7 competition for funding is low,<sup>as in the nontradable sector.5</sup> Given the high degree of variability<sup>of intzrest rates across informal markets and</sup> among different types of lending,<sup>"the main burden of ensur"ng that there</sup> is uniformity in borrowing rates<sup>and that competition is brLadly based</sup> rests with direct bank lending"<sup>(Shaw 1973:85).</sup>

# **3.** The Sri Lankan Setting

After becoming an independent<sup>member ot the British Commonwealth in</sup> 1948, Ceylon (as it was then<sup>commonly called) maintained an open trade</sup> reginte and a generally free domestic economy,<sup>but subsequent government</sup> decisions had practically closed<sup>the economy to the free flow of imports by</sup> the mid-1960s. By then, the Bank of Ceylon had<sup>been nationalized for</sup> five years and a state-owned commercial<sup>bank (The People's Bank) had been</sup> established to meet the financial<sup>needs of Ceylon's rurel areas. Aided by</sup> prohibitions on the opening<sup>of new branch offices by foreign banks, and the</sup> opening of new accounts in foreign<sup>banks by Ceylon's inhabitants,</sup> the two state-controlled banks had grown rapidly. The<sup>financial sector was</sup> extremely repressed, and there was<sup>little room for independent and</sup> efficient financial intermediation<sup>(Khatkhate,</sup> 1982). The insurance industry had been nationalized<sup>in 1963, and large and growing percentages</sup> of the industrial, trade, and<sup>agricultural sectors were owned by</sup> inefficient state enterprises.<sup>The currency was highly overvalued, and</sup> most prices were stringently<sup>controlled.</sup> Despite the steep rise in government<sup>intervention in the economy during</sup> the 1960s, Ceylon's economic<sup>growth was fairly respectable. The average</sup> annual rate of GDP growth<sup>during the decade was 4.5 percent, while average</sup> annual growth in per canita<sup>income was 2.1 percent.</sup> The period from 1970 to 1977 was<sup>marked by further government</sup> intervention in the economy<sup>and declining growth rates. In 1972 (the same</sup> year in which Ceylon was<sup>formally renamed Sri Lanka), the government</sup> consolidated its control over<sup>the mobilization of household savings by</sup> setting up a National Savings Bank.<sup>By the mid-1970s, almost C0 percent of</sup> the total credit extended<sup>by al' financial market institutions was directly</sup> absorbed for budgetary purposes<sup>(Lee, 1987), and the balance was rationed</sup> in favor of preferred institutions<sup>(mostly public corporations). With the</sup> enlarged conscription of funds<sup>from the banking system to finance public</sup> sector activities, the government<sup>succumbed to the temptation to set</sup> interest rates at low levels.<sup>Given continuing inflation (which had begun</sup> in the late 1960s), this<sup>produced negative real interest rates (Table 4).</sup> The stock market stayed in<sup>the dolcdrums during the first half of the</sup> 1970s, with total share turnover<sup>declininr to 2.5 million Rs. in 1975,</sup> compared with 19.8 million in<sup>195'</sup> fV arinatilakp 1986). Constraints<sup>on</sup> foreign exchange remittances<sup>JiscUadeid f'reign-ownec</sup> 4 companies from **buving** 5. One way of saving this is that the a tivlties of the informal sector are less contestable as it isz **ihroft** A f're ipn competition, 6. For details on Sri Lanka's trade and i'evelApment policy since independence see Rajapatirana f19988 and th *1.'rks cited theiein.