By Hema Senanayake –

Money is society’s standard unit for measuring economic value. Like any standard of measurement, its usefulness depends on its credibility. Because money can be created at relatively low cost, hence its issuance must be carefully regulated. Most of the money in modern economies is created by banks under a mechanism known as Fractional Reserve Banking. If money is produced in excessive quantities relative to the economy’s capacity to produce goods and services, its purchasing power declines, foreign exchange value collapses, prices rise, and money becomes a less reliable measure and store of value. Therefore, maintaining the integrity of the monetary unit is one of the key responsibilities of a country’s monetary authority. However, if the monetary authority does not have a proper mix of policy tools, the issuance and destruction of money cannot be properly regulated. Recently, we saw that this was happening in our own country. Therefore, this essay proposes that the Central Bank of Sri Lanka (CBSL) should acquire a new policy tool to regulate money supply.

As mentioned above, most of the modern money is created by the commercial banking system. It is done when banks make loans. Hence, credit growth is an important parameter in maintaining the integrity of the monetary unit.

If private credit expands rapidly and surges in imports and put pressure on the balance of payments and the exchange rate, then it might require restraining banks’ lending capacity without relying solely on higher interest rates. It is true that CBSL can indeed reduce commercial banks’ lending capacity temporarily through Open Market Operations by selling government securities. But this strategy does not work for long because commercial banks convert one liquid asset into another (i.e. government securities). This means that the total liquid assets of the banking system may remain broadly unchanged even though the composition changes. Therefore, lending capacity may not disappear simply because of the composition of liquid assets is changed; banks can become more constrained if regulatory liquidity requirements tighten. Sri Lanka does not have an effective mix of macroeconomic policy tools to do it.

This is why some economists argue that open market sales of government securities are often effective for managing short-term liquidity and interest rates, but they may be less effective at restraining sustained private credit growth when banks have abundant liquidity and alternative funding sources.

For countries like Sri Lanka, where rapid private credit expansion can quickly translate into import demand and exchange rate volatility and hence a structural liquidity policy tool, such as the Statutory Liquidity Ratio (SLR), can complement open market operations by directly influencing the proportion of bank liabilities that must be held in liquid assets, thereby having a more persistent effect on banks’ lending capacity.

India uses SLR to restrain private credit growth, even though it is not used in day-to-day operations at present. In India’s context, SLR sets the minimum percentage of a bank’s Net Demand and Time Liabilities (NDTL) that must be held in the form of liquid assets, mainly government securities, cash, and gold, as prescribed by the Reserve Bank of India.

If the Reserve Bank of India (RBI) raises the SLR, banks must hold a larger share of their deposits in liquid assets. This leaves fewer funds available for loans to businesses and households, reducing credit expansion and overall liquidity in the economy.

If the RBI lowers the SLR, banks are free to use more of their deposits for lending, increasing credit growth and liquidity. From a macroeconomic perspective, the SLR influences the banking system’s capacity to create credit and helps moderate excessive credit growth that otherwise could fuel inflation or worsen external imbalances. India’s Statutory Liquidity Ratio is a macroeconomic policy tool that can be used to influence liquidity in the banking system. However, today it plays a more complementary role than it did in the past. At present, the minimum SLR stays at 18%. The maximum it could go up to is 25%.

For the Central Bank of Sri Lanka, a statutory liquidity ratio can similarly function as a macroeconomic tool. If private credit expands rapidly and puts pressure on imports, the balance of payments, and the exchange rate, increasing the SLR can restrain banks’ lending capacity without relying solely on higher interest rates. This is particularly relevant in small open economies where strong credit growth can quickly translate into higher imports and foreign exchange demand, destabilising the exchange rate mechanism.

This policy tool (i.e. SLR) should not be misunderstood as similar to LCR (Liquidity Coverage Ratio). The parameters used in calculating the LCR measure a bank’s resilience. The LCR measures whether an individual bank has enough High-Quality Liquid Assets (HQLA) to withstand a severe 30-day liquidity stress. Instead, the SLR influences a macroeconomic parameter known as credit growth or credit expansion.

In view of the above, I earnestly propose that the CBSL must acquire a structural liquidity control policy tool on the money supply side. We must be ready in advance for the containment of the import-driven next wave of currency depreciation.