ECONOMYNEXT – Sri Lanka’s banks have raised more foreign currency deposits locally, cut foreign borrowings and increased fx loans and investments in the year to June 2025, a Financial Stability Report issued by the central bank said.
Sri Lankan banks had forex balances of 2.9 billion US dollars in foreign institutions as of the end of 2Q 2024, down 790.2 million dollars from a year earlier.
Domestic systemically important banks had balances of 1.4 billion US dollars and foreign banks 1.2 billion dollars, the report said.
Foreign currency liabilities of banks had grown 7.6 percent to 13.3 billion dollars by end June 2025, up from 3.6 percent the previous year, mainly driven by forex deposits, which had grown since the second quarter of 2023.
Banks had cut foreign borrowings by 11.2 percent in the year to June, reducing or not renewing credit lines, leading to an increase in net foreign assets.
Sri Lanka’s banks instead of borrowing to lend domestically – as they had before the potential output targeting crisis which led to sovereign default – had been investing their dollar balances in foreign banks in syndicated loans and foreign government securities.
Analysts had called for Sri Lanka’s government to structure syndicated loans with banks to use some of their dollar loans and settle maturing debt instead of using proceeds of rupee loans and buying dollars from the central bank which were raised through swaps.
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Flushed with dollars after monetary stability was restored, Sri Lankan banks had financed foreign entities including the State Bank of India with the dollars.
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Sri Lanka banks also finance foreign governments.
“The banking sector significantly diverted FCY funds from balances with financial institutions abroad to FCY loans and investments in foreign sovereign securities,” the central bank report said.
“…[I]ncreased investments by banks in foreign sovereign securities contributed to a notable increase in FCY investments.
“D-SIBs were the largest investors in these securities, accounting for 84.8 percent. While investments in foreign sovereign securities carry minimal credit risk, they remain subject to exchange rate risk.”
“Moreover, the distribution of such securities across measurement categories by end Q2 of 2025 suggests a tilt towards Fair Value Through Other Comprehensive Income (FVTOCI) holdings, indicating a strategy of
maintaining flexibility in liquid sovereign investments while recognising fair value changes in equity.”
Sri Lankan banks ended with large dollar balances after rates were hiked and monetary stability was restored and the government repaid Sri Lanka Development Bonds in rupee securities.
Banks then used their deposits to buy dollars instead of giving fresh loans, clearing a mis-match in their books (negative net open position) against dollar deposits or credit lines.
Banks also used rupee deposits (instead of giving credit) to buy dollars and cover their provisions for ISB losses, ending up with billions of dollars in foreign banks including NOSTRO accounts. They were also used to pay down maturing credit lines.
As a result of paying down foreign credit lines, getting more deposits and financing foreign governments and other entities, net foreign assets were now positive.
“…[W]ith the higher expansion in FCY assets compared to FCY liabilities, net FCY assets of the banking sector significantly grew by 42.5% y-o-y to USD 1.5 bn at end Q2 of 2025,” the financial stability report said.
“Accordingly, the net FCY assets of the banking sector surpassed the pre-crisis level during the period under review.”
Sri Lankan banks borrowed heavily abroad after the end of a civil war and lent to the government, including when flexible inflation targeting/potential output targeting triggered forex shortages.
Macroeconomists also encouraged banks to borrow abroad and gave forex risk guarantees through central bank inflationary swaps.
When the currency eventually collapsed from open market operations for potential output targeting, the central bank made record forex losses as reserves were negative.
Analysts have pointed out that some of the inflationist policy errors that led to the external default have now been systematized in the controversial new monetary law.
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Some of the losses were recouped when the rupee appreciated from 360 to 300, as net foreign assets were then negative.
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Ironically the central bank now stands to make profits as inflationists debase the rupee amid record currency account surpluses, putting pressure on households including those in poor and marginal income brackets, as well SOE finances and government debt overall.
Since Sri Lanka has a very high private savings rates it is easy to build reserves, childishly simple to have a strong exchange rate and finance itself, as long as parliament can bring laws to control the central bank’s inflationist operating frameworks, analysts have pointed out. (Colombo/Oct12/2025)
