The Evolution of Central Banking and a Future Course

The Evolution of Central Banking and a future course for Central Banking in Sri Lanka By Nalini Jeyapalan

Governor Ajith Cabraal, Deputy Governors, W.A. Wijewardena and Ms.Jayamaha Esteemed colleagues and friends

I have returned to the Bank after 36 years. The Central Bank of Sri Lanka invited me to give this 56th Centennial lecture. I decided to accept its invitation for two reasons: to encourage the Bank and its employees to play a more active role in the economy because the development of our country is at stake. Sri Lanka is still affected by the slow growing economic destiny to which it has been linked for decades. In the latter part of the twentieth century, our small country dissociated itself from the global economy that was put in place by the British. We had a class of indigenous entrepreneurs associated mostly with the plantation sector. We had a great advantage then of fluency in the English language. Those plantations were nationalized and English speedily abandoned. In business, it is prudent to hold on to advantages you already possess while reaching out for more.

The other reason is that I wanted to come back to my country at least one last time, and how better to do so than under this special circumstance? I hark back to the song of a popular American folk singer, the late John Denver. He sang,

“Hey! It’s so good to be back home again!”

The Central Bank of Sri Lanka wrote that the subject of this lecture should be under the spacious word “Economics”; specifically, that I relate it to “Central banking evolution and the future horizons of central banking.” I have modified the topic to make it more pertinent to a developing country by relating it to Sri Lanka. However, I do not propose to discover out-of-datedness, because changes in the Bank Rate, among the earliest of monetary tools, is the main weapon in the Federal Reserve Bank’s arsenal and the only one that is closely watched by the American financial system and the business community. My purpose is to comment on the incompleteness of the Bank’s role in the context of a developing country like Sri Lanka. Bear with me as I trace the political and economic events over several decades because the Bank’s evolution took place against that backdrop. I will go on to propose a future course for central banking in Sri Lanka by relating its functions to the theme of my lecture- the entrepreneur.

Ever since Sri Lanka gained her independence from the British in 1948, we have been criticizing the economic structure that we inherited. Sometimes, we even imply that there

1 was some Machiavellian reason that the British designed it so. If we reflect rationally, it was a design by the British to create a vast global economic empire. Production in the colonies was a minor component of an economic network that brought together the whole world into a global marketplace. In the colonies, British entrepreneurs assisted by the hand-in-glove relationship with the British colonial government cleared the land, planted crops, built an infra-structure of fine roads and railways to transport the produce to auction houses in the sea ports and from thence, British ships carried those goods to the mother country for further processing, secondary or tertiary, or as in the case of tea, for sale and distribution to markets around the globe. The British Empire created the first global economy and global market place. The work was not easy, but British entrepreneurial foresight and tenacity made it possible. To show how challenging those times were I narrate an account I read in the diary kept by a young man who was sent to the hill country of Ceylon where the jungles were being cleared for growing tea. I was in the Reading Room of the British Museum then, doing research for the thesis I submitted to Cambridge University for the doctorate degree; the Central Bank was supporting me at that time. Therefore, consider this narrative as a tiny return on your investment.

Tea was being planted all over the central provinces of Ceylon. Roads to those plantations were then sometimes unpaved, and transportation up those winding tracks to Nuwara Eliya and beyond were horse drawn carriages. The young man whose diary I read rode a horse- drawn wagon to his destination, a tea plantation somewhere in hill country of Ceylon. As he approached his destination, it began to rain. Such a blinding tropical rainstorm he had never before seen. The wagon could take him no further. The driver dropped him off by the wayside, dumped his bags beside, and waved his arm in the general direction when asked to show the way to his destination. The fearful and hazy wilderness was all his eyesight, blinded by pelting rain, gave of the surroundings. He was scared stiff and frantic because he had no idea where to go. He was in a strange country, abandoned, bewildered and so alone. After the wagon had disappeared from sight, a strange sensation of unease in his legs made him look down at his booted feet. He was repulsed by what he saw: creatures he had never seen before in his young life were inching up his boots, crawling under his leggings and on to his legs. The rains had brought forth the bloodsucking leeches swarming and feasting on him. His predicament was heartbreaking. Desperate and not knowing what else to do, he squatted on a nearby rock, and began to pull the vermin out as fast as they were hooking on, a completely futile task. Seated on that rock, amidst the blinding rain, he began to weep like a child! Entrepreneurship is not easy; it is fraught with risk and uncertainty. Perhaps that is the reason why Sri Lanka remains undeveloped. The wealth of the nation will grow when the wealth of the entrepreneurs increase steadily. Adam Smith in his famous book that inquired into the wealth of nations wrote that each man when thrown on his own resources labors effectively to produce and enrich the nation. He described such men as entrepreneurs. To enliven my plea for promotion of

2 entrepreneurship and innovation, I shall quote a poem written by a young nun who lived in, I believe Argentina, several hundred years ago. The poem entitled, She Ponders on a Way of Life Binding Until Death was translated from the Spanish to English by Alan Trueblood and published by Harvard University Press. It fired my imagination because the theme suggests the making of an entrepreneur. She wrote: If men weighed the hazards of the sea, None would embark. If they foresaw The dangers of the ring, rather than taunt The savage bull, they’d cautiously withdraw. If the horseman should prudently reflect On the headlong fury of the steed’s wild dash, He’d never undertake to rein him in Adroitly or wield the crackling lash. But were there one of such temerity that, Facing undoubted peril, he still planned To drive the fiery chariot and subdue The steeds of Apollo himself with daring hand He’d stop at nothing, would not meekly choose A way of life binding a whole life through.

Sor Juana describes the psyche of an entrepreneur, the businessman who is largely responsible for western economic development. Later on in this lecture I will show you the relevance of this reference to entrepreneurs and how I propose to tie up the Central Bank with entrepreneurship and innovation.

The Monetary Law Act of Sri Lanka bewilders me; bewildering because its responsibilities, objectives and goal appear to be stated out of sequence. The Central Bank is “responsible for the administration, supervision and regulation of the monetary, financial and payments systems of Sri Lanka.” Its objectives are to secure ‘economic and price stability’ and ‘financial system stability’ with a view to encouraging and promoting the development of the ‘productive resources of Sri Lanka’, i.e. economic development of our country. Underlying this sequence in the statement of purpose and objective there is the implication that promoting economic and price stability and financial system stability will promote economic development. My questions are: In a developing economy, if we secure financial and price stability at any given moment in time would our goal of promoting the development of our productive resources have been interrupted or assisted? How compatible is the economic development of a developing economy with financial and price stability? Hark back to American economic history and recall the facetious statement that was a popular tutorial subject in the University of Ceylon in my time, “America developed on bad banking.”

3 Within an economy, there are two identifiable flows, a real flow of goods and services and the money flow that finances it. In a developed economy like the United States where the flow of goods and services is strong and sustained, a stabilizing monetary role is appropriate for its central bank, the Federal Reserve Bank. We, In Sri Lanka, inherited from the British a financial system that serviced the self-sufficient, plantation-based economy rather well. It was not designed to serve the needs of a developing economy. From time to time, the Monetary Law Act was changed to bring it in line with the economy’s needs, but those changes have not done so because we have been too cautious to stray from the trodden path. In Sri Lanka, central banking theory assumes that regulating and stabilizing the flow of money and credit, will somehow increase the flow of goods and services. The conventional role of central banking when simply conceptualized is: Central Bank controls commercial banks’ reserves and the Bank Rate to influence the nation’s money supply. The lower cost of credit and greater availability of credit influence investment spending and capital formation, leading to more employment and more income; thus the wealth of the nation is enhanced. I do not disclaim that regulation of the banking and financial system, in the sense of the simple transmission of orders is useful to maintain a semblance of order. It makes everybody believe that something is being done to correct imbalances, but whether it will ease the country toward the full employment of its productive resources, land, labor and capital is highly debatable. It is my contention that by attempting to stabilize prices and money supply in the context of a developing economy, the central bank may even hinder rather than assist the process of economic growth. As I see it, because of so many bottlenecks that characterize underdevelopment, a developing economy puts pressure on prices, balance of payments and so on, as it moves toward the fuller employment of it productive resources.

When operating, as it should, the central bank in a developing economy must move it toward the full employment of all its resources by helping to initiate the production of goods and services. More important than financial and price stability is the initiation of entities called firms so that there is plenty out there to stabilize and put in order.

The role that I have in mind for the Bank is unconventional. When operating appropriately the Central Bank must assist in creating those entities that increase the flow of goods through the economy.

It seems to me that in the Monetary Law Act we have put the cart before the horse. When production in the corporate sector is high and the wealth and income of the nation begins a steady climb to reach a sustainable double-digit level, then and only then is the pursuit of financial and price stability meaningful. In this lecture I propose a course that rearranges the order- the goals are financial and price stability and the Bank will achieve those goals by promoting innovation and enterprise, i.e. by promoting the

4 corporate entrepreneurial sector of the economy. So doing it will achieve sustainable double-digit economic growth.

It is also my contention that we have not achieved double-digit economic growth because we have neglected innovation and entrepreneurship in financial planning and economic policy making not realizing the importance of both in the development of the western economies.

Looking back at our country’s history, I believe that there were entrepreneurs amidst us and we unwittingly let those indigenous entrepreneurs languish. Let us ponder a while on the economy we inherited in 1948. We were the inheritors of two economies that were operating side-by-side- one the vibrant capitalist-based export economy of tea, rubber and coconut, well serviced by a financial system created for that purpose, and the other, the comparatively self-sufficient economy of rural farmers, artisans and craftsmen who prior to British occupation were operating under the patronage of kings and chieftains, but who were later leveled to subsistence status by war and the overthrow of the monarchy. It was those artisans and craftsmen who transformed wood, stone, copper, brass, silver and gold into incomparable works of art seen today in temples and the ruined cities. After Independence in 1948, the Senanayaka Dynasty sponsored the peasant farmer, perhaps because in the caste system that was created by the Sinhalese royalty to entrench the workers into defined occupational grooves, the farmers were at the top. Also, rural agricultural development was visualized as taking place amidst green pastures, farmland, blue skies and a sedentary lifestyle while industrial development created robots out of men and degraded their souls. Oliver Goldsmith deftly summarized our attitudes in the rhyming couplet

“Ill fares the land to hastening ills a prey

Where wealth accumulates and men decay.”

The attributes of small-scale agricultural production were officially promoted even by the Central Bank. We sponsored a small network of rural banks to assist small peasant farmers. In the context of Ceylon where the average holding outside the plantation sector was small, the characteristics of underdevelopment were unwittingly perpetuated by the government in the many decades that followed independence: output per capita remained small, surplus generated in the rural agricultural sector was small, and technology used in that sector was unsophisticated. We neglected occupations such as jewelry making, blacksmithing, woodcarving, ivory and bone carving, and jaggery making.

Rather interestingly, those Sri Lankans with an entrepreneurial bend of mind are the poor. They are entrepreneurs who, because of their poverty and few options, are compelled to exercise ingenuity, creativity and resourcefulness just like entrepreneurs in the west.

5 However, their resources and capital investment are meager; often a shed by the roadside and within, a few tables on which they display their stock-in-trade. In 1992, I bought a beautiful tablecloth from an old woman who was standing outside Laksala. It is still admired by my guests, but she had only one to sell. Most Sri Lankan entrepreneurs operate at subsistence level; they aspire to earn a small target income sufficient to feed the family barely and to keep a flimsy roof over their heads. They do not have the capital to expand their business; I shall describe them as subsistence entrepreneurs.

In China where there is a similar tradition of indigenous arts and crafts going back to thousands of years, the artisans are thriving today under the sponsorship of the Chinese government and the western entrepreneur in the form of multi-national companies. The Chinese appear to have mobilized those indigenous artists and craftsmen rather well. The Chinese Government has successfully brought together the indigenous subsistence entrepreneurs into a league with the sophisticated western entrepreneur in factory settings to make gadgets for western markets, the enterprise often funded by the more affluent western entrepreneurs. Under the sponsorship of the latter, the former uses its inherited talents and skills to turn out artifacts and ornaments that grace the shelves of gift shops in the Metropolitan Museum of Arts, The Boston Museum of Fine Arts and so on. The sustainable 10 per cent growth rate achieved by the Chinese is to a large extent because of this tie up between the indigenous subsistence entrepreneurs under state sponsorship and the roving American corporation. I believe this sponsorship of the indigenous entrepreneur who might otherwise have languished accounts for a good portion of the growth momentum in the Chinese economy.

Today, the American multi-national companies are trying to create a new global market. Chinese factories work twenty-four hours a day for seven days a week, the only country in the world to do so systematically, to supply toys, textiles and small appliances to western markets. The Chinese are on their way to superpower status. Using the advantage of strong export markets in toys, textiles and small appliances, they are diversifying their economy rapidly, achieving at last reckoning a ‘sustained’ 10 per cent growth rate. They have even taken baby steps in rocket science. The Chinese students who go to the west to spend the country’s foreign exchange are mainly in business, sciences and technology. There are hardly any postgraduate students from China in Economics departments in the western universities.

We gained independence in 1948 and ever since have denounced our economic structure but even though we have changed its basic design, nearly 20 percent of the Gross Domestic Product is still derived from the three commodities, tea, rubber and coconut. In the period 1990 to 2005 the growth rate in GDP has fluctuated between 4.3 and 6.0 per cent. A recent publication of the Central Bank entitled, Financial Stability Review, 2005 states

6 “Sri Lanka’s corporate sector is very small.”

The question arises why have we failed to energize our corporate sector that is so critical for economic development? Why has our objective of rapid economic development through diversification eluded us for almost sixty years? I intend to put forward a few reasons, ties if you will, that bind us to slow development.

First of all, may I suggest that the reason is our pre-occupation with study of Economics and macro-economic variables such as Gross Domestic Product, National Income, Exports, Imports, Saving, and Investment. The Federal Reserve Bank and the Bank of England are more likely to nudge these macro variables in desired directions to preserve financial and price stability because the United States and England are advanced capitalist economies where corporate culture is established, growth, income and employment are high and sustainable, the banking habit is widespread, the stock markets are alluring and the financial system well integrated. More importantly, at last count that I am aware of, i.e. 2001, there were about 30 million firms in the United States and it was then estimated that more than 1.1 million enterprises were launched each year. The role of the central bank in such economies is mainly supervisory, appropriate in developed countries where the capitalist system is well established and there are millions of healthy and buoyant firms producing goods and services that increase Output, Growth and Employment. Nearly all of the new jobs created in the United States are by new firms. In the last 20 years, 36 million new jobs were created. In the United States, about $100 billion dollars of informal risk capital are available for new business and another $50 billion or more from professional sources to back ventures of small entrepreneurs. In Sri Lanka, the support small entrepreneurs get from venture capitalists, financial institutions and policy-makers is so poor to even seem non-existent.

In Sri Lanka, the Central Bank is looking down from up above. For decades the Bank has put policies in place that it hopes will impact the macro-economic variables to move them in the desired direction. However, macro-economic variables such as Gross Domestic Product and exports are aggregates, and I do not believe that a government agency has the power to change them in the desired direction, from less growth to more growth while focused on stability. In my opinion the major obstacle to development is the lack of an entrepreneurial force, the absence of incentives for the emergence of an entrepreneurial class, the lack of financing for the sustenance of the indigenous entrepreneurial class, and its limited access to markets, both domestic and international.

Macro-economic variables are the sum total of output of production and services of small and large entities called firms. Firms are the building blocks of the capitalist economic system. However, the Theory of the Firm has been left out of the grand design of our economic development plans and even the central banking functions are

7 conceptualized without reference to it. In the beginning, soon after independence we thought that the revitalization of rural agriculture and the subsistent rural peasant will make the difference, and that we could restore our historical glory by diverting productive resources away from the corporate plantation sector to the rural farm economy. We have eliminated our reliance on imports of rice, but the economy has not surged forward because the growth momentum created by small farmers is too small to make the difference.

The volume of goods and services produced within the corporate sector must increase to meet consumer needs. If entrepreneurship and the formation of firms within are inadequate to set in rapid motion the production of goods and services while the financial system is energized from above, there will be inflation. You then have to release the throttle to let off some steam; more imports to relieve pressure on prices leading to balance of payments problems.

The poor presence of the corporate sector may be gleaned from the report of the Central Bank that at the end of September 2005, all debt instruments in the debt market totaled Rs.962 billion of which government securities amounted to Rs.949 billion or 99 percent, while corporate debt accounted for a measly 1 per cent. I do not know what satisfaction the Central Bank of Sri Lanka can gain from this fact that corporate debt has not increased the stress on financial events; stability we have, but at what price? However, the Central Bank concluded, “In view of its low penetration, developments in the corporate debt market do not pose a threat to financial stability in Sri Lanka at present.” I challenge the Bank to do what it takes to cause the highest penetration possible by the corporate sector in the debt market; let the Central Bank aim to achieve a fifty-fifty split between government and corporate debt; if it succeeds we will have more capital formation and more corporate activity. Ted Turner, the media mogul and among the foremost entrepreneurs in the world, once said

“I’ve got more awards than anybody-anybody my age. I’ve probably got more debt than anyone in the world.”

If you look at a balance sheet of any giant corporation in the USA, the debt to total asset ratio may often be very high. Some of the most powerful firms in the world are highly leveraged.

How about the fledgling equity market in Sri Lanka? It is reported that at year-end 2005, 239 companies were listed on the Colombo Stock Exchange. Market capitalization rapidly increased from Rs.382 billion at year-end 2004 to Rs.752 billion at end-October 2005. The Central Bank rightly concluded that the lower capital cost was the reason for increased activity in the share market. The market was moving in the right direction because the

8 bigger firms were seeking investment capital in the equity market. The Central Bank was unable to determine whether the increased activity was driven by “speculation or fundamentals”. In the primary market comprised of investment bankers mostly, where corporations issue shares to raise capital, the drive is based upon fundamentals; in the secondary market, the Stock Market, where outstanding shares of corporations are bought and sold, the compelling factor is often speculation. I buy those shares expecting to sell them later at a higher price. Speculation is good in the early stage of the stock market’s development because more investors will be drawn to it. We have a streak of the gambling instinct within us. Activity is a measure of success of a market and volatility is the price we may have to pay for greater participation by the public. Greater participation is critical because the stock market sets the price at which corporations can issue shares to raise capital. My question is why did market capitalization collapse to Rs.584 billion by year-end 2005, a drop of Rs.168 billion in two months? The stock market that was taking baby steps at the time suffered a huge setback. Was the set back caused by official intervention because of our concern for stability?

The Financial Stability Review of 2005 reports that

“The capital market, where longer term funds…are raised plays an important role as far as financial system stability is concerned.”(Italics mine).

Stock market volatility was reported to have increased in the latter part of 2005, thanks mainly to the increase in “profits of some of the listed companies, higher level of liquidity in the economy, increased foreign participation, and search for higher returns by investors.”

The Central Bank wondered whether “the continuing rise in equity prices could be a threat to financial stability?”

I say that the threat to financial stability is that market capitalization is poor. The corporate presence in the debt market is poor and the equity market is abysmally stable. Energizing the equity market must be the long-term goal of the Central Bank; to do so we need to energize the private sector.

Why has so little been done so far to energize the private sector? Why has there been disconnect between the macros and the micros for so long? Why has the theory of the firm that is critical in employment creation, income generation, and production of goods and services been omitted from central banking policy making discussions? Why have we failed to establish a framework within which firms can flourish and grow?

The theory of the firm is private enterprise and it is associated with capitalism, a word we economists learned to despise in the University of Ceylon. We were committed to social

9 justice and the distribution of the output mostly from public ‘enterprise.’ We nationalized the tea estates, the only vigorous and buoyant sector of our struggling economy. We, including myself, cast the entrepreneur in the role of an exploiter. Today, the capitalist system has snuck in through the back door, but we treat it as we would a stepchild.

Another reason for the lapse is that the brightest among us have the civil service mentality because the education system we inherited from the British was not designed to create entrepreneurs; rather, civil servants. I got a degree in Economics where the focus is on macro-economic variables. Even when I got the opportunity to go abroad, I acquired more academic qualification in economics. There were no business schools in my time in most universities. There was only a fledgling business school in Cambridge and a few students enrolled in it, none from Sri Lanka. I returned to Sri Lanka in 1965 and was content to indulge in a way of life that John K. Galbraith described as the “Art of genteel and elaborately concealed idleness.”

Another reason for the disconnect is that we in the Central Bank serve international lending agencies like the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD) very well, a service that keeps us tethered to the macros. Those institutions visit us periodically to see whether we use the monies we borrow wisely. I recall the flurry of activity within the Central Bank whenever those teams visited us periodically to disturb our peaceful repose. On the eve of their arrival, we compiled large amounts of macro-economic data and described them in several reports- the bigger the report the more evidence of prudent usage.

Lastly, few among the middle class in Sri Lanka have the psyche of entrepreneurs. We do not have a culture of entrepreneurship- the corporate culture. Entrepreneurship generates and utilizes immense human energy. An entrepreneur is someone who pushes the threshold of danger outwards. Entrepreneurs are bold, ingenious, determined and daring. They are the people who initiate, organize, plan, manage and control a business. They assume risks, and they know how to cope with uncertainty and the frustration of not being able to get jobs done in a timely fashion. Entrepreneurship requires a passionate commitment to a project. Entrepreneurs are men and women who seeing the hazards of the sea, still embark; they are fearless as the skiers who go hurtling down an icy precipice, they venture into the leech infested jungles to open up land, dive into the bottom of the ocean to examine what lies there and they take on the humongous waves on scanty surfboards- it seems so easy to us who watch them from afar. Among American entrepreneurs I have observed a commitment to self-reliance, a recklessness that I shall describe as fearlessness, and the urge for economic independence. There is also a certain climate in the USA that supports the emergence of new entrepreneurs. It is this supportive environment within which American entrepreneurs flourish.

10 In Sri Lanka, the middleclass who has disposable income to set up in business educate their children to function as civil servants; only those who are denied admission to the several institutes of higher learning are encouraged to become entrepreneurs. Our culture does not place a high value on being your own boss. The environment does not support or promote entrepreneurship. Quite often children from middle class families are too protected and therefore they do not develop the psyche of entrepreneurs. Few among our youth know how to swim in the turbulent seas surrounding our country; perhaps many do not know how to swim at all. They do not go mountaineering on their bikes; they do not go camping in the jungles; there are no rinks for roller-blading or exercise gyms to transform them from fearful to fearless. Few have the mental drive to participate in the Olympics. From childhood American children are encouraged to scale the highest mountain and dive into bottom of the sea. They develop into strong and sturdy young men and women who have the mental energy, fearlessness and resourcefulness to be entrepreneurs. In my middle class neighborhood in the United States where homes of lawyers, professors and doctors abound, a ten-year old child peddles bundles of newspapers straddled on a bicycle that he can barely balance. He is out there early in the morning on a cold wintry day when temperatures are in the teens to make money before setting off to school. To become a successful entrepreneur one must demonstrate the spirit of independence from a young age. Entrepreneurship is a long learning process; we are not born to be daring; we learn to be daring. It is estimated that about a seventh of the working population in the USA is self-employed. To become self-employed was on the mind of every business student I taught. None wanted to work for another. How energized that economy is because of that spirit. The most successful entrepreneurs thrive on the edge of chasms.

The thesis I put forward is: look after the micros and the macros will take care of themselves, up to a point, of course. I urge the Central Bank to make its role more complete by linking its purpose and functions not only to macro-economic variables but also to micro-economic theory, i.e. the theory of the firm. The purpose is to stimulate a slow growing economy. The Bank will have to relearn the task of money management in this new and dynamic environment; it must learn to transit from mainly supervising the financial system to vigorously encouraging capital investment by entrepreneurs and creating a financial system that is designed to assist the corporate sector. “Stable money and credit markets may be crucial success factors for financial system stability” but they are sometimes incompatible with the formation of business enterprises, or more importantly, they do not assist in creating the right environment for entrepreneurs to grow and flourish.

What I propose here today is contrary to the conventional role of central banking. Today, the role is circumscribed by too much theory and ideology; I propose a more pragmatic role for the Bank.

11 Since I left the Central Bank there have been many revisions to the Monetary Law Act. Those revisions have given the Central Bank new powers and an array of new tools to perform new functions more appropriate for developing countries. In April 2006, the Central Banking function was revamped to include a development objective. A Central Bank Strengthening Project (CBSP) was described to support the Bank

“In its efforts to effect a fundamental restructuring and reorganization program to create a lean, well functioning, modernized, and efficient central bank capable of supporting strong economic growth over the medium and long term.”

There was also reference to “human resource development”. When I first read the reference to the need to develop human capital, I was elated because, here at last, we were addressing a need that is a precursor to economic development. But upon closer reading of the modernization program, I found that the Bank was only mindful of its own employees. A staff development plan was being put in place. In this lecture, I shall take the concept of “Human Resource Development” further to include the entire economy.

What does human capital mean? People transform into human capital when they participate in the production process. There are four forms of such participation: labor, landowner, financier and entrepreneur. Historically, the government has taken most care of labor and landowner because it is politically expedient to do so. Up to now, the Central Bank has controlled the money supply, banking system, balance of payments and foreign exchange reserves. It regulated institutional funds mostly and exercised supervisory control over the financier of the macro-economic system. The entrepreneur was neglected even when it is he or she who combines the other forms of human capital in the production process and is the link among them. It is the entrepreneur who also links the consumer to the production engine. If you describe the firm as the building block of the economic system, I say the entrepreneur is the architect, engineer, bricklayer, carpenter, and the painter. The entrepreneur sets the production process into motion by taking the decisions of what, how and for whom to produce. The entrepreneur takes the initiative and brings the factors of production together in an enterprise called a business to produce either goods or services for the community. The entrepreneur bears the risks of the enterprise and he is often an innovator of a product like Bill Gates of Microsoft or of a service like Google. We need more entrepreneurs. Entrepreneurs are the main source of economic growth; they generate income and wealth of a nation; and they create jobs.

The only reference to private enterprise that I can find in the Annual Report of 2005 is quoted below:

“The private sector needs to take their own initiatives to intensify competitiveness through increasing productivity, continuously engaging in research and development activities and

12 facing the challenges of globalization while reaping benefits from it, without seeking any undue protection from the government at a high social and economic cost.” (Italics are mine)

What a tall order that is for start up firms and small subsistence entrepreneurs!

I have been thinking of ways to bring the central banking functions in line with what I propose: stimulate the formation of firms and motivate an army of entrepreneurs to plan, organize, manage, and control our economy so that we can increase Output, Growth and Employment. It is imperative that small entrepreneurs who start up firms have the resources and know-how to succeed. Who better than the Central Bank, because of its pivotal role in the economy, to help initiate and nurture the development of entrepreneurship within Sri Lanka? Under the caption ‘Safety Nets and Social Protection’, The Annual Report of the Central Bank in 2005 outlines a policy of empowering and facilitating “vulnerable groups and disadvantaged persons to engage in productive economic activities.” Would it have a plan to include Sri Lanka’s small start up enterprises and small entrepreneurs?

Specifically, I propose the following:

The Central Bank shall establish and maintain a Department of Innovation and Enterprise (DIE) to understand the role of new businesses in the economy and supply business incubation services to mainly new entrepreneurs. The DIE will be an important conduit for synthesizing entrepreneurial need and its supply. It shall determine the kind of opportunities that motivate entrepreneurs, understand the problems they face, be aware of the skills required to survive in a business undertaking, and generally, determine the legal, financial and organizational changes that are required to improve the climate for innovation and entrepreneurship. The DIE shall supply educational and directional services to the corporate sector and so doing promote a vigorous entrepreneur class in Sri Lanka. The DIE shall serve new entrepreneurs by helping to start-up businesses and assist existing business, local or foreign, to grow. It shall be the think tank for the corporate sector- the laboratory that investigates the opportunities that motivate entrepreneurs, the problems they face, and the traits and skills required to survive in the chosen business undertaking. The DIE shall investigate the general characteristics of the entrepreneurial process within the country and help formulate, implement and execute policies to assist new entrepreneurs. The DIE shall disseminate information on how to launch a business through operations planning, financial and market planning. The DIE shall provide business support services, such as product planning and development, help develop feasibility studies, promotional plans, prepare market studies, and sales strategies for new business.

13 The DIE shall help to design a new financial framework or assist in the adaptation of the existing financial system where entrepreneurs, small and large, can raise venture, investment and working capital. The DIE shall develop policies to improve the supply of venture capital to small business and startup firms, and so doing help in capital formation within Sri Lanka. The DIE shall put in place resources and facilities to support personal ventures and be alert to shifts in the demand and supply of venture capital.

The DIE shall help create a horizontally integrated market-related structure within which businesses can flourish

To perform these functions the Central Bank must

-Recruit a distinguished businessman from either within Sri Lanka or from a country of similar cultural background to head the DIE.

-Mandate training in business finance, management & marketing, entrepreneurship and innovation, information systems, decision sciences & accounting for all officers of the DIE.

- Facilitate the supply of technical assistance and help disseminate technological know- how.

- Help transform the talent in the civil service and banking sector into entrepreneurial talent by sustaining entrepreneurship education and by spreading the entrepreneurial message around educational institutions, high schools, colleges and the universities.

- Help design curriculums in educational institutions to encourage risk-taking and creativity, teach business formation, structure, strategy and performance. (The skills of entrepreneurship that need to be developed include: business management, ability to organize, networking, being team players, decision making and planning, finance, accounting, management and marketing, art of negotiation, risk taking, innovation, creativity and persistence. Entrepreneurship education is a critical need for promoting the corporate culture within Sri Lanka.)

-Recognize factors that are detrimental to the emergence of entrepreneurship, factors that dampen individual effort, initiative and the forces that penalize success,

- Determine what turns us into people that dislike taking risk; what is it in the Sri Lankan landscape, political and social, that deadens the spirit of enterprise

- Help to develop the infrastructure to facilitate the work of entrepreneurs by removing bureaucratic obstacles and uncover those factors that discourage investment, dampen individual effort and obstruct enterprise.

14 - Scrutinize the regulatory climate within which firms operate and help initiate changes that are needed to ease the burden new businesses bear.

- Examine the legal code to determine the laws that are detrimental to the development of entrepreneurship

-Organize workshops to train business executives and bring in speakers who have the experience to initiate and run a business. It must initiate business periodicals to educate entrepreneurs and keep them informed of the facilities that are available to assist them in new ventures

-Research international and domestic markets for the corporate sector. Research product packaging, price and advertising needed for successful marketing.

- Be positioned to help those firms that dare to start up to stay employed at their maximum potential

- Reduce the insecurity that prevents entrepreneurs from starting out. Business arrangements that modify or control insecurity include insurance. It must determine the insurable risks and help create facilities to take care of such risks while keeping premiums affordable.

In my lecture I have urged the Central Bank to play a unique role in our economy by initiating and instituting the changes I have described. By shifting its focus from mainly macros to the micros also, including the theory of the firm in its purpose and functions, and shifting some attention from the financier to the entrepreneur, the Bank will help create the corporate culture and the supportive environment for business formation. Successful intervention to promote entrepreneurship requires as much skill and insight as are needed to regulate the financial system, but look at the outcome: more growth, production and employment. Entrepreneurship innovates and creates; it creates supply by bringing products and services to the market, and creates demand for those products and services by providing employment.

Thank you ladies and gentlemen.

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