ECONOMYNEXT – Sri Lanka new International Monetary Fund program is expected to have a ceiling on central bank net credit to government, an official said amid concerns over the inability to retain bought reserves, high excess liquidity and renewed monetary debasement in 2025.
In the current phase of the IMF program, the ceiling on domestic assets of the central bank is flat, with no requirement to sell down government securities, unlike when larger volumes of reserves were collected amid a falling ceiling in previous stages with a falling ceiling.
A note-issue bank that buys dollars at a specific exchange rate, and extinguishes the rupees created from the purchase (sterilizes through deflationary policy) prevents the reserves being demanded back for imports by domestic economic agents or banks who end up owning the expanded reserve money.
If the new rupees are extinguished for an asset sold outright the bank-of-issue can retain (own outright) the original forex reserves by giving to the banking system as asset it can own which is not circulating medium (reserve money) or customer bank credit or gilts.
In the existing program the ceiling is static, though coupon repayments on the central bank bond portfolio in cash is deflationary, helping retain some of the dollars bought by the central bank.
Any unwinding of buy-sell swaps with domestic banks is also deflationary and can push up net reserves of the bank of issue.
RELATED : Sri Lanka central bank net reserves rise as some inflationary swaps unwound
The IMF views the quantitative performance criteria on the ceiling of domestic assets (defined as net credit to government) largely as a tool to prevent fiscal dominance of monetary policy.
“The number has been set from the beginning of the program, exactly on the back of the
new Central Bank Act,” Evan Papageorgiou told reporters after concluding a staff level agreement, which will lead to a new set of quantitative targets for the central bank and the government.
“One of the key parameters of this act was to prevent financing of the government and
break the fiscal dominance.
“That is being observed, and again, I cannot talk about the current review.
“Our expectations are that it will continue to be in place.”
Having given the note issue bank ‘independence’ Sri Lanka’s parliament is helpless in blocking its inflationary policies and is fully dependent on the IMF to control its liquidity injections, analysts have pointed out.
The central bank is currently trying to push up cost of living by 5 percent a year, despite high levels of poverty created in wake of the last currency collapse.
Its attempts to run aggressive inflationary policy though a ‘single policy rate’ and an abundant reserve regime, led to a public outcry in late 2024, with a correspondent reduction in its ability to buy dollars, let alone retain them.
The central bank is still free to depreciate the currency and push up food and energy prices particularly in the light of a ‘flexible’ exchange rate, which gives the note-issue bank full discretion to engage in monetary debasement.
Before the last review revealed the flat QPC on domestic assets, analysts who track the inflationary policies of the central bank closely had warned that unless there is a ceiling on domestic assets, it will lose the ability to collect dollars and forex shortages will re-emerge.
Unless there is a falling ceiling on its domestic assets, the ability to retain collected dollars would be reduced to coupons paid by the Treasury on its bond and any unwinding of buy-sell swap contracts with domestic banks.
If a scarce reserve regime is abandoned for a single policy rate with an abundant reserve regime, actual forex shortages would result and risks of a second default is almost certain, analysts have warned.
RELATED : Sri Lanka faces default risks after abandoning scarce reserve system
Sri Lanka’s central bank triggered forex shortages as private credit recovered midway in the last two programs (2011/2012) and in 2018, resulting in amended targets and/or waivers of QPCs.
Sri Lanka authorities have not requested waivers of QPC in the current review, IMF officials told reporters indicating that the QPC on net international reserve at least for June had been met.
The central bank had settled some of its reserve related liabilities with dollars retained with deflationary policy, helping growth net international reserves, though there are doubts about meeting year end gross reserves projections.
In Sri Lanka, there is growing understanding that fiscal dominance is not the problem, given the emblematic inflationary policy in 2018, when then Finance Minister Mangala Samaraweera cut deficits and market priced fuel, removing even de facto fiscal dominance.
However, the central bank printed money through open market operations and swaps for flexible inflation and potential output targeting and to maintain its policy rate after interventions.
In 2018, when inflationary policy was deployed under flexible inflation targeting to maintain a mid-corridor interest rate, a deputy minister of the then administration pleaded in public for a scarce reserve regime to reduce injections and allow interbank rates to rise to the ceiling.
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“If it is hitting the ceiling and you’re not injecting money at below 8.5 percent, then it’s alright and there’s no need currently to increase your policy rates,” then State Minister for Economic Affairs Harsha de Silva said.
“But at least let the overnight rates be within the higher margin of the policy rate. It’s prudent.
The central bank is currently running a scarce reserve regime and has stopped inflationary open market operations but the threat of inflationary policy exists as a gazette has been issued for a ‘single policy rate’, has not been rescinded.
When Harsha de Silva and other critics of inflationary policy started the fight against the central bank in 2004, there was fiscal dominance of monetary policy from Treasury macro-economists amid an expansion of the deficit from fuel subsidies.
At the time, Governors A S Jayewardene, Sunil Mendis, and Deputy Governor W A Wijewardene, favoured sound money and economic stability, and did not appear to believe that high inflation and monetary debasement leads to growth or that an ‘output gap’ can be bridged by inflationary policy.
Ironically, the legal power for macroeconomists to depreciate the rupee was given in a reform carried out by Governor Jayewardene which removed a requirement to maintain the external value of the rupee.
Before the reform the rupee was depreciated on a questionable legal basis, critics have pointed out.
Sri Lanka’s rupee had been depreciated over 2025, amid record current account surpluses but high levels of excess liquidity against which the currency is not defended for private transactions.
However, some collected dollars have been sold to the Treasury in unsterilized sales to repay debt in 2025, withdrawing some of the excess liquidity, in a classical style defence of the currency.
Analysts have urged the Treasury to buy its own dollars from the market to avoid a second external default from any central bank reluctance to run deflationary policy required to buy dollars. Treasury purchases of dollars like those of importers are reserve money neutral transactions. (Colombo/Oct16/2025)
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