ECONOMYNEXT – Sri Lanka has recorded a balance of payment deficit in December 2025, for the first month of the year, after running consistent surpluses in the previous month of the year, official data show.
The December deficit was small, at 22.1 million dollars, compared to an overall BOP surplus with the 2,890.4 billion US dollars, helped by deflationary policy of the central bank, which was disrupted in the last quarter amid inflationary open market operations to suppress rates.
Sri Lanka’s single policy rate, which is a de facto floor rate, requires large volumes of excess liquidity to maintain, turning a scarce reserve regime into an abundant reserve one, analysts have pointed out.
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Under an ARS framework, the liquidity injected to suppress rates blows the balance of payments apart, when private credit recovers.
The new money triggers cascading (multiple rounds) of private credit, which then hits the balance of payments as imports, leading to currency depreciation, parallel exchange rates and social unrest or foreign reserve losses if the money is redeemed by dollar sales.
In December, Sri Lanka re-structured its foreign debt, but Sri Lanka also received budget support loans from multilateral lenders.
There is no problem in meeting lumpy outward liabilities with reserves built up over a period, especially if they are fiscal reserves held by the Treasury, the use of which are monetary policy neutral.
The reserves lost then has to be re-built with deflationary policy over subsequent weeks or months.
Sri Lanka operates a so-called flexible inflation targeting framework, based on econometrics (data driven monetary policy) disregarding classical economic principles and laws of nature, leading to balance of payments crises, whenever inflationary open market operations are deployed to cut rates, analysts have shown.
The path to Sri Lanka’s last currency crises, which ended in sovereign default, started in the second half of 2019, as inflationary open market operations were deployed to cut rates despite tax hikes made earlier and market pricing of fuel.
Analysts warned in 2019 that the central bank’s operating framework has to be changed to avoid default as peacetime currency crises came one after the other due to flexible inflation targeting (targeting a big increase in cost of living without a clean float), mid-corridor targeting (abundant reserve regime) and potential output targeting (printing money claiming growth is low after a stabilization crisis triggers an output shock).
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In 2018 analysts also warned the central not to take the foot off the pedal after it ran out of Treasury bills. (Sri Lanka’s Central Bank should sell own securities in new credit cycle)
From 2015, when Sri Lanka cut rates under flexible inflation targeting with mid-corridor targeting, which amounts to a single policy rate, the country had market access and could borrow heavily and prevent rates from shooting up steeply in the stabilization crisis that follows.
Sri Lanka now has no market access and the central bank also has reserve related liabilities after its own borrowings made to suppress rates, which it has to settle by operating deflationary policy at an appropriate interest rate.
Sri Lanka gross official reserves have also declined steadily. Gross reserves can fall when the central bank settles its loans to India or the International Monetary Fund, though net reserves, which are linked to the BoP, do not.
However all of these have to be steadily built in intervening months to maintain payments, as well as meet IMF reserve targets.
The central bank’s best tool to operate deflationary policy is the outright sale of domestic securities in its portfolio. Sri Lanka ran out of Treasury bills in the last quarter and now has only bonds.
The interest coupons on the bonds are deflationary and can help run BOP surpluses by moderating and sequencing credit as long as policy rates are not out of line.
Sri Lanka’s private credit also surged to crisis level highs and boosted imports to 1.9 billion US dollars in December, without car imports as excess liquidity was maintained in money markets.
The excess liquidity in money markets have been extinguished by February
Analysts have pointed out that reserve losses are caused not by imports, cars or otherwise, but inflationary open market operations which trigger outflows greater than inflows as the central bank re-finances private credit with its liquidity tools.
It is a fairly simple process to maintain external stability and collect forex reserves through a ‘scarce reserves regime’ as budgets are now better, as long as money is not printed through inflationary open market operations to drive unsustainable private credit, analysts say.
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The mistaken ideas about the balance of payments, disregarding teaching of classical economists including David Hume, Henry Thornton, David Ricardo, James Mill, Robert Torrens, and Austrian and German economists, has led to chronic inflation and exchange controls in the last century and the final collapse of the Bretton Woods.
The ideas only survived in the last century in the Federal Republic of Germany, Austria, Denmark, Switzerland, some East Asian territories including Singapore, Macau, Hong Kong, Taiwan and some Gulf Cooperation Council Nations which do not go to the IMF.
The UK itself had to go to the IMF with sterling crises, after rejecting their own classical greats and adopting Keynesianism or that the belief growth could be achieved with some inflation. (Colombo/Feb09/2025)
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