Finance in Developing Countries

P.C.I. Ayre

• Publisher: Taylor & Francis
• Year: 2013
• eBook ISBN: 9781135164577
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

First Published in 1977. This issue of the Journal is devoted to papers dealing with various features of the financial process in developing countries progress. While the majority of papers included deal with various aspects of the domestic financial system, a paper is included which lies in the field of international finance and there are two papers within the field of public finance as conventionally defined.

Money Supply, Inflation and the Balance of Payments in Sri Lanka (1959–74)

by K. E. A. de Silva^*

This study estimates the influence of monetary expansion on inflation in Sri Lanka during the period, 1959–74. After a brief discussion of the historical background, a theoretical model is presented to show the link between money supply, inflation, and balance of payments deficits. The rest of the paper is devoted to the statistical testing of the model. One of the findings of this study is that, for the entire period, 1959–74, money supply has not exerted a statistically significant influence on domestic inflation. But for the more recent period, 1967–74, the impact of money supply on inflation appears to be statistically significant. It is also found that domestic inflation has not been strong enough to have an adverse effect on exports, although further research is obviously necessary to shed more light on this question.

I. THE MONETARIST INTERPRETATION OF INFLATION

Developing countries which embark on development programmes often experience inflation and balance of payments difficulties. Johnson [1964] has argued that the particular method of financing economic development is sometimes responsible for these problems. Specifically, Johnson’s hypothesis is that monetary expansion associated with government borrowing from the banking system is a key factor contributing to inflation and balance of payments deficits. This hypothesis is often referred to in the literature as the monetarist interpretation of inflation.¹

The present paper is an attempt to examine the relevance of the monetarist interpretation to Sri Lanka’s experience during the period 1959–74. Between 1959 and 1966 Sri Lanka enjoyed a period of relative price stability, as the Consumer Price Index² increased, on the average, at a mere 1 per cent annually (Table 1); but since 1967 the Consumer Price Index has shown a more rapid increase (between June 1967 and June 1974 the average annual increase has been approximately 7 per cent).

Section II provides a broad outline of the main economic developments in Sri Lanka during the period under examination. In section III we present the basic model to be tested and discuss its important features. Section IV deals with the limitations of data and the statistical analysis. The main conclusions are summarised in section V.

TABLE 1

THE COLOMBO CONSUMER PRICE INDEX

		(1952 = 100)
1959		105.2
1960		103.5
1961		104.8
1962		106.3
1963		108.8
1964		112.2
1965		112.5
1966		112.3
1967		114.8
1968		121.5
1969		130.5
1970		138.2
1971		141.9
1972		150.8
1973		165.4
1974	1st quarter	178.3
1974	2nd quarter	182.7

Source: Annual Reports of the Central Bank of Ceylon.

II. MAIN ECONOMIC DEVELOPMENTS IN SRI LANKA

In the late 1950s the most serious economic problem facing Sri Lanka was the increasing external resources gap³ (69 million rupees⁴ in 1952–56; 297 million rupees in 1957–60). During these years money supply had increased rapidly due to government borrowing from the banking system. The increase in the money supply, however, did not generate inflationary pressure. Instead, it led to an increase in the demand for imports which was financed by running down the considerable foreign exchange reserves left over from the tea boom of 1954–56. As exports remained relatively stagnant or increased very slowly due to poor world market conditions, the increase in imports meant an increase in the external resources gap. The Government reacted to the adverse trend in the balance of payments by imposing restrictions on imports. Import duties and quotas were levied on many commodities, especially on consumer goods other than basic necessities. To supplement the import restrictions, the central bank enforced general and selective credit controls such as an increase in the bank rate, higher reserve requirements, and higher margin requirements on many imports.

An important factor contributing to the increase in money supply during a major part of the period of this study was government borrowing from the banking system (Table 2) to finance the growing budget deficit (500 million rupees during the fiscal year, 1960–61; by fiscal year 1970–71 it had increased to 1,327 million rupees). The increase in the budget deficit was mainly due to the increase in transfer payments (of which the food subsidies were the most important item) and more active government involvement in the provision of social services. The principal lender to the Government was the central bank and the main instrument of lending was the treasury bill. The total value of treasury bills outstanding was subject to a ceiling which could be raised only by Act of Parliament. But, with the persistence of large budget deficits, the treasury bill ceiling was raised from time to time. Thus, during the fiscal year 1959–60, the authorised limit on treasury bills was raised twice by parliament to 450 million rupees in October 1959 and to 650 million rupees in August 1960. By July 1972 the authorised limit had risen to 2,500 million rupees.⁵

TABLE 2

MONEY SUPPLY AND GOVERNMENT DEFICIT FINANCING

		Government transactions with the banking system
	Money Supply	Central Bank Loans and Securities	Commercial Banks Securities (in millions of rupees)	Total
1959	1,178	514	330	844
1960	1,209	760	336	1,096
1961	1,289	903	357	1,260
1962	1,343	1,081	428	1,509
1963	1,506	1,228	422	1,650
1964	1,622	1,358	423	1,781
1965	1,716	1,347	455	1,802
1966	1,659	1,529	441	1,970
1967	1,808	1,652	377	2,029
1968	1,913	1,960	387	2,347
1969	1,883	2,064	303	2,367
1970	1,967	2,220	638	2,858
1971	2,149	2,261	689	2,950
1972	2...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• INTRODUCTION
• THE INFLATION TAX IN DEVELOPING COUNTRIES
• MONEY SUPPLY, INFLATION AND THE BALANCE OF PAYMENTS IN SRI LANKA (1959–74)
• MONEY, PRICES AND THE BALANCE OF PAYMENTS: INDONESIA 1968–73
• FINANCIAL INTERMEDIATION AND ECONOMIC GROWTH IN LESS-DEVELOPED COUNTRIES: A THEORETICAL APPROACH
• SECURITIES MARKETS IN LESS-DEVELOPED COUNTRIES
• EVOLVING OPEN MARKET OPERATIONS IN A DEVELOPING ECONOMY: THE TAIWAN EXPERIENCE
• RURAL CREDIT AND THE COST OF BORROWING: INTER-STATE VARIATIONS IN INDIA
• EXCHANGE RATE POLICIES FOR DEVELOPING COUNTRIES
• PAYROLL TAXATION IN DEVELOPING COUNTRIES: THE PHILIPPINE CASE
• LAND TAXATION AND ECONOMIC DEVELOPMENT: THE MODEL OF MEIJI JAPAN