ECONOMYNEXT – Sri Lanka’s foreign exchange reserves dropped 206 million US dollars to 6,080 million US dollars in June 2025, amid warnings that the last rate cut was risky to the country’s ability to collect reserves and repay debt.
Sri Lanka’s central bank bought 119.3 million US dollars from banks in June and sold 7.3 million dollars, indicating that monetary policy was not fundamentally inflationary.
Though the central bank had run exceptional deflationary policy since around September 2022, after India stopped giving loans to intervene for imports and print money, concerns have been raised since the last quarter as private credit picked up.
Sri Lanka was driven to serial currency crisis purely with aggressive macro-economic policy (rate cuts/sterilized forex sales), a frenzy of foreign borrowings and eventual Latin America style default by targeting a mid-corridor rate and potential output under flexible or discretionary inflation targeting.
Sri Lanka’s gross official reserves have not grown since October 2024.
In the last quarter the central bank printed large volumes of money through open market operations, to target a mid-corridor or single policy rate, triggering an abundant reserve regime in the first red flag.
The interbank rates rose as a price signal to raise deposit rates and should not have been tamped down with ‘heavy lifting’ style injections but rates should have been allowed to hit the ceiling rate (reverse repo standing facility) in a scarce reserve regime.
The central bank then formalized the mid-corridor rate as a single policy rate, with International Monetary Fund technical advice.
A true ‘single policy rate’ is actually a floor rate operated with excess liquidity (ample or abundant bank local currency reserves) backed by domestic assets found in some floating rate regimes where inflation has now become very difficult to control, and there are fears of 70s-style stagflation like conditions re-emerging.
A central bank subject to foreign reserve targets, however cannot operate such a regime with liquidity injections (called ‘heavy lifting’), as the central bank will then end up spending reserves for private imports instead of collecting them.
A central bank can also drive up credit and mis-direct the markets if it can make participants believe that lower than market rates were justified, without actually printing money through open market operations (heavy lifting) in a process known as ‘signalling’.
However signalling will eventually discourage savings, boost consumption and credit.
The last rate was cut as deposit rates were starting to edge. Economic analysts have labelled the definitive rate cut that tips the credit system over the edge the ‘unkindest cut’ of all.
Sri Lanka has to repay debt and collect reserves (which is the same as repaying debt) by operating an interest rate structure that allows such transfers of real wealth (from domestic savings) to take place, by squeezing the current account or running a surplus.
The central bank ran out of Treasury bills to sell and sales of other securities have not yet started.
The central bank however gets interest coupons on its long-term portfolio (about 300 billion last year or about a billion US dollars), which is deflationary and helps mop up savings from the domestic banking system.
To prevent a second default, the Treasury should look at collecting its own dollar reserves, analysts have said, as the central bank cannot be depended on to be the ‘banker of the government’ and provide it dollars, especially if it runs inflationary policy to target a single policy rate.
Before open market operations were invented by the Fed in the 1920s, leading to the policy rate and external instability without war, central bank could do it without a problem. Under a scarce reserve regime, it could be done subject to certain limits.
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In June also the central bank bought over 100 million dollars on a net basis and some excess liquidity is down.
A central bank can sell reserves to the government or any other party as long as the intervention is not offset with new printed money, a process Adam Smith called “the web of Penelope; the work that was done in the day was undone in the night.”
At the time the Bank of England was obliged to provide reserves not only for imports but also to any domestic note holder.
Forex shortages emerge when a bank of issue (the agency that provides bank notes or circulating medium) over-issues money due to a flaw it is operating framework, where domestic and external anchors conflict.
Since the end of the war the most dangerous time for Sri Lanka has been when macro-economists start to think of ‘growth’ and engage in what is quaintly called ‘monetary accommodation’ abandoning stability and triggering currency crises.
The central bank’s own net foreign assets have also been improving, indicating that it is not losing reserves on a net basis even if official gross reserves are going down or not growing for 8 months.
Sri Lanka’s central bank has a weak stability mandate with a 5 percent inflation target being allowed by its law and in a democratic country it is up to the parliament to control the bank of issue and compel it to provide sound money to the people, analysts say.
Classical economists have said that sound money should be a constitutional right, in the style of a bill of rights so that elected governments are not ousted by rising cost of living and peoples economic freedoms are not violated.
Macro-economists usually blame deficits (politicians) or imports (cars, gold and oil are favourite scapegoats) and the current account deficit (mercantilism) after triggering balance of payments troubles with inflationary policy.
When import controls are imposed or the currency falls due to anchor conflicts, the public hold politicians accountable not macro-economists who reject economics of primarily David Hmune, Adam Smith, David Ricardo, Henry Thornton, James Mill among others and put their faith in statistics.
(Colombo/July08/2025)
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