Central Banking in the Sri Lankan Developmental State

Central Bank Governor Prof. W. D. Lakshman - Pix by Ruwan Walpola

Following is the full speech of Central Bank Governor Prof. W.D. Lakshman made at the celebrations to mark the 70th anniversary of the Central Bank of Sri Lanka.

“The root of wealth is economic activity and lack of it brings material distress. In the absence of fruitful economic activity, both current prosperity and future growth are in danger of destruction – Kautilya, Arthashastra”

The broadly defined policy framework and institutional structure, which carried Japan after World War II and the so-called newly industrialised countries (NICs) in East and South East Asia subsequently, into high growth trajectories has been widely described as a “developmental state” structure. 

This is not a conceptually defined, distinct and unique category of State formation – but a practical combination of systems, institutions and practices with clearly laid down intentions of achieving developmental objectives. 

The expression had one of its earliest appearances in development literature in the well-known study of Charmers Johnson titled ‘MITI and the Japanese Miracle’ (1982) 1 which examined how post-war Japan had achieved its very rapid development. It is the post-war Japanese State system with its idiosyncratic elements that he tried to capture with this name.  

One way of describing the developmental state structure is to see it as a combination of selected items of two contradictory systems – the capitalist market economy and the socialist command economy. Expressed alternatively, the developmental State, according to Charmers Johnson himself, is a “plan-oriented market economy system”. 

The institutional framework of the developmental State can be constructed and established in countries characterised by fundamental structures either of capitalism or of socialism, as these latter terms are widely understood. Developmental State structures have operated, both, before and after this term came into vogue in development literature, within diverse socioeconomic and political contexts. 

Naturally, institutional structures and rules of the game of developmental State do not and cannot, therefore, be uniform across countries. Amid differences, one observes certain key similarities in developmental states in different countries:

1. Market mechanisms and processes are carefully planned, closely monitored, and guided by the state, if the overall system is market-based and dominated by markets. Alternatively, if the overall system is socialist and centrally planned, markets are allowed to freely operate in permitted subject areas. A developmental State is in some strategic sense, a mixed economy with markets and State mechanisms operating side-by-side in a manner that is complementary and mutually reinforcing. A highly penetrating central State apparatus has been developed for effective guidance of markets with the singular focus on productivity growth and industrial upgrading  

2. The developmental State builds up and rests on a coalition of three forms or agents of capital for the promotion of accumulation: (i) domestic private capital, (ii) foreign private capital and (iii) domestic State capital. The existence of this coalition among the 3 forms of capital and their relative roles is consciously accepted, with their respective roles allowed to change with the passage of time. Depending on underlying socio-political and economic conditions, the relative strength and prominence of different elements in this three-party coalition had varied in different countries which adopted developmental State structures as well as over time 

3. Countries which adopted developmental State structures have invariably been those experiencing late and uneven processes of development. These countries used the developmental State structure to catch up with their forerunners. Mercantilist/protectionist policies, therefore, would characterise development policy in general, and industrial policy, in particular, of a developmental State, at least in early stages. In respect of particularly strategic industries, protection has been provided through prudent use of tariffs, subsidies, technological assistance and targeted finance. Realising that comparative advantage of a country is dynamic and changeable, through conscious actions the developmental State would use its industrial policy for consistent industrial upgrading and creation of export opportunities. Having built up their strength in production activities in terms of productivity levels, catering initially to the domestic market, developmental states have generally become at somewhat higher levels of development, very strongly export-oriented

4. Developmental states have also developed the characteristic of working as corporations do with respective business models. Like in a corporation, the Government in a developmental State would plan and guide the country’s development processes. An insulated and development-minded bureaucracy, largely comprising of technocrats, has been a characteristic feature of these states enabling them to achieve their corporate-like character, justifying the use of ‘Inc.’ following the country name in expressions like Japan Inc., Korea Inc., China Inc. and so on. There is already a group of activists strongly suggesting that we too must start calling ourselves Sri Lanka Inc.

5. Of great significance in developmental states of East and South-East Asia have been the structures of matching and mutually complementary institutions. These institutions were not operative all at once, but gradually brought into being as required by changing circumstances and needs. In addition to the effective bureaucracy noted above, the institutional structure comprised of the Judiciary, property rights regime including intellectual property rights, capital markets, legal systems, financial structures including banking, corporate governance systems, public finance institutions, social welfare and labour institutions, technology transfer and innovation systems and so on, and structured to promote and guide socioeconomic development. These institutional arrangements were brought into being gradually with development, learning about the types and characteristics of institutions to be set up, from financial experiences in other countries

This gives me the opening to enter the topic chosen for this Anniversary Oration – the central bank and central banking in a developmental State structure. The Central Bank, as an institution came into even today’s developed countries relating late in their processes of development. 

The establishment of a Central Bank in Sri Lanka just two years after political independence was indeed quite a speedy and conscious politically motivated action. Having experimented with different development policy stances and frameworks, Sri Lanka has now arrived at a watershed like situation where the people seem to have opted for shared and inclusive socioeconomic development through a State-guided policy regime. 

The policymaking systems and approaches, and administrative and other mechanisms are being developed to facilitate the above result. Sri Lanka appears to be on its way to develop its own developmental State model. In this context, the Central Bank of Sri Lanka, with its 70 years history, is being expected to play its role as an agent of development.  

As an economic institution, the central bank has come to be considered a cornerstone of a stable economic system. As an institution, the central bank had to go through a long historical evolution to gain this lofty status and this history was indeed full of debate and contention about central banking concepts. 

This debate was about the nature of the role of a central bank, vis-à-vis, a country’s stability and growth. According to H.A. de S. Gunasekera (‘From Dependent Currency to Central Banking’2), unlike in many countries which established central banks in inter-war and post-war periods, in Sri Lanka, the Central Bank was set up in conditions of public indifference and apathy in respect of such an institution for the country. 

The inception of the Central Bank

‘The Report on the Establishment of a Central Bank for Ceylon’3 presented by John Exter, whom the Government of Ceylon invited from the US Federal Reserve to advise on the subject, was indeed the draft Monetary Law Bill, interspersed with short comments/reasoning about certain proposed provisions in that Bill. 

The Report was conspicuous in its absence of any in-depth analysis of basic problems of money and credit in Sri Lanka then, although in the letter of submittal John Exter referred to his having collected “sufficient material…. for a further report” which however, was never released. 

What was done therefore, appears as a mere superimposition of a Central Bank on the extant banking and credit structure of the country. The Central Bank proposed by Exter, who later helped operationalise his proposed Bank as its first Governor, however, has had strong elements of longevity. It survived 70 years, subject to only relatively minor changes, in its governing legislations.

Even at the time of its establishment, there were concerns that the Central Bank “…. ignored the vital relationship between central banking policy and policies of long-term economic development” (Gunasekera, 1962, p. 261). This was despite Exter including, certain developmental objectives as the last two items in the famous four-fold objectives he assigned to the proposed Central Bank:

 

i. The stabilisation of domestic monetary values

ii. The preservation of the par value of rupee and the free use of the rupee for current international transactions

iii. The promotion and maintenance of a high level of production, employment, and real income

iv. The encouragement and promotion of full development of the productive resources of the country 

Even though items (iii) and (iv) above were included in Central Bank objectives, Exter himself was sceptical about a Central Bank’s ability to achieve these objectives, directly. He shows his non-agreement with Keynesian policies for full employment through deficit financing in respect to the “chronic” type of unemployment in Sri Lanka.  In support of his contention, he also highlighted the adverse balance of payments implications of any such demand expansion policy for employment generation in the import-dependent Sri Lankan economy. Thus, even in Exter’s thinking, the stability objective was perhaps predominant. 

The hypothesis about the incompatibility of a central bank’s stability objective with needs and concerns of economic development applies, perhaps more strongly, today with the reduced two-fold stability objectives which govern the Central Bank actions since the 2002 revision to the Monetary Law Act. 

The reduced two-fold objectives are that of maintaining; (i) economic and price stability, and (ii) financial system stability. The absence here of the fundamental objectives of spurring economic development is quite conspicuous. 

In addition, with our move towards the neo-liberal framework of economic policy, particularly after 1990s, one could see the emergence and strengthening in Sri Lanka, too of the mainstream view of a Central Bank that is independent of the Government. 

Furthermore, this mainstream view also highlights the use of indirect methods of monetary policy, i.e., working through financial markets and interest rates, as opposed to direct credit allocation methods like subsidised interest rates, capital controls, credit ceilings and targeted lending. 

The implications of these principles of central banking as espoused in mainstream theory, are far reaching as Gerald Epstein argues in ‘Post-war Experiences with Developmental Central Banks: The Good, the Bad and the Hopeful, UNCTAD/2009’4. 

Central Bank independence

The concept of Central Bank independence implies that no Central Bank should be subject to pressures from the Government to finance its activities and expenditures. It probably does not leave room for even collaborative development – targeted activities of fiscal – monetary authorities. 

The dominant focus on avoidance of inflation implies that the Central Bank should not be directly concerned with objectives like full employment and development. However, one could argue that even in the strictest practical inflation targeting regimes, a Central Bank seeks to achieve price stability by stabilising the economy around its potential, which is an indirect acceptance of the importance of maximum employment. 

In relation to the indirect instrument of interest rate, the Central Bank has broadly allowed market forces to determine lending and deposit interest rates while guiding them with policy interest rates. Although with hesitation, the Bank has recently moved to exercise intervention in markets to keep Treasury bill and bond rates at low levels. 

This has helped to maintain a low interest rate regime for promotion of developmental expenditures and of source, to ease the fiscal burden of debt repayment. However, there has been widespread criticism of stubbornly high margins kept by banks, and sluggish and asymmetric adjustments in their lending rates, in response to changes in policy and other rates under Central Bank control. 

The Central Bank has intervened from time to time by introducing regulated interest rates to rectify these adverse outcomes at least to some extent, although these are frowned at by the banking community. 

The latest in this type of intervention is comprises regulation of interest rates on credit card advances, pawning and temporary overdrafts, as well as on chargeable penal interest rate margins. The need for such intervention was felt even in 2019, during which regulations on, both deposit and lending rates of banks were introduced.   The Central Bank has generally attempted during its period of existence to keep its policies and measures within the confines of the relevant mainstream thinking as defined by the MLA of 1949 as marginally revised subsequently. 

Despite the revision of Central Bank objectives in 2002, the MLA still had whatever provisions of the 1949 formulation that were included in it to accommodate non-stability objectives or to be used “in particular situations” or “for use in crises or to forestall a crisis”.   In any case, the force of events which unfolded through interactions of socio-political and economic factors, both of domestic and global origin, has compelled the Bank, on many occasions, to move beyond the domain as defined by mainstream central banking theory. In order to do this, the Central Bank has effectively used, to the extent possible, the flexibility that was there in the MLA.

Exter himself had alluded to these conflicts and accommodations that were required in the implementation of the Bank and he proposed: “A monetary system that is stable and at the same time responsive to the needs of a growing country is a necessary but not a sufficient condition of orderly economic development. “An alert reader, especially one who is familiar with the interplay of economic forces, will readily realise the potential conflicts and inconsistencies involved in the above objects… Many governments and central banks have tried to promote economic development at the sacrifice of monetary stability. Such conflicts cannot be avoided.

To be continued tomorrow

Footnotes

1 Johnson, Chalmers (1982), ‘MITI and the Japanese Miracle: The Growth of Industrial Policy, 1925-1975’, Stanford University Press

2 Gunasekera, H. A. de S. (1962), ‘From Dependent Currency to Central Banking in Ceylon: An Analysis of Monetary Experience 1825-1957’, G. Bell & Sons

3 Exter, John (1949), ‘The Report on the Establishment of a Central Bank for Ceylon’, Ceylon Government Press

4 Epstein, Gerald (2009), ‘Post-war Experiences with Developmental Central Banks: The Good, the Bad and the Hopeful’, G-24 Discussion Paper Series, United Nations Conference on Trade and Development