Prior to the establishment of the Central Bank, functions relating to central banking were conducted by the Currency Board System that was set up under the Paper Currency Ordinance No.32 of 1884.The money supply was tied to the Sterling Balances which were the Reserve Currency.The money supply could not increase unless the External Reserve increased since the Rupee was backed by Sterling as the Reserve Currency and was fully convertible to Sterling (not to the other currencies) as we were members of the Sterling Area. There was also the Dollar Area.
If the External Reserve fell the domestic money supply was automatically reduced and if it increased the domestic money supply automatically increased in the same ratio. We were on a Sterling Exchange Standard in the parlance of monetary economists. The domestic economy was completely tied to the Foreign or External Balances and if the latter changed so did the domestic money supply. The advantage it had was that there was no room for money creation by the Central Bank or the Government and it ensured external balance (correcting deficits in the balance of payments more or less automatically by changing imports).
The Money Supply increased if our External Reserve increased and shrank if it was reduced. But this meant the authorities could not conduct an independent monetary policy and the rationale for the establishment of a central bank was just that – to ensure an independent monetary policy. So, domestic monetary conditions varied with the external balances. This system had the advantage of an automatic correction mechanism for a deficit in the current account of the balance of payments. But it required control over foreign capital inflows and outflows. It also pre-empted the need for a central bank.
Exchange Control had been introduced during the wartime and it was continued even after the war because the authorities wanted to control the domestic money supply instead of leaving it entirely to external forces. Changes in the domestic money supply affect domestic prices and inflation as well as external imbalances. That in fact was the purpose in establishing the Central Bank – to obtain domestic control over the money supply. The domestic money supply was backed by the Sterling Reserve and it could not change unless the Sterling supply also changed in the same direction. This was the Sterling Exchange System which prevailed in the Sterling Area during the war and was only gradually dismantled after 1950.
Ceylon however continued with the Sterling Exchange system for a longer time. But there was a cry for monetary independence just as for political independence. The prevailing system of changes in money supply was based on the Sterling Exchange Standard. The domestic money supply could increase only if the Sterling Reserve increased. It automatically decreased if the Sterling Reserve declined. This ensured stability in the balance of payments but it meant no control over domestic price level. Prices would rise if the foreign balances increased since there was a fixed ratio of the Ceylon Rupee to the Pound Sterling at Rs 6.95 per Pound. It could be changed by devaluation but it was generally held as long as the balance of payments was in balance. But if there was an outflow of pounds then protective action was by way of devaluation of the Rupee.
Similarly the domestic currency varied with the Sterling Reserve. The domestic currency was managed by a Currency Board which converted Sterling for Rupees and vice versa. The whole Sterling Area was managed by the authorities instead of the Ceylon Rupee as such. But the Currency Board System meant that the domestic money supply varied with the external balance. It meant domestic monetary expansion or contraction depending on the external balance. There was no scope for an independent monetary policy.
So, after gaining political independence, the Currency Board System was considered inadequate and unsuitable for meeting the needs of a developing country and an independent nation. Therefore, in July 1948, the Government of Ceylon requested the United States Government for technical expertise to set up a central bank, which resulted in Mr. John Exter, an economist from the Federal Reserve Board of the USA being appointed to carry out this task. The services of Mr. N. U. Jayawardena, Controller of Exchange, perhaps the only recognized Economist in the country was made available to him
He recommended the setting up of an independent central bank. His Report was accepted by the government and the Central bank was set up as per his recommendations. He had argued the case for an independent central bank independent of the government of the day. So the Currency Board System where the money supply automatically varied with our external reserves was replaced by a central bank which regulated the money supply although it had to cope with the same external factors.
On 7th June, 1949, John Exter made an interim report making certain specific preliminary recommendations in regard to the monetary system, the organization of the Central Bank, guiding principles of monetary administration, and instruments of central bank action. Thus the Central Bank came to be established and Exter recommended an organization independent of the government for it was well known that where the central bank was under the control of the government, the latter would create money ad lib to fund the budget deficit and cause inflation as happened in Latin America. So, there is a strong case for central bank independence from the government normally exercised through the Treasury. Limits were also placed on central bank lending to the government not to exceed 10% of total government revenue.
But someone has to appoint the Governor. It was not made a career post for central bank officials since such officials would have a narrow technical view of monetary control and monetary discipline. But it was realized that the Governor of the Central Bank should be the key monetary adviser to the government acting with the Monetary Board of the Central Bank. The Governor needed independence from being dictated to by the Treasury or the Ministers who were not naturally prone to maintain monetary discipline. Without monetary discipline there could be runaway inflation as more and more money is created to satisfy the desires of the politicians who want to spend money even by creating it. This danger was recognized by the authorities and the statesmen and hence the need for central bank independence. But someone must appoint the governor and this decision could not be taken away from the government of the day which, of course, meant the Minister of Finance and the Prime Minister. So, the decision is vested with the Prime Minister hoping that he would act with a sense of responsibility. It may become a vain hope if the post becomes subject to controversy.