ECONOMYNEXT – Sri Lanka’s central bank has made 231.9 billion rupees (about 770 million dollars) worth unsterilized foreign exchange sales to the government in the first half of 2025, reducing excess liquidity in the banking system, official data shows.
From January to June 2025, the central bank had created 299.4 billion rupees with outright dollar purchases from banks (1,014 million), 2.1 billion rupees from miscellaneous injections, the central bank’s Market Operations Report said.
The central bank has also injected 109.3 billion rupees by engaging in rupee generating dollar swaps, without buying reserves outright for its own securities.
In the first six months of 2025 a total of 410.8 billion rupees of inflationary operations (that expands reserve money) has been conducted.
Liquidity had disappeared (deflated) through 6.7 billion rupees of maturing bonds, 95 billion rupees of coupons paid on government bonds (which will reduce domestic credit and prevent dollars in reserves being demanded by imports).
Currency use has also gone up by 106.4 billion rupees.
Unsterilized Sale
The central bank has sold dollars to the government for 231.9 billion rupees also reducing liquidity, in an unsterilized dollar sale.
A dollar sale by a monetary authority that does not have a policy rate, reduces liquidity and rupee reserves owned by banks in exact proportion to the outflow of dollars from reserves, automatically keeping the exchange rate and domestic credit in balance.
The reduction in liquidity leads to a tightening of liquidity (deflationary policy), which will eventually push up interbank rates, based on classical economic principles generally known as the price-specie (or reserve)-flow mechanism originally clearly explained by David Hume.
So-called currency crises are triggered by a central bank which replaces the lost liquidity through open market operations to prevent the rates from going up, rejecting classical economics.
When liquidity falls and there is tendency for the interbank market to get active, and rates to rise.
Any attempt to suppress interbank activity through a single policy rate with inflationary open open market operations will tend to reduce the ability to collect reserves and eventually lead to net forex losses or depreciation or both.
Cutting rates through ‘signalling’ can reduce reserve collections without causing forex shortages per se.
Already in 2025, the rupee has fallen despite current account surpluses indicating that the central bank was not conducting sufficient deflationary operations to match the dollars it is purchasing.
RELATED : Sri Lanka rupee depreciates amid record current account surplus : Analysis
Rejecting Classical Economics
Analysts have warned that Sri Lanka’s interest rates cannot be cut based on a claim that historical inflation was low (flexible inflation targeting) which is a spurious monetary doctrine that rejects economics.
All recent externally defaulting countries without war and repeated IMF bailouts, have similar frameworks.
While soft pegs which sterilize forex reserve sales with new money (which has not happened up to June) to suppress market rates are fundamentally flawed, adding an inflation target makes the policy conflicts even more toxic, EN’s economic columnist Bellwether says.
That the operating framework is flawed is shown by the existence of exchange controls and the resorting to frequent trade controls.
Rates are dependent on domestic private credit developments and debt repayment requirements, which may in turn be financed by gilt sales to the market (at an appropriate rate) since the government does not have a surplus in the budget to pay down maturing debt with taxes.
If the central bank does not conduct sufficient deflationary operations it will lose the ability to collect enough dollars and give to the government, leading to a fall in reserves.
The government then has to come up with a plan to buy its own dollars from the market with cash raised from bond sales.
RELATED : Sri Lanka Treasury should buy its own dollars to settle debt and avoid second default
Attempts to control rates through open market or other operations had led to currency crises in 2012, 2016/16, 2018 and 2019/2022 without war and ultimate default, analysts have warned.
Neither can rates be cut to boost ‘potential output’ as the resulting currency crises shrinks the economy.
A 5 percent inflation target also makes a currency crisis more likely, and the resulting inflation in any case saps consumer spending and wages of hard-working people and savings of the thrifty, eventually denying capital for investments.
Concerns have been raised on recent rate cuts, amid a strong credit recovery, even as reserve collections have slowed down over several months.
The central bank can buy dollars outright as long as interest are at a level where credit disbursements from banks are less than deposits (and loan repayments) for which an appropriate rate is required.
In early 2019, EN’s economics columnist Bellwether explained that several flaws in the operating framework of the central bank (including the buffer strategy) is likely to lead to another crisis and default.
The 2018 the crisis was emblematic as it was created despite fiscal corrections and showed that fiscal corrections was not going to solve the problem rapidly ratcheting foreign debt from monetary instability.
RELATED : Sri Lanka has to reform soft-peg to avoid monetary instability, default: Bellwether
Buy Sell Swaps
In the first six months of the year the central bank has also injected 109.3 billion rupees into the banking system, by engaging in rupee generating foreign exchange swaps, without buying dollars outright.
A generating swap is a derivative contract where dollars are bought in the spot market for new money, with an undertaking to sell forward at a fixed price (regardless of the exchange at that time) giving rise to a contingent liability for the central bank, and creating new money for a commercial bank to lend.
The central bank may be purchasing dollars collected by banks in the past (when dollar loans by banks were repaid in rupee securities years ago for example), and the transaction has nothing to do with current external developments except in so far as new NRFC deposits are raised.
Even if swaps are done with new forex deposits, a contingent liability arises for the central bank and therefore the government.
The transaction also tends to push interest rates down in the same way money is printed through open market operations, out of line with current external sector developments, though foreign reserves are seemingly going up.
Analysts have warned that building reserves through swaps is similar to the policy error made by the central bank of Lebanon and the policy errors committed in general by the Federal Reserve that led to the collapse of the Bretton Woods system and eventual bailouts by Roosa bonds.
Swaps will lead to negative foreign reserves and large losses when the currency eventually collapses from the suppressed interbank or other rates.
Up to around the third quarter of 2024 in particular, the central bank had conducted exceptional policy missing its high inflation target with East Asian style deflationary policy providing dollars not only for the government to repay debt but also repay its own debt and build reserves on both a net and gross basis.
(Colombo/Aug04/2025)