ECONOMYNEXT – Sri Lanka’s gross official foreign exchange reserves dropped 205 million US dollars to 6,326 million US dollars April 2025 from 6,531 million dollars in March, official data showed, despite some dollars bought from markets.
Sri Lanka’s gross official reserves in April 2025, is below the 6,472 million dollars reached in October 2024, when the central bank printed large volumes of money to push call money rates down as private credit picked up, ahead of the last rate cut.
Though the printed money deals were terminated in the first quarter there was then a liquidity build up from unsterilized dollar purchases.
Excess liquidity from unsterilized dollar purchases that is sloshing around the banking system, represents ‘uncollected’ foreign reserves that will be used by banks for domestic credit, which will generate imports and reduce the ability of the central bank to buy dollars in subsequent weeks.
Sri Lanka’s government has to make debt repayments and the central bank also has to repay its own loans taken from India to suppress interest rates and finance imports in the last currency and default crisis.
The repayment of central bank debt taken to suppress rates in the past will however reduce net foreign assets of the central bank (and by extension net international reserves), even though gross official reserves remain static or drop.
Gross official reserves are however a number that foreign investors and others watch.
Sri Lanka central bank, as banker to the government, also provides dollars to repay fiscal loans. However, without deflationary policy (mopping up excess liquidity keeping rates slightly higher than if purchases were not sterilized) it cannot hold the purchased dollars for any considerable period of time.
Because the government does not have a foreign exchange trading desk, the Treasury is completely hostage to deflationary policy conducted by a central bank, EN’s economic columnist Bellwether says.
Central banks in the UK (as well as currency boards) were able to perform these functions without a problem for centuries before the policy rate and open market operations were devised.
But as soon as a modern central bank starts cutting rates for its own political objectives such as pushing growth (potential output) or pushing up an inflation tax on the poor (flexible inflation targeting) its ability to collect reserves and provide sound money to the public is compromised.
Under a very narrow or single policy rate, the problem can become acute as any rupees borrowed by the government through Treasury bills and exchanged for foreign reserves will lead to a liquidity drop and a rise in the ‘single’ policy rate.
Money will then have to be printed injecting rupee reserves into the banking system to bring the single policy rate down, shattering the scarce reserve regime needed to collect foreign reserves.
In the first two months of 2025, government borrowings have reduced amid better tax collections, giving more space for private borrowings. I April the single policy rate is higher than the floor rate, unsterilized liquidity from dollar purchases keeping liquidity, though the collected reserves seem to be barely enough to repay debt, based on gross reserve trends.
Related Sri Lanka ‘single’ policy rate signals interbank rates to stay up
From 2015 to 2019, the problem of the single policy rate (mid-corridor targeting) and the inability to collect reserves was overcome by heavy foreign borrowings including under the Active Liability Management Law.
Related : How Sri Lanka’s IMF-backed ‘Young Plan’ fired a foreign debt death spiral: Bellwether
DEBT SCRAMBLE: During each currency crisis, net debt went up at a rate above the dollar financing of the deficit.
At the time the rating space was there to borrow abroad and maintain interest rates below what was required to repay foreign debt by purchasing dollars from the domestic market as private credit recovered after each stabilization crisis.
Analysts warned at the time that Sri Lanka would run out the rating space to suppress rates through foreign borrowings.
Related Sri Lanka needs monetary discipline to avoid further downgrades: Bellwether
In 2025 Sri Lanka no longer has the rating space to borrow abroad to suppress rates and repay debt, or to target the single policy rate with inflationary open market operations (abundant reserve regime) and lose whatever reserves were collected when rates were less tightly targeted.
Analysts have warned that flexible inflation targeting and data driven monetary policy – especially in the context of a reserve collecting central bank which is a de facto pegged regime – are spurious statistical doctrines that reject classical economic principles explained by Hume, Ricardo, Smith and even Cantillon before them.
Under an abundant reserves regime the United States is also flirting with a debt crisis.
Under flexible inflation targeting and data driven monetary policy Sri Lanka ran into back-to-back currency crises as private credit recovered from the previous crises, and the stabilization crises that followed killed growth and reduced the ‘potential output’ which was also a statistical construct based on backward looking data. (Colombo/May08/2025)
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