ajith nivard cabraal : overview of financial and economic developments in sri lanka keynote address by mr ajith nivard cabraal, governor of the central bank of sri lanka, at the opening of the financial services academy at the centre for banking studies, rajagiriya, 5 march 2007. * * * ladies and gentlemen : today we all have gathered here to witness an important step towards the development of the financial landscape and knowledge pool of the country, the establishment of the financial services academy, a landmark organization that we hope, would shape the future of our financial services industry. as we know, the sri lankan economy recorded a growth of 7. 8 per cent in the first three quarters of 2006 and according to current available data, it is very likely that the economic growth in 2006 would be well over 7 per cent. this will be the highest since 1978. towards such growth, the contribution of the services sector was easily the highest and of such high growth sector, the growth in financial services was highly significant. it is therefore widely acknowledged that the contribution of the financial sector for the achievement of growth of the country is enormous, and whatever we do in that connection, would be of overall immense value. the developments in the financial sector also helps the economic growth through several other channels as well : it improves the efficiency of business processes, attracts investment, reduces unemployment and enhances access to finance, to name a few. we are happy that during the recent years, our financial sector has also improved in every respect. this is clearly evident when we look around the financial institutions, financial markets and the developments in financial infrastructure. within the last five years, assets of the licensed banks in the country doubled. altogether, there has been an addition of over 400 branches of these banks. other financial institutions including registered finance companies, leasing companies, insurance companies, merchant banks, venture capital firms and unit trusts have also grown in sympathy with the banking sector. at the same time, we have also progressed rapidly in the financial infrastructure developments as well. this is particularly visible with the leap forward in the payment system development as evidenced by the implementation of a real time gross settlement system in 2003. now, 84 per cent of the value of country ’ s payments are settled through the rtgs system. in 2006, we completed the cheque image truncation project, reducing the maximum cheque clearance time to 2 working days, which is another significant achievement. the colombo stocks exchange remains one of the most technically advanced

another monetary dimension. on the liability side of bank ’ s balance sheet, it has liabilities on account of currency issue and demand deposits maintained by commercial banks. these liabilities are known as monetary liabilities, since they constitute the reserve money of the system. all other liabilities, including the capital and reserves, are, therefore, called nonmonetary liabilities. when reserves are built - up to be equal to the bank ’ s domestic liabilities, its monetary liabilities would vary exactly in accordance with the movement of the bank ’ s net foreign assets. when the bank raises its net foreign assets, monetary liabilities or the reserve money would increase by an equivalent amount. when the opposite takes place, reserve money would fall. this is similar to the operation of a partial currency board system on a voluntary basis in sri lanka. it is considered a partial currency board system because it backs both the currency issue and the demand deposits of commercial banks by an equal amount of foreign assets. in a currency board system, only the currency issue has to be backed with foreign assets in this manner. since the system voluntarily practiced by sri lanka provides a wider backing than the currency issue, it could be considered as a more prudential system than even a currency board system, provided that net foreign assets always remain a positive number. if they become negative due to the fact that bank ’ s foreign liabilities are greater than its foreign assets, it poses the bank to a new type of a risk. the risk becomes very much material in a situation where there are continuous balance of payments deficits and if the bank is required to raise foreign loans to meet the emerging foreign exchange requirements. in this situation, the backing of the monetary liabilities by foreign exchange reserves would sever, making monetary liabilities highly vulnerable to emerging market developments, specifically what would happen to the net domestic assets of the bank. when the net foreign assets are negative, it exerts pressure for domestic assets to increase in a compensatory manner, for otherwise, there would be a huge liquidity crunch in the economy adversely affecting all the economic activities. such a sudden and rapid increase in domestic assets would reduce the ratio of capital and reserves to the domestic assets to unacceptable levels. the corollary would be that both the foreign assets and reserves would fail to back the bank ’ s monetary liabilities. to mitigate this risk, it may be necessary to maintain the reserve level greater than the value of the domestic assets of