Can you give some background information on the history of the Central Bank, its main responsibilities?
Sri Lanka regained independence in 1948 soon thereafter, in 1950; it replaced a traditional Currency Board system with a central bank, with even wider powers than a typical central bank of the times. It was given stronger powers of bank supervision as found in the United States. At the same time it was expected to develop the weak banking system of the country. It was also expected to undertake research into the economic and financial conditions of the country, and frequently report to the government on the need for corrective action. For this purpose, it was given an unusual authority even to pick outsiders and train them in economics and finance. It was entrusted with public debt management and exchange control on behalf of the government.
Meanwhile, as in other countries, the Central Bank had the responsibility in conducting monetary and economic policies with a view to maintaining domestic price stability and exchange rate stability while it was expected to function as the banker to the government. The Central Bank's ability to finance budget deficits was curtailed by precluding it from subscribing to government loans, except for short term accommodation through treasury bills. Of course it was also the currency issuing authority. The government's authority to borrow locally as well as abroad required the prior consent of the Bank, which had to report on whether the consequences of such borrowing were favorable or adverse. The power of the Central Bank was entrenched by not permitting the government to issue directions and by protecting the tenure of the Governor and the Deputy Governor. Later, the Bank was entrusted with the unusual responsibility of managing the finances of the national social security system.
These were very wide powers and responsibilities entrusted to a fledgling central bank. Having worked here for 42 of the 50 years, I can confidently say that the Central Bank took its tasks and responsibilities very seriously and performed them, as many others will agree, with reasonable success.
At the outset, the country moved towards a system of ever increasing controls and regulations. The Central Bank administered one of the tightest foreign exchange regulatory systems in the world for almost a quarter century. However, since adoption of free market reforms in 1977, the Bank moved strongly in liberalizing the control regime and promoting market-oriented policies. The Bank has come a long way from the command structure of 50 years ago to the highly consultative and consensual policymaking body. A regular meeting with bankers and treasury official's leads to frank discussions on national economic issues and solutions are implemented with a high degree of consensus.
The Central Bank has played an important role in developing the financial sector. Despite over 100 years of commercial banking by foreign banks in the country, banking has had not spread to the hinterland. The state-owned Bank of Ceylon and the People's Bank - bank of the cooperative movement - were encouraged to span out into the rural areas, which example was later followed by the large foreign banks as well as the new local private banks. Although Sri Lanka can be deemed a well-banked country there are weaknesses evident in the continuing high spreads between borrowing and lending rates. The Central Bank has continuously encouraged competition among banks, a policy that is now bearing fruit. With growing globalization, the banks are also encouraged to expand into neighboring countries, where they have done quite well so far. At the same time, the Bank adopted an open policy regarding entry of new foreign banks to the country. In fact, several leading international banks such as the Citibank and the Deutsche Bank came to Sri Lanka under this policy.
Ensuring safety of the financial system is one of the major responsibilities of the Central Bank. The Bank conducts regular detailed onsite supervision of commercial banks, long-term lending institutions and hire purchase companies. In addition, it does off-site supervision on a quarterly basis. It has adopted all the prudential guidelines of the Bank for International Settlements and banks are continuously encouraged to conform to these standards. There has not been a single bank failure for over 100 years. But a few hire purchase companies got into difficulty in the 1980s as a result of imprudent lending, and had to be rehabilitated at substantial cost. Similarly, the two state banks have had to be assisted to compensate them for government policy directed lending on two occasions.
Foreign banks in Sri Lanka are branches of their global operations and are not required to incorporate separately in the country. This gives added financial strength to these institutions because they are fully backed by their headquarters. With regard to capital adequacy and other regulations, the foreign banks are treated on par with local banks. The two big banks are state owned and their share has come down from 80 to 50 per cent, the share lost by them having gone to foreign banks and local private banks. Restructuring of these two large banks is now being undertaken with a view to granting them full commercial autonomy.
The Central Bank has also pioneered several improvements in financial infrastructure. It operates an automated cheque clearing system and is in the process of introducing scripless trading in government securities and a Real Time Gross Settlement system for all large payments very soon. It has assisted the development of longer term lending by promoting several development oriented banks, some of which are now gone over to the private sector. It has also developed an active foreign exchange market since the floating of the rupee this year, and dynamic money and capital markets with active trading. It has completely automated the national social security system, which has become a major investor in government securities and in the share market.
Are there any new foreign banks, which are foreseeing establishing offices in Sri Lanka?
There was an influx of banks to the country after the 1977 liberalization, because Sri Lanka had an open door policy. Since then some international banks have tended to centralize their operations regionally and have reduced their reach with the benefit of modern speedy communications. Yet all major international banks such as the Citibank, Deutsche Bank and Standard Chartered Bank see a long term future in the country and the region. Ever since the global financial crisis of 1997, interest of banks coming to Sri Lanka has waned, although some are discussing regional banking prospects with the growing integration of South Asian economies under preferential and free trade arrangements.
To what extent do you anticipate mergers between smaller banks in Sri Lanka?
Outside the two large State banks, all banks in Sri Lanka are relatively small. However, there are about four local banks, which are emerging very strongly and competing very effectively. They have even pioneered technological advancements, compelling the big banks to follow. At the same time the foreign banks that were concentrating on very narrow trade financing have come to expand aggressively. These are healthy signs. Some of the very small banks have yet to make the mark. If they cannot establish strong niches, I am afraid that they might have to consider mergers. We also have a new phenomenon of long term development banks (which do not accept demand deposits as commercial banks do) entering the fields of commercial banking and insurance. They see the advantage of providing a full range of services. They are also aware that the insurance industry in Sri Lanka has got stunted in the past by government ownership. Hence, there is enough to go around and I expect to see further dynamic expansion rather than consolidation under hardship. We have to remember that the spreads between borrowing and lending in Sri Lanka are still very high. Only more competition will bring down the interest rates.
You mentioned that the Central Bank conducts monetary policy as its priority, can you elaborate on this aspect of your operations?
Monetary policy is basically trying to determine the cost and availability of money in the economy. It concerns the regulation and money supply and the levels of interest rates, taking into account the price increases in the economy. During the last few years, we have been successful in controlling money growth to about 12 to 13 per cent by what people say is a tight monetary policy. This is inevitable when successive governments have tried and often failed to control fiscal deficits, which tend to increase money supply and cause inflation. Thus tight monetary policy becomes a reaction to expansionary fiscal policies. Interest rates go up because of heavy government borrowing. They also have to be pitched above inflation and inflation expectations. If interest rates are artificially kept below inflation, people will be discouraged from saving. Unfortunately when interest rates are at high levels, investment is discouraged. This leads to a cyclical situation of high fiscal deficits leading to high inflation and interest rates, pre-empting people's savings for budgetary financing, crowding out resources from the private sector, discouraging investment and economic growth. In such a scenario monetary policy is only dampening inflation and salvaging growth. | Hitherto, the Central Bank has targetted the monetary base in order to contain money supply and interest rates. It is now considered more desirable to target inflation instead. As in many other countries, we will have to forecast inflation by understanding the process better, and thereafter determine appropriate interest rate and exchange rate policies. Here, we will have to work very closely with the Treasury and the Ministry of Finance to understand clearly the emerging fiscal situation. Thereafter, we will announce the target inflation and the appropriate monetary and exchange rate policies that will be used to achieve that objective. Even now, whenever prices are increasing sharply, the Central Bank is obliged by law to write to the government proposing remedial action. These reports in the past have been confidential. In the future, we may have to go more open with these reports. They say that economic policy is best conducted in a transparent manner.
Late last year, the government faced a revenue shortfall and resulting heavy borrowing led to an acceleration of interest rates and inflation. This had a negative effect on our balance of payments, specially on account of higher import payments. As a result, reserves were lost and the currency was floated early this year to reflect market conditions. This took the forex markets by surprise; but because continuous adjustment of the exchange rate in the past had released pressure in the market, the currency did not overshoot after the floating. However, as a precautionary measure, interest rates had to be raised sharply, much above the higher rates caused by heavy government borrowing. Since that time the exchange market has stabilised remarkably and the bank has taken corrective action to ease the high rates in the country. I think that we can expect a further easing of interest rates, if the inflationary pressure can be kept down.
The current world economic situation with soaring oil prices affects us all. How does this particularly affect the Sri Lanka economy?
We are not an oil producing country and when world prices go up, we have no choice but to follow suit. The problem is that energy prices have such a strong impact on inflation and cost of living. Hence, energy price adjustments are made gradually, allowing the economy to adjust. High prices tend to encourage the development of alternate sources of energy, but these take time and require heavy investment. Hence, people immediately resort to use fuel wood, which unfortunately affects the environment.
We have for a long time been dependent on environment friendly and low cost hydropower. But such resources are getting used up and changing weather patterns have made supplies unreliable. Hence, there are no easy alternatives to costly thermal energy. Coal and gas are options that are being considered. Anyhow the increase in the price of oil from US$ 12 to US$ 36 per barrel within a short time has been a sharp shock to the economy. The resulting inflation made exports less competitive and the exchange rate had to adjust to restore competitiveness.
How would you describe the investment climate in Sri Lanka and what are in your view the most positive and negative aspects for this environment?
Sri Lanka was a very attractive place for investment because of many reasons such as the salubrious climate and living conditions, widespread use of the English language, reasonably good infrastructure and strategic location on trade routes. But the internal conflict since 1983 has tended to deter investment, even though only a small part of the country is seriously affected. This situation is aggravated by widespread reporting of the incidents as engulfing the whole country.
We were the first country in this region to liberalize the economy in 1977, long before Malaysia or Thailand. The new freedoms attracted many foreign investors because there was less bureaucracy and regulation. There was high literacy and high productivity. Communications were good. We were recognized as an efficient and productive investment location. Some investors centralized their operations from here for the global market. Even though the domestic market was small, the investors felt that they could tap the regional and the global markets from Sri Lanka. The Free Trade agreement signed with India last year has opened great prospects of promoting trade and investment, because it is based on a negative list of excluded sensitive items, the rest of the trade being free. India is a vast market accounting to about 80 per cent of the market in South Asia. India has been opening its economy, realizing the fact that if trade is restricted, it could only give rise to smuggling. In a few years, India and China will continue to grow and this will be helpful to all neighboring countries in the region. The Indo-Sri Lanka Trade Agreement will also help joint ventures between the two countries.
We have enormous prospects for tourism in a small place with a diversity of attractions to offer. With universal education, we are also producing people who are more capable of handling new technology. Colombo port has been transformed as one of the best in the region. We also have a highly efficient telecommunication system. I cannot exactly say what the future has for telecommunications but there is a lot of telecommunication-related business coming in to Sri Lanka.
All these should make Sri Lanka an attractive place to invest. There are attractive concessions offered to investors. The only negative aspect has been the internal military conflict in a part of the country, which has created a negative image.
Far Eastern Economic Review will be back in two to three years time to do a new report on Sri Lanka. In terms of your future, where do you see Sri Lanka on the economy in that period of time and what would you like to tell the readers?
The current internal conflict cannot go on for long, certainly not two to three years, because it has almost exhausted the various parties to the conflict. No party expects to win and enforce its will on the other. Meanwhile, everyone expects sanity to prevail and for the conflicting parties to get together and work out a decent compromise.
Thus when you come in two to three years time, I am sure you will be visiting a country at peace, with considerable prosperity all round. The damage from the conflict will have been repaired. Without the conflict, Sri Lanka has the potential of growing at 8 to 10 per cent per year, perhaps more. The coming down of trade barriers will give considerable opportunity for enterprising Sri Lankans to develop their trade and services. There will be vigorous free trade among South Asian nations. Sri Lanka could grow as an efficient service hub for South Asia, even for the regions beyond. Tourism would have developed as a major industry. It could be a regional centre for telecommunications, aviation, shipping, education and medical services of high quality. Its export-oriented industries in tea, rubber, leather, spices, garments, gems, ceramics and electronics will be the leading sectors. New export-oriented industries would have commenced. Efficient exploitation of the massive fishery resources of the Indian Ocean will add a new export sector. Large fertilizer deposits will be exploited and the surplus will meet the deficits of India and China. It will have a well-developed infrastructure in roads, railway, canals and air services. The work on the second international airport and development of the great natural harbors at Trincomalee and Hambantota will have commenced. The average incomes of the people would have risen by at least 25 per cent.
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