest rates.At the initial stage, the CBSL had to face a distinctive experience due to the export boom. Because, the Korean War boom resulted to increase in export prices especially rubber and coconut. The Korean War which was broke out in the period 1949-1950 led to the increase in export prices as a result of increasing the demand suddenly and the uncertainties generated by the war. This was also affected by the devaluation of Ceylon rupee in 1949 and a large accumulation of external assets threatened the stability of the price level. Hence maintaining the stability of the rupee was the main function of the monetary policy. In achieving a likely inflation, commercial banks were asked to invest their foreign reserves in abroad. By December 1951, the external assets were increased up to Rs.1185 million from Rs.934 million in 1949. There was an immediate increase in money supply from Rs.663 million to Rs.1106 million due to the monetization of exports. The increase in money supply led to the increase in purchasing power and it pushed up the general price level. Normally, when the money circulation in a particular country increases, it would positively affect to the interest rate movements(Kelegama, 2004).
In this era the government was encouraged to liberalized import controls for several countries; especially Dollar countries by the surplus in balance of payments and also middle income earners were able to consume luxury goods. But the banking system had to face many problems. Through them inflation was the major one and monetization of foreign exchange receipt put further pressure on it. CBSL aimed at to control increase in external assets due to favorable BOP. Further it managed the credit for non-essential purposes while increasing the domestic production of consumer goods and services by reducing the imports control in 1951 as a remedy for continuously rising prices. During this period commercial bank in Ceylon had more excess reserves due to the increase in money supply and exports by making traditional policy tools worthless. So, the Central Bank increased reserve ratio from 10% to 14%. In addition Central bank decided to engage with open market operations for the first time but it was not successful due to the smallness of the bank’s portfolio. After the end of the boom monetary authority had to adjust for new economic conditions due to the changes in certain key indexes such as Export Prices, BOP, Money Supply and External Assets. In this crisis situation CBSL had to finance a large budget deficit by using direct advances. Since the bank’s view was that it would be inappropriate to increase interest rate when there is an inflationary situation, bank rate was tried to be constant at 2.5%. Treasury bill rate increased up to 0.92% in 1952 from 0.4%. Further it increased up to 2.47% in 1953(Karunathilake, 1973). An important feature of that particular period was that heavy borrowings of the government from the banking sector which resulted in inflation. There was an improvement in 1954 after the recession in 1952 and 1953. Government had a budget surplus and external assets were at Rs.1135 million while trade surplus was Rs.412 million. The reason behind this situation is that the Tea Boom. The increase in money supply in 1954 was less than the increase in external assets compared to the Korean War Boom. The major task of the monetary authority was to increase money supply during that period. In here Treasury bill rate has declined to 1.65%. In 1955 government did not borrow from the Central Bank and it did not engage with open market operations. Interest rates declined moderately. The strategy used by the Central Bank is to ask the government to hold the budget deficit at a favorable stage. In 1958 monetary authority had to face three major problems. Those are high level of budget deficit, tight cash position of commercial banks and adverse BOP. To increase the cash base of the banks Central Bank discounted their Treasury bills and allowed to borrow at a moderate interest rate. During this period money supply increases due to the large increase in Central Bank’s assets.
Monetary Policy After 1960
There is a landmark in Ceylon monetary policy in 1960 due to the BOP problems which were prevailing over three years before. In here money supply rose by 3.5% and the value of imports declined by 13.1%. But in 1961 BOP was appeared to be favourable. Central bank introduced quantitative restrictions on imports while controlling bank credits in this year and ceiling rate was 6% on commercial banks. Further it obtained Rs.53.8 million from International Monetary Fund in April 1961. Commercial banks were permitted to hold a special reserve equal to 38% on demand deposits instead of 12% general reserve requirement. Due to the excess budget deficit government had to borrow money by issuing Treasury bills in 1962. As a result of following an expansionist fiscal policy the money supply was increased by Rs.54 million in this year and the liquidity assets that had a declined in 1958, rose again up to Rs.466 million(Cooray, 2003). Treasury bill was the only instrument to borrow money to the government to finance the budget. Monetary policy was directed towards controlling further expansion of bank credit and directing credit for essential purposes. In 1963 Ceylon had to face an inflationary situation and lack of certain imported goods. And also credits to the private sector from the commercial banks were the major factor of monetary expansion. And further they formulated a monetary policy in achieving a higher economic growth in the same year. Due to the higher prices in imported good Sri Lanka faced a severe balance of payment problem in 1964 and foreign exchange controls caused to the ability of achieving raw material, machinery and spares needs. Central bank report for this year has been mentioned that since the commercial bank did not make a proper investigation regarding the flow of credit, it had use further credit control and moral suasion was also successful in directing credit for productive purposes.
During this period the objective of monetary and fiscal policy was to restrain from monetary expansion by having a closer correspondence between aggregate demand and supply. In 1965 the performance of Ceylon became unfavorable due to low increase in GNP. In here the special case is that there was a contractionary effect on money supply by the Central bank credit to the government. By increasing Bank rate in to 5% and introducing special reserve requirement of 28% on the Peoples Bank, took further steps to control credit expansion. From 1966 to 1969, Ceylon experienced an improvement in economic condition as a result of increasing domestic production. In 1967 Sri Lanka rupee was devalued to provide an incentive to exporters by 20%. In 1970 bank rate was increased up to 6.5%. The minimum and maximum rates on advance were 7% and 9.5% respectively. Since Sri Lanka experienced a BOP deficit in 1972 due to the excess liquidity, a restrictive monetary policy was introduced and in achieving monetary stability there was a limited credit expansion to private sector. The ceiling on bank credit which had prevailed previous years was removed in 1972. However no changes were made to the SRR. So, commercial banks were informed that not to increase credit to non-essential purposes such as consumption and speculative stock building. Though these controls were existed up to 1974, the demand for bank credit was increased. When we consider about Ceylon monetary situation in 1976, the proportion of the reserve requirement was gradually decreased and a ceiling was imposed on bank credit on non-essential purposes(Central Bank of Sri Lanka, 1986). In 1977 there was a land mark in monetary policy due to the launching aggressive monetary measures. As a whole, during the period of 1960 to 1977 administrative type of monetary policy was pursued to face BOP difficulties and to have price stability. For that purpose traditional credit control and introduced selective controls to promote credit to the development of priority sectors.
References
