SRI LANKA: An Introduction to Corporate/Commercial

Achieving and Maintaining Economic Stability: The Role of the Central Bank of Sri Lanka Act

Introduction

In 2022, Sri Lanka faced its worst economic crisis, attributed by many to years of economic mismanagement, poor governance, implementation of ad hoc and politically motivated policies exacerbated by the impact of external factors such as the Easter Sunday bomb attacks and COVID 19.

In the background of economic turmoil and pursuant to agreement reached with the International Monetary Fund, the Sri Lanka Government commenced a process of significant legal reform to, amongst other things, strengthen fiscal oversight, improve debt management and address vulnerabilities in the financial sector. The enactment of the Central Bank of Sri Lanka Act and the Banking (Special Provisions) Act in 2023 and the enactment of the amendment of the Banking Act and the Public Debt Management Act in 2024 are part of this reformatory program.

The Central Bank of Sri Lanka Act, No. 16 of 2023 (the “Act”), is a significant legislative reform aimed at modernizing the governance and operational framework of the Central Bank of Sri Lanka. This Act (which repealed the Monetary Law Act No. 58 of 1949) was introduced to ensure greater autonomy, accountability, and transparency in the functions of the Central Bank and in this article, we explore its key provisions and discuss how they can help achieve economic stability in Sri Lanka.

Key Provisions of the Central Bank of Sri Lanka Act

Strengthening Governance and Independence

A critical aspect of the Central Bank of Sri Lanka Act is the emphasis on the independence of the Central Bank. The Act provides that the Central Bank shall have administrative and financial autonomy and delineates the terms and conditions for the appointment and removal of the Governor and members of the Governing Board and the Monetary Policy Board, aiming to insulate the Central Bank from political interference. By ensuring that the Central Bank operates independently, the Act fosters a stable environment where monetary policies can be formulated and implemented based on economic realities rather than political expediency.

Establishing Clear Objectives

The Act clearly defines the primary objectives of the Central Bank, which include maintaining domestic price stability and financial system stability and promoting a sound financial system. By focusing on these core objectives, the Central Bank is better positioned to implement policies that curb inflation, stabilise the currency, and foster a resilient financial sector. These objectives are crucial for creating an environment conducive to economic growth and stability.

Enhanced Monetary Policy Framework

The law introduces a more robust framework for the formulation and implementation of monetary policy. The Central Bank is tasked with setting clear inflation targets and utilizing a range of monetary policy tools to achieve these targets. This framework includes regular assessments of economic conditions and adjustments to policy instruments as needed. By maintaining a stable inflation rate, the Central Bank can provide a predictable economic environment that encourages investment and growth.

Credit Management and Fiscal Discipline

Under the new Act:

• the Central Bank is authorized to provide provisional advances to the government under strict conditions. These advances must be repaid within six months and cannot exceed 10% of the revenue of the first four months of the preceding financial year.
• additionally, the Central Bank can purchase government securities in the primary market for a limited period, with specific restrictions such as obtaining approval of Parliament and lending being limited to instances where there is a Proclamation under the Public Security Ordinance for the preservation of public security and order or a global health emergency that substantially and materially affects market funding by the government), to prevent dependency.

These provisions ensure that while the government can access necessary funds in an emergency, there are safeguards to prevent excessive borrowing and maintain fiscal discipline.

The law also mandates the conversion of outstanding credits from the Central Bank to the government into negotiable debt instruments over a specified period. This provision aims to streamline fiscal responsibilities and reduce the direct financing of government expenditures by the Central Bank. By promoting fiscal discipline, the Act helps mitigate the risks associated with high levels of public debt and enhances the overall economic stability of the country.

Financial Stability and Macroprudential Authority

The Central Bank is designated as the macroprudential authority responsible for financial stability under the Act. This role involves developing and implementing macroprudential policies, cooperating with other financial regulatory bodies, and ensuring the resilience of the financial system. By addressing systemic risks and enhancing the stability of financial institutions, the Central Bank is equipped to prevent financial crises that could destabilise the economy.

Contributions to Economic Stability

Price Stability and Inflation Control

A key objective of the new Act is to maintain price stability. By targeting a stable inflation rate, the Central Bank can create a predictable economic environment. Stable prices are essential for businesses to make long-term investment decisions, for consumers to plan their expenditures, and for maintaining the purchasing power of the currency. Effective inflation control can also reduce the cost of living and improve the standard of living for citizens.

Confidence in the Financial System

The provisions of the Act for enhancing the governance and independence of the Central Bank, along with its role as the macroprudential authority, contribute significantly to the stability of the financial system. A stable financial system is critical for economic growth as it ensures that savings are efficiently channelled into investments. By preventing financial crises and promoting sound banking practices, the Central Bank can build confidence among investors and the public.

Fiscal Discipline and Sustainable Debt Levels

By imposing limits on provisional advances, grant of credit and managing the conversion of outstanding credits, the Act promotes fiscal discipline. Sustainable debt levels are crucial for maintaining economic stability as high levels of public debt can lead to higher interest rates, inflationary pressures, and reduced investment. The Act's emphasis on fiscal discipline helps ensure that government borrowing remains within manageable limits, reducing the risk of fiscal crises.

Transparency and Accountability

The Act includes provisions for enhancing transparency and accountability within the Central Bank. Regular reporting on monetary policy decisions, financial stability assessments, and the publication of relevant economic data ensure that the public and investors are well-informed. Transparency fosters trust in the Central Bank's actions and policies, which is essential for maintaining economic stability.

Resilience to External Shocks

The Act's focus on maintaining financial stability and implementing effective macroprudential policies enhances the economy's resilience to external shocks. Whether it is a global financial crisis, commodity price fluctuations, or geopolitical tensions, a resilient financial system can better absorb and adapt to these shocks, minimising their impact on the domestic economy.

Conclusion

The Central Bank of Sri Lanka Act represents a significant step towards strengthening the governance, independence, and operational framework of the Central Bank of Sri Lanka. By focusing on key objectives such as price stability, financial stability, and fiscal discipline, the Act provides a robust foundation for achieving and maintaining economic stability. As Sri Lanka navigates its economic challenges, the effective implementation of this Act will be crucial in fostering a stable and prosperous economic environment in the country.