Independent central bank is for citizens and not for politicians

Three years ago, in 2022, inflation as measured by the Colombo Consumers’ Price Index or CCPI was running on average at about 63% and the official exchange rate was unstable with a lucrative black market for foreign currencies. All indications were that Sri Lanka, unless proper policies would be adopted, would descend to a basket case like Lebanon. This did not happen because the central bank’s management, with financial as well as policy support of the International Monetary Fund or IMF, was able to tame the rising inflation and keep the exchange rate at a stable level

In a recent talk show titled ‘Modern Talk’ hosted by Channel 7 television, successor to the former YA Television, the young talk show hostess Nimna Perera asked me whether the current central bank management had been doing its job properly in managing the economy.1

Taming inflation

As a journalist, she was voicing the sentiments of the public openly in that talk show. There should not be objection to this approach because that is the duty of an anchor-woman by her viewers. In answering her question, I summarily told her that the central bank is an independent organisation as mandated by the new Central Bank of Sri Lanka Act or CBA and, under the mandate given to it by the new legislation, it is doing perfectly well in taming inflation and restoring the stability of the exchange rate. However, it requires further elaboration. 

Three years ago, in 2022, inflation as measured by the Colombo Consumers’ Price Index or CCPI was running on average at about 63% and the official exchange rate was unstable with a lucrative black market for foreign currencies. All indications were that Sri Lanka, unless proper policies would be adopted, would descend to a basket case like Lebanon. This did not happen because the central bank’s management, with financial as well as policy support of the International Monetary Fund or IMF, was able to tame the rising inflation and keep the exchange rate at a stable level.

New central bank law

It was the IMF which insisted from time to time that the existing central bank law, Monetary Law Act or MLA, was defective because it permitted a governmental officer, Treasury Secretary, to sit on the decision-making body of the Bank, the Monetary Board, as a vote carrying member. Further, MLA permitted the Central Bank to finance the budget by buying Treasury bills issued by the Government from primary auctions. This facility, known as ‘monetary financing’, was liberally used by all finance ministers since independence reducing the Bank to a primary source of Government funding.

During the Governorship of W.D. Lakshman from 2019 to 2022 who followed a monetary policy program presented by a breakaway group called Modern Monetary Theorists increased the Central Bank net funding of the Government from about Rs. 2.8 trillion at end 2019 to about Rs. 5.8 trillion by end 2021. This was an increase of about 107%. This was the reason for the inflation rate to accelerate to 63% and for the rupee to fall in the value against foreign currencies. Hence, one of the conditions which IMF imposed on Sri Lanka when it approved a financing facility for the country was to introduce a new central bank act removing these undesirable features, among others, from the laws of the country.

Accordingly, in 2004, a new central bank act was drafted and the then Prime Minister Ranil Wickremesinghe agreed to have it approved by Parliament. However, his Government was ousted in the next general elections and the successive Government led by President Mahinda Rajapaksa, on the advice of his chief economic advisors, did not want to make the central bank an independent institution. Accordingly, the draft act was shelved. Then, in 2018 again, on the insistence of IMF, a team led by the present Governor of the Central Bank who was the Senior Deputy Governor at the time, drafted another central bank act. Ranil Wickremesinghe who was the Prime Minister at that time agreed to have it introduced. The draft act was gazetted as a bill for consideration by Parliament. 

However, Sri Lanka lost on this occasion too because the new Government that was formed in 2019 under Gotabaya Rajapaksa did not want to make the central bank an independent institution. He was guided by the same policy advisors who had earlier forced Mahinda Rajapaksa to shelve the draft central bank bill. Podu Jana Party which supported Gotabaya Rajapaksa also did not want to make the central bank an independent institution. This position was changed after Gotabaya Rajapaksa had to resign from Presidency in mid-2022. IMF did not stop its agitation for making the central bank an independent institution and it was made one of the loan conditions when it rescued the country through a new extended fund facility in early 2023.

Ranil Wickremesinghe who was the interim president at the time with the support of the parliamentarians from the Podu Jana Party reintroduced the previously shelved central bank legislation. This was facilitated by his two policy advisors, the Central Bank Governor Nandalal Weerasinghe and Treasury Secretary Mahinda Siriwardana, who were all out for a new central banking law. Hence, credit should go these three individuals plus all parliamentarians who voted for this new legislation.

Case for making central bank independent

I had argued for an independent central bank when I delivered the 68th Anniversary Oration of the Central Bank in 20182 and in a subsequent public lecture at the central bank in 2019.3 The present governor of the Central Bank, Dr. Nandalal Weerasinghe delivering the 75th anniversary oration of the Central Bank in 2025 touched upon the same subject from a different perspective.4 He covered the issue of why central bank independence matters, from the perspective of how it matters in crisis, recovery, and beyond. 

Emphasising on the importance of an independent central bank, he concluded: “History and global experience demonstrate that central banks with clearly defined mandates, well established boundaries, and adequate operational autonomy are best positioned to deliver on their promises. A clear mandate not only guides the institution but also provides a transparent benchmark for accountability to both policymakers and the public. Narrowly defined roles prevent central banks from straying into policy domains that rightly belong to elected governments. The CBA enshrines this clarity for the CBSL”.5 

He demanded that it is the responsibility of future generations to protect, preserve, and promote the independence of the central bank. He concluded that “Only then can it continue to serve as a steadfast anchor of stability – an essential foundation for sustainable growth and shared prosperity”.6

Governor Weerasinghe’s appeal to the future generations for the preservation of central bank independence is based on a fundamental feature of this characteristic of central banking. This was also raised with me by Channel 7 hostess Nimna Perera. That is because central bank independence is needed not by any politician or governors of central banks or their officials. It is needed by the members of public who rely on central banks to issue means of payment for exchanging real assets they are holding

CB independence a matter for all

Governor Weerasinghe’s appeal to the future generations for the preservation of central bank independence is based on a fundamental feature of this characteristic of central banking. This was also raised with me by Channel 7 hostess Nimna Perera. That is because central bank independence is needed not by any politician or governors of central banks or their officials. It is needed by the members of public who rely on central banks to issue means of payment for exchanging real assets they are holding.

The Central Bank’s only power is to issue money in the form of currency which people use as a medium of exchange, store of value, unit of account, and a means of making deferred payments. But currency is just a nominal asset – an imagination in the minds of people – and it has any real value if it can be exchanged for real goods or services which people can consume or use inputs for producing further goods or services. People who have real assets like their labour services or other investments that can produce real goods or services exchange them for money because it is the most convenient method to do it

Meaning of money printed by CB

The Central Bank’s only power is to issue money in the form of currency which people use as a medium of exchange, store of value, unit of account, and a means of making deferred payments. But currency is just a nominal asset – an imagination in the minds of people – and it has any real value if it can be exchanged for real goods or services which people can consume or use inputs for producing further goods or services. People who have real assets like their labour services or other investments that can produce real goods or services exchange them for money because it is the most convenient method to do it. 

This can be illustrated with an example. Suppose a person has his labour services and exchanges 8 hours of his labour for a currency note with a face value of Rs. 1,000. The Central Bank uses real resources like security paper, paints, printing machines, labour and so on, but the cost of these real resources is a faction of the face value. Suppose that cost is just Rs. 20 in monetary terms. Thus, in this example, when this currency note is exchanged for 8 hours of labour services, the central bank makes a profit of Rs. 980. This is an unequal exchange since the labour owner spends 8 hours of real labour whereas the central bank spends only Rs. 20 equal to about a little less than 2 hours of that labour.

An unequal exchange leading to an inflation tax

Then, the question is why the labour owner agreed to that unequal exchange. That is because the central bank promises that person when he goes to the market with that 1000-rupee currency note, he could buy a basket of real goods and services worth of Rs. 1,000. Suppose that basket consists of a kilogram of milk powder. Therefore, the labour owner exchanges 8 hours of his labour not for a 1000-rupee currency note but for a kilogram of milk powder. But the Central Bank plays this game with other people also. When all of them go to the market and ask for 1 kg of milk powder, because of supply limitations, its price goes up. Suppose that it has now gone up to Rs. 2,000 a kilo. At this price, the labour owner can buy only half a kilo of milk powder. The lost half a kilo of milk powder is a tax he has paid to the government. Since this tax has arisen from inflation, it is known as the “inflation tax”.

The responsibility of the central bank is to keep this inflation tax at or near zero level so that people who choose to exchange their real assets for a nominal or imaginary asset like money are not cheated. For the Central Bank to do this miracle is its ability to make monetary policy decisions independently of the Government. Therefore, the Central Bank independence is needed not by politicians or those in the central bank but by the people who use its money for exchanging for real assets.

The responsibility of the central bank is to keep this inflation tax at or near zero level so that people who choose to exchange their real assets for a nominal or imaginary asset like money are not cheated. For the Central Bank to do this miracle is its ability to make monetary policy decisions independently of the Government. Therefore, the Central Bank independence is needed not by politicians or those in the central bank but by the people who use its money for exchanging for real assets

Loss of money’s value due to inflation

In the previous Central Bank setup under MLA, the Central Bank came under pressure from the Government because the Treasury Secretary who acted directly under the Minister of Finance was a vote carrying member of the Monetary Board and the Bank could buy Treasury bills from the primary issues. These two worrisome features facilitated the ministers of finance to tap the easy Central Bank printed money for financing the budget instead of trying the more difficult tax generating path. Thus, once the Government’s borrowing limits have been approved by Parliament when the appropriation act was passed, the borrowing power was directed towards the Central Bank to fill the gap in the budget. 

This caused the money supply to increase unwarrantedly forcing the general price levels to rise continuously resulting in a fall of the real value of the money printed by the central bank. If we consider the CCPI which was at a level of 100 in 1952 had risen to 24750 by end-2024 when it is formulated into a single series. What this means is that a rupee in 1952 is worth less than a cent in 2024 indicating a continuation of the payment of the inflation tax by those who held on to the money issued by the Central Bank. This is not a healthy feature by any standard.

CB playing the game according to the law

That is why in the new CBA, Treasury Secretary has not been permitted to serve on the decision-making bodies of the Central Bank, and the bank has been prohibited to do what is known as monetary financing of the budget. Accordingly, after the new act came to operation in September 2023, the Central Bank has played the game strictly according to the law and kept the increase in the general price level as shown by CCPI at near zero level. In other words, the inflation tax has been reduced by the new Central Bank to a zero level. The credit for this accomplishment should go to the Central Bank management as well as the Governments of Ranil Wickremesinghe and Anura Kumara Disanayake which have honoured the independent status of the Central Bank. However, this cannot be guaranteed in the future. That is why Governor Weerasinghe pleaded with the future generations also to protect, preserve, and promote the independence of the bank.

Therefore, an independent central bank is for all Sri Lankans, and it is their duty and obligation to preserve it.

Footnotes:

1https://www.youtube.com/watch?v=TonJ64EBEB4

2https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/speech_20180828_68th_Anniversary_Oration_e.pdf and also https://www.youtube.com/watch?v=2DWd4LdcJrw

3https://www.youtube.com/watch?v=IIO6UWkqrZw

4https://www.cbsl.gov.lk/en/node/19142 and also, https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/about/20250829_75th_oration_transcript.pdf

5Ibid, p 24.

6Ibid, p 24.

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)