ECONOMYNEXT – Sri Lanka’s deposit rates have edged up over June after a controversial rate cut in May 2025 while overnight rates have also moved up from the fall, in a scarce reserve regime up to last week, official data show.
Call money rates, where banks lend and borrow from each other without collateral, have also moved up after initially falling in the wake of the rate cut and volumes have also gone up.
The weighted average new lending rate of banks has also risen up to the end of June, after falling initially.
More deposits are required to feed an expanding credit demand as the economy recovers from a stabilization crisis that came after a currency crisis triggered by previous rate cuts.
Sri Lanka has seen a fall in forex reserves from October 2024, when large volume of money was printed to push down rates ahead of a rate cut in the last quarter, in a pattern similar to an abundant or excess liquidity regime (single policy rate) now seen in developed nations with high inflation and political instability.
However, in recent weeks a scarce reserve regime has been operating and interbank rates have moved up as excess liquidity from previous dollar purchases fell amid forex reserves sold to the government to settle debt.
Under a scarce reserve regime, printed money is given to banks for overnight clearing purposes which have to be settled with new deposits or reductions in credit in the ensuing days.
Call market volumes have also picked up as banks started to borrow from each other instead of relying on printed money from inflationary open market operations.
A central bank with overly loose liquidity facility can kill an interbank market stone dead, EN’s economic columnist Bellwether says. In the late 1990s, with the spread of Real Time Gross Settlement systems, central banks started to give intra-day liquidity free of charge.
As a result there is no market for intra day money. Only very few central banks which have monetary knowledge (such as the State Bank of Vietnam) charge for intra-day money.
New lending rates however have fallen in June, central bank data show.
This may be due to more competition which leads to a narrowing of margins, or a temporary fall due to the signalling effect of the last rate cut.
Narrowing margins is an indication of greater efficiency of the banking system, but it may discourage banks from buying Treasury bills and bonds at sharply lower rates.
If more deposits are raised at higher rates, curbing consumption, there is a chance for the central bank to collect more foreign reserves to repay debt.
At the moment the Treasury does not buy its own dollars to settle debt and is hostage to the central bank running deflationary policy to collect reserves and re-sell them to the Treasury.
Since the central bank is targeting a policy rate and there is no commitment to deflationary policy, especially in the current revised IMF program (the ceiling on domestic assets of the central bank does not slope downwards), there have been calls for the Treasury to buy its own dollars to avoid a second default.
RELATED : Sri Lanka Treasury should buy its own dollars to settle debt and avoid second default
Rising deposit rates and call money rates could lead to higher reserve collections, but if dollars sales to the Treasury leads to persistent liquidity shortages that keep overnight rates at the ceiling it would be prudent to raise the ceiling rate, EN’s economic columnist Bellwether says.
However, under a scarce reserve regime with a wide corridor all kinds of shocks to the credit system can be easily sorted with short term rates moving to maintain convertibility, leaving long term rates largely unaffected, unless markets have been taught to respond to a ‘transmission mechanism’.
The narrowing of the corridor rate from 150 to 100 basis points, was one of the policy errors that led to serial currency crises after the war and ended in sovereign default.
There have been warnings that unless a scarce reserve regime with a wide corridor is operated Sri Lanka will default a second time, as the country no longer has the rating space to borrow abroad to settle maturing debt as happened after 2015 in particular.
RELATED : Sri Lanka faces default risks after abandoning scarce reserve system
After the end of a civil war rates cuts and the targeting of a mid-corridor rate reduced the ability of the central bank to collect reserves by squeezing the current account, and the government instead borrowed heavily abroad through illiquid sovereign bonds as well as syndicated loans from China among others.
Sri Lanka also started an active liability management law to borrow dollars to settle loans instead of running deflationary policy to settle maturing debt from current inflows.
At the time Sri Lanka had the rating space to borrow.
The single policy rate with an abundant reserve regime was originally cooked up by macro-economists to quickly pump up (reflate) asset prices which were deflating from the burst housing bubble.
The housing bubble proper was fired by macro-economists largely with the use of a scarce reserve regime in a floating exchange rate in the Fed, over a period of about 7 years after making claims that there was ‘deflation’ in the late 1990s.
The single policy rate/abundant reserves regime has now been normalized by macro-economists and there is inflation, social unrest and political instability in Western nations where elected governments find it difficult to operate even one term like in the 1970s Great Inflation period.
The International Monetary Fund has also given technical assistance to operate a single policy rate with state liquidity forecasts instead of a scarce reserve regime after giving technical assistance earlier to calculate potential output. (Colombo/Aug18/2025)
Continue Reading