ECONOMYNEXT – Sri Lanka’s rupee has depreciated in 2025, amid record current account surpluses, balance of payments surpluses and the central bank collecting fewer dollars than in 2024, due to a deep flaw in its operating framework.

The depreciation is coming from selective denial of convertibility to private citizens (not returning dollars for people’s imports after allowing excess liquidity from previous FX purchases from them to remain unsterilized) and only giving dollars to the government to repay debt for cash.

The problem of inflation and currency depreciation and its consequent accompaniment of political and policy instability, exchange and trade controls, out migration to countries with monetary stability and diverting foreign investors to stable countries, is due to monetary mis-governance.

Problem of Accountability

Persistent monetary instability is not an economic problem but a political and legal problem involving a central bank with a deeply flawed operating framework and the absolute lack of accountability for its actions.

The lack of accountability is characteristic in exchange and trade controls imposed on its victims, (the denial of economic freedoms) and the election of nationalists and interventionists to power who promise various utopias, which then lead to the denial of civil freedoms, the oppression of large populations, especially minorities.

A publicly declared and openly admitted reflation or inflation bias of the central bank and attempts to deliberately push up inflation and deny monetary stability is not always necessary; a flawed operating framework which rejects classical economics is enough.

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Sri Lanka’s central bank has busted the rupee from 4.77 at its inception and the membership of the International Monetary Fund the following day, due to its obsession with controlling interest rates with open market operations.

The bulk of the depreciation came after 1978, when the Fund changed its articles to allow depreciation, going against the primary reason for its establishment after World War II.

In the 1980s, under American ‘Washington Consensus’ Latin American and other nations which had monetary instability and economic controls were actively urged to depreciate, on Mercantilist ‘competitive exchange rates’ doctrine (a type of REER targeting, which is also a type of inflation bias), relegating them to basket case status.

However, the export powerhouses in East Asia (Hong Kong 1950s), Taiwan (early 1960s) and Singapore (late 1960s) rejected the doctrine from the end of World War II and, after the Bretton Woods collapsed, appreciated the currencies instead, going diametrically in the opposite direction.

Hunky Dory Depreciation

By all accounts the rupee of the money monopoly is falling, amid a remarkable recovery in the economy. For a ‘flexible’ exchange rate regime, which has rejected classical economic principles, a strong credit recovery and investor confidence is a most dangerous time.

External inflation is also curbed by slightly better US Fed policy.

Sri Lanka’s so-called ‘economic fundamentals’ are improving day by day. But the rupee is falling.

Sri Lanka in 2025 has posted record current account surpluses, budget deficits have shrunk, and the Treasury is supposedly ‘overflowing’ with cash, denying the favorite scapegoats macroeconomists and inflationists blamed currency problems on in the past.

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The rupee is depreciating now due to denial of convertibility, a phenomenon described in the heyday of classical liberalism in Britain as the ‘Political Ravishment’ of the currency.

The identification of the problem and its resolution by the British parliament led to the Sterling becoming the pre-eminent currency of the world until the eve of World War I.

Sri Lanka’s monetary problems, then, are actually a fault of the Parliament, stemming from its failure to limit discretion (flexibility) of the central bank and curb its inflation bias.

It has nothing to do with the economy or ‘economic fundamentals’. The only flawed ‘fundamental’ is the deeply-flawed operating framework of the bank of issue.

Is the rupee depreciating due to money printing?

What is called money printing in the context of a reserve collecting central bank are bank notes created against domestic assets, which leave its net reserves down when the cash is redeemed for dollars. In that sense, rupees created by buy-sell swaps have the same effect.

The central bank is not printing money in large quantities after inflationary open market operations (term and overnight) below its scarce reserve window stopped in 2025 and an infinitely more prudent, scarce reserve regime in line with classical economics was re-established.

If the central bank was printing money on a net basis over many weeks, the ability to collect reserves would be lost after six to eight weeks (as it happened in November and December 2024), and it would then lose reserves on a net basis and the currency would be under depreciation pressure.

Money has been printed through buy-sell swaps, but during some months they have reversed, having a deflationary impact.

Any dollars sold to the government at the same rate as that it was bought reverses the inflationary effect.

Any dollars sold to the government (or anyone else for that matter) at a rate higher than the rate at which the central bank bought the dollars from private citizens, has a permanent net deflationary effect.

In fact, the Bank of Thailand, after World War II, when Japan was defeated by the US, liberating the country from its grip, built most its reserves using the deflationary effect of the price difference between the dollars surrendered by the exporters and the price dollars were sold to importers (i.e the profit).

That the central bank is able to collect dollars from the market (though it has been unable to retain them due to lack of sufficient deflationary policy involving sell-down of its domestic assets) shows that the rupee is not under serious depreciation pressure, that there is some deflationary policy and that technically there is a balance of payments surplus.

That is the requirement for upward pressure on the rupee and for the central bank to maintain control of the exchange rate and its grip on the external sector.

The broad increase in central bank net reserves is a testimony to this fact. That the central bank is repaying reserve related debt – below the line so-to-speak – shows that there is a BOP surplus and the rupee is not under pressure except during expansions of buy-sell swaps.

Then why is the rupee depreciating?

The rupee depreciating because the central bank is over-purchasing dollars, above its deflationary policy.

And, it is pushing down the currency month after month from each level it is weakened to, at the end of the previous month.

The depreciation during 2025, has essentially been, due to denied convertibility to private citizens.

The excess liquidity from dollar purchases from the private sector were partially sterilized – or intermittently sterilized – through deflationary operations of the coupons on its bond stock.

But when the remaining excess liquidity – which almost hit crisis levels highs of 200 billion rupees 2025 at times – and turned into imports through private credit, dollars were not returned to the private sector.

Convertibility was given to the Treasury but selectively denied to private citizens, who by the way had supplied the dollars, or ‘deposited’ them in the central bank in return for banknotes.

And when bank notes returned to the central bank through the credit system as imports for redemption, the central bank denied convertibility as if there was a floating rate, having bought them a few days earlier, as if there was no floating rate.

This is the key problem of the intermediate regime.

This then is a Political Ravishment of the rupee with an extra twist.

In essence, a discriminatory suspension of convertibility targeted purely towards private citizens. It is only in October that 10 million dollars were returned after wresting 55 million from them.

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The actions has the same effect as the surrender rule which failed the float in March 2022.

What is the original political ravishment of a currency?

Currencies only started to depreciate in the peacetime in the 1930s after the policy rate infected developed nations. Before that all exchange rates were fixed to each other through gold.

The parity may be different but due to the lack of a political policy rate and a transmission mechanism, the exchange rates held.

For example an ounce of gold was 4.23 Sterling in say 1797 and it was the same in 1821 when convertibility was restored after Napoleonic wars and the war against the inflationists (the Anti-Bullionists) was won. It was also 4.24 when convertibility was restored in 1927 after World War I, but the inflationists won in 1931 due to the policy rate, with Keynes being the top cheerleader.

The US dollar was about 20 to the ounce of gold for a couple of centuries (there was no Fed and money was issued by a series of free banks tied to gold with no policy rate) until it was devalued to 35 in 1934 after the Fed invented indiscriminate open market operations, fired the 1920s credit bubble which ended in the Great Depression.

Long term rates did not go up with every change in the short-term rate to maintain convertibility before the invention of the political policy rate and ‘transmission mechanism’, a phenomenon that can be seen in GCC countries, Hong Kong and Singapore even to this day.

In 1797, with the onset of the Napoleonic wars, money printing led to a run on gold from the Bank of England, like there is a run on dollars in present day central banks. The Bank of England then inveigled the government to allow it not to return gold and effectively floated the pound.

Prime Minister William Pitt the Younger (he was 24 years old at the time) issued a Privy Council order permitting the Bank of England not to return gold (other banks usually ‘closed their doors’ upon suspension of payments).

This led to the cartoon of a younger man kissing an old lady dressed in Bank of England notes. That is how the Bank of England ended up with the now famous name of ‘Old Lady of Threadneedle Street’.

The caricature was made by James Gillray, sometimes called the father of the political cartoon.

These events show that the public was aware of money, depreciation and they did not suffer in silence by skipping meals or leaving the country, after failing to challenge inflationists or macroeconomists, unlike now.

Now, inflation biased intermediate regime central banks can float without any permission and short change the people with depreciation.

Later the Parliament passed the Bank Restrictions Act to allow the Bank of England to float.

The intense debate on money – the Bullionists and the Anti-bullionists (inflationists) – with Ricardo on the Bullionists’ side and Thornton in the middle, then took place.

Remarkably, the Sterling did not depreciate against gold a lot initially in an early lesson that floating rates do work, if there are no surrender rules.

The Bullion Committees of the Parliament later forced the Bank of England to restore convertibility after a period of deflationary policy brought the price of gold back down and reserves matched the reduced note issue.

The second Bullion Committee of 1819 was chaired by Robert Peel. Ricardo was a member, as MP for Portarlington.

Peel later brought the Bank Charter Act against the Bank of England when he was Prime Minister.

He also ended the Corn Laws making England a great free trading industrial power, with cheap food, not unlike what happened to the East Asian export powerhouses that had monetary stability starting with Hong Kong after World War II.

In East Asian countries like Malaysia and Vietnam, food, including proteins are cheap.

A democracy fails if macro-economists debase money

In a democracy, it is up to the parliament to control the central bank. It is silly to give any state agency, least of all an agency with a money monopoly any discretionary powers – ‘flexible’ this, ‘flexible’ that.

In the US, the Congress itself has given the dual mandate indirectly. Both Volker and Greenspan (until 2001) ignored the dual mandate.

President Anura Dissanayake was right to call for exchange rate stability in his budget speech.

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The decision to give macro-economists the discretion for ‘exchange rate policy’ and also do monetary policy is the problem of the new monetary law and its extreme intermediate regime (flexible exchange rate).

As an elected leader of the people, the President should call for a strong currency. Ultimately, politicians are held accountable for depreciation and inflation by the voters.

What he should not do is to ask for interest rates to be kept down.

Rates will fall if monetary stability is maintained for a few years without a crisis.

A stable exchange rate is nothing other than low inflation and an operating framework without anchor conflicts.

Without a stable (non-inflating) currency produced by a central bank with a conducive operating framework, there cannot be free trade or an export boom.

Central banks with monetary problems and discretionary policy are not accountable. As a result, nothing gets fixed. That is why currency crises repeat and countries are dragged to the IMF again and again by the macro-economists.

In the old days either such banks of issue closed their doors, or like in the case of the Bank of England, political leaders backed by the parliament severely curtailed discretion and made them do their job – which is providing stable, non-inflating money, that was a store of wealth, and a unit of account on which families and businesses could build a future on.

And money, on which an investors could place their trust and not be used as a cover up for monetary policy errors through ‘exchange rate as the first line of defence’ which put foreign investors to flight and make exporters and remittance senders hold back.

Ordinary people have to put their life on hold, due to trade and exchange controls to ‘save foreign exchange’ and wait for the central bank to get its act together, only to run into the same crisis two years later.

People have a right to live in the country of their birth. Sri Lankans do not have to go to work in currency board-like regimes in the Middle East that have no policy rate and import labour.

Before the central bank was set up, Sri Lanka also imported labour.

Is there a currency crisis ongoing?

Not yet. Strictly speaking it is a partial or selective denial of convertibility to private citizens by the monopoly bank of issue, that is driving the currency down. The principle is the same as the surrender rule, where dollars are taken for new money and they are not returned when the notes hit the forex market through loans or direct consumption.

Since the Sri Lanka’s private savings rates are high, it requires credit for all converted rupees from dollar earners to hit the FX market.

But when private credit is strong it is very easy to create a currency crisis and a default with a well-timed rate cut and confidence shocks that destroys the people’s faith in the currency of the bank of issue.

Peacetime currency crises are much worse than wartime ones since business confidence is high and people and businesses are optimistic and willing to take loans and invest.

That is why the post-conflict 2011/12 crisis hit very fast and the ‘Yahapalana’ period Groundhog Day style currency crises came very fast and the rupee depreciated very fast.

The central bank should strip the coupons of its bond portfolio and sell them down as deep discount bonds every week. Not very big volumes but every week or every two weeks and keep steady pressure.

The central banks should stay back and allow the rupee to appreciate to 300 to the US dollar.

How much of a margin is there?

Though the scarce reserve regime helps, the May rate cut has reduced the monetary buffer this country had. This column had already pointed out that the IMF’s ARA metric makes no sense. Any reserve buffer has to be fiscal, like a sinking fund.

Monetary reserves cannot really help if there is a policy rate.

There are several developments in December that can help the rupee. In December during the holidays, export firms shut down plants and do scheduled maintenance. They will usually sell dollars to do that. Festival advances are also given to workers by dollar sales.

But if the confidence shock is great and they think that the central bank, by using its discretionary flexible exchange rate will push the rupee to 310 or 312, they will use their rupee credit lines and keep the dollars, pushing up domestic credit.

Another factor that can help the rupee is the surge of remittances that comes in December. If the central bank stays away from the market the rupee may be able to appreciate as credit tends to slow with the holidays.

After the money printing bout in late 2024, the private credit contracted in January 2025, helping the rupee.

On the other hand

Whether private credit will slow in January 2026 remains to be seen, as private credit demand is much stronger now and there is a lot of approved but undisbursed credit.

If the confidence shocks from the flexible exchange rate is very high, rupee bond holders will also leave, as they did during the Yahapalana Groundhog Day currency crises due to ‘exchange rate as the first line of defence’ or interest rate as the last line of defence.

It is a spurious doctrine. Any capital flight should crowd out private credit to maintain external stability and maintain reserves if interest rates moved in a corridor. If it hits the ceiling for a length of time, the ceiling should be raised.

Commercial vehicles imports are also getting stronger. Unlike cars which have very high taxes (only about one third of the vehicle credit subject to LTV hits the forex market) commercial vehicles have lower tax levels, meaning more of the loan will hit the forex market.

They are also relatively more leveraged. Building materials are the same. That is why the last currency crisis stopped only after building materials and machinery and equipment slowed with contracting credit. Cars were blocked anyway.

That cars cause reserve losses, or gold, or oil, or debt repayments or capital flight, are simply narratives spread by macroeconomists who have rejected economics. The problem is in the fixed political policy rate.

The claims that they make now to escape accountability for flawed operating frameworks, either in monetary or exchange rate policy, have been debunked many times by classical economists in the past..

The single policy rate (though it is no longer as deadly as the floor rate of 8.26 percent maintained with inflationary open market operation in late 2024) is still a danger that can and will most likely mis-direct credit and drive loan demand towards mal-investments soon.

The other danger is the 5 percent floor inflation target, which drives a central bank to re-flate for no reason at all.

That target has led to repeated currency crises or depreciation or both and eventual external default.

What do to?

Strip some coupons of the central bank bond holdings and sell whether or not there is a downward sloping ceiling in the IMF program for net credit to the government.

To retain 100 million dollars as reserves, 30 billion rupees – discounted value – of securities will have to be sold down a month, minus the coupons. It if is more, then more will have to be sold down.

If the interest rates go up momentarily, so be it. If the central bank makes losses, so be it.

Let the Treasury buy its own dollars.

If reserves are needed to pay debt, make an externally financed sinking fund (as Sri Lanka had under the currency board). Domestic buffers are not useful, especially in a small open country like Sri Lanka.

Don’t make the Treasury surrender dollars. Let it be in a fiscal reserve, like a sinking fund as it was in British Ceylon.

The longer the exchange rate is maintained, with appropriate fluctuations in short term rates that match credit demand, the greater the chance of long-term rates falling permanently over time.

It should be kept in mind that Sri Lanka’s troubles started in 1952 by doing the opposite. Nothing much has been learned.

Just because the IMF comes up with statistical frameworks or single policy rates (floor systems are deadly) rejecting economics, Sri Lanka does not need to follow them.

These spurious doctrines have been debunked multiple times by classical economists for over two centuries.

After the civil war ended, instead of a peace dividend, Sri Lanka got flexible inflation targeting and potential output targeting.

Potential output targeting and rate cuts by inflationary open market operations (and not from falling rates from a strong currency and low or no inflation), is John Law, pure and simple.

John Law who fired the Mississippi bubble made the same mistakes that Bernanke did when he misled Greenspan into firing the Housing Bubble and Benjamin Strong did when he fired the Roaring 20s bubble.

Sri Lanka’s sudden increase in poverty, and the troubles of the West, with soaring stock markets and overfilled soup kitchens, are results of the Cantillon effect.

Richard Cantillon – former associate of John Law who shorted Mississippi shares later – has given one of the most cogent critiques of central banks with discretionary powers and what they do to the people. That holds true to this day.  (Colombo/Nov23/2025 – Updated with links. Typos corrected)