Sri Lanka central bank was created in August 28, 1950 switching its anchor currency from Sterling to the US dollar. Sri Lanka had previously kept a fixed exchange rate with the Sterling (originally the Indian rupee) through a currency board from the previous century.
But the country experienced problem with trading in the so-called 'dollar area' after Britain lifted gold convertibility of the sterling. A failed float of the UK currency in 1946 reduced confidence in the Sterling further.
A currency board could not print money (cannot manipulate interest rates but can only target a fixed exchange rate) and kept inflation low and also served as a hard budget constraint for the government.
Sri Lanka abandoned the stable peg and became a money printing pegged exchange central bank a so-called 'soft peg' where an attempt is made to target both the exchange rate and interest rates with disastrous consequences.
Soft pegs were mainly promoted by the US under the leadership of Harry Dexter White, the architect of the Bretton Woods system of unstable dollar pegs.
Knowing that targeting both the interest rate and exchange rate was not possible, the International Monetary Fund was created to 'bailout' excessive deficit spenders who mis-used central banks and printed too much money and triggered balance of payments crises.
Sri Lanka joined the IMF the virtually the day after the soft pegged unstable pegged exchange rate central bank was created.
A debilitated Britain, bereft of foreign reserves and beholden to the largess of the US, led by John Maynard Keynes was overruled in her attempts to create a separate global currency.
The failure of Britain to successfully float the Sterling in 1946 following the Anglo-US agreement put the final nails in the coffin. Keynes subsequently died, giving the US a free hand in international monetary policy and pursuing the US goal of breaking into Sterling area trade.
In July 1950 the The Banker magazine made a dire prediction on the proposed central bank law, devised by John Exter, a Federal Reserve official.
"The law has been drawn up under American tutelage and along the lines that have been the subject of experiment is certain Latin American countries for some eight years past," said the opening lines of The Banker analysis.
"The step from an "automatic" currency system (such as that Ceylon inherited with its old Colonial Currency Board) to an ultra-modern "managed" currency system is necessarily fraught with great dangers and there may be some who will regret that Ceylon has decided to run such risks at this time."
Following the creation of the central bank and the removal of the hard budget constraint Sri Lanka started to print money to deficit spend. National debt rose from 16.5 percent of gross domestic product to over 100 percent in subsequent decades.
Within three years of its creation draconian exchange controls were put in place taking away the liberties of the people to move their savings and shutting the door to Sri Lanka ever becoming a financial centre to Asia. Before independence foreign companies had raised money in the Colombo stock market.
Balance of payment crises, trade controls followed in rapid succession.
The rupee fell from 4.76 to the US dollar (and 13.66 to Sterling) to a little less than 112 rupees now.
There was high inflation, price controls (which created black markets in domestic goods) as well dual exchange rates (multiple currency practices) and black markets in forex.
Soft peg Collapse
The Bretton Woods system collapsed in 1971-1973 as the US defaulted on its obligations and printed money to finance the Vietnam war firing the first 'oil shock' and commodity bubble.
Countries with deeper monetary knowledge abandoned soft pegs and went for floating exchange rates. Countries like Singapore flirted briefly with a float and went back to a stable currency board.
Lacking monetary knowledge Sri Lanka closed its entire economy, unemployment shot up to over 20 percent or around the levels seen in the US during the Great Depression.
US president Richard Nixon also imposed trade controls (the 'Nixon shock') but citizens of that country forced the state to roll them back within a few months.
Japan and Germany were among the first countries to successfully tame inflation in the floating exchange rate period in the mid 1970s, successfully ending labour unrest that continued to dog the US and UK.
The US successfully tamed inflation in the early 1980s after breaking the second oil shock and commodity bubble.
No policy independence
Sri Lanka's inflation topped 26 percent in 1980, a record not broken until 2008 when the US fired another massive commodity bubble and subsequent economic collapse.
Singapore and Hong Kong (which also re-established a currency board in the turmoil surrounding the bursting of the second commodity bubble) became financial centres of Asia.
Linked to the US dollar, countries that continued to dabble with soft-pegged exchange were doomed to inherit economic collapses created in the anchor currency country and also suffer higher than anchor levels of inflation as more money was printed to manipulate rates.
Performance of soft-pegged countries showed that monetary policy independence that was supposed to come from the ability to print money was only an illusion.
Pegged countries go from high inflation to tighter-than-currency board monetary policy which results in large foreign reserve accumulations (essentially deficit financing the anchor currency government), causing severe stresses to the economy and people.
Following the East Asian currency crisis, many countries moved out of defending pegs. During the current crisis, East Asia fared well, allowing exchange rates to move and avoiding major balance of payments crises.
Since 2007 however Sri Lanka's central bank has kept relatively good monetary policy having low inflation, despite running into a balance of payments crisis, triggered largely by the withdrawal hot capital.
In good times higher-than-anchor-currency-interest rates attract speculative capital to soft- pegged regimes, firing inflation which need still higher interest rates to combat inflation, drawing still more speculative capital.
Sri Lanka's central bank has a tool called a 'central bank security' which worsens the pro-cyclicality of monetary policy and capital flows while helping easy financing of US deficits.
Currency boards (hard pegs) have an automatic protection against hot capital flows, in the form of falling interest rates warding off so called 'carry trade'.
During the recent crisis, Hong Kong (which has a currency board) attracted massive capital flows and interest rates turned negative, while most countries including Sri Lanka experienced capital flight.
Following monetary reforms in the mid 1990s when combating inflation was given more emphasis under governor A S Jayawardene, inflation fell and currency depreciation reduced.
Jayawardene pointed out that the poor suffered from inflation the most.
During that time the bank also pulled back from quasi-fiscal activities like creating money for rural credit re-finance, all of which had contributed to massive currency depreciation, loss of purchasing power of the working people's salaries, falling living standards and general impoverishment in post independence years.
Loan re-finance has now re-commenced, though the current Governor Nivard Cabraal has said it will be strictly limited to an existing revolving credit limit.
In recent years some analysts have called for a re-establishment of a currency board, or at least a fundamental reform of monetary law to protect the poor, economic liberties of the people and preserve economic stability.
Under governor Cabraal the bank has re-gained some credibility for resisting Treasury pressure to print money (fiscal dominance of monetary policy) though concerns rose from the first quarter of 2010 about fresh monetization of debt.