ECONOMYNEXT – Dollar backing for Sri Lanka rupees improved to 19.9 percent in February 2025, from 17.5 percent in January, as net foreign reserves of the central bank topped a billion US dollars, official data show.
Net foreign assets of Sri Lanka’s central bank increased to 316.4 billion rupees (about 1,070mn) in February 2025 from 266.6 billion rupees (about 895 million dollars) in January.
In order to collect foreign reserves and keep them, the central bank has to run deflationary policy (withdraw liquidity) by outright sales of domestic assets.
However, some of the reserves the central bank has collected is now represented by unsterilized excess rupee liquidity which can be turned into domestic credit and imports as loan demand picks up.
Central bank ran down its foreign reserves to cut rates and also borrowed from other central banks through swap lines to sell reserves it did not have and offset them with printed money to suppress rates during the last currency crisis which ended in a sovereign default.
Sri Lanka’s parliament has to change the monetary law of the central bank to legally block borrowed reserves being used to suppress rates, boosting imports and widening the current account balance, analysts have said.
The longer the period rates are mistargeted, the worse the fallout during the stabilization crises that follows. The outcome of open market operations backed rate cuts include bad loans and output shocks (slow or negative growth) as well as sovereign default in extreme cases.
Other options to maintain monetary and exchange rate stability include compulsory rate hikes when reserve cover falls below a pre-set threshold (such as 120 percent) as well as lowering the inflation target of the central bank to to reduce the discretion to conduct inflationary policy.
Macroeconomists have won the right to create inflation of 5-7 percent under Sri Lanka’s controversial new monetary law.
The central bank’s policy rate of 8.00 percent is now only 1 percent below the upper limit of the inflation target, indicating what is called the ‘real’ interest rate in the age of permanent inflation.
The central bank’s floor rate of 7.50 percent is only 50 basis points ‘real’ now compared to the inflation target.
The central bank had net foreign assets of 148 percent of the monetary base (as defined in Sri Lanka), in the last quarter of 2014 when aggressive flexible inflation targeting based on backward looking 12-month historical inflation began.
The IMF also has another econometric measure called an assessing reserve adequacy (ASA), all of which are shattered to smithereens when excess liquidity is dumped into the banking system to suppress overnight interbank rates or mistarget longer term rates via the ‘transmission mechanism’. (Colombo/Apr01/2025)
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