ECONOMYNEXT – Sri Lanka’s private credit recovered strongly in March, and the rupee whimpered in cascading credit driven by money printed through fx swaps and dollar purchases that aggressively signalled the market to depreciate the currency.

The external problems are coming amid current and overall budget surpluses.

On Tuesday, the rupee fell to 323.25/75 to the US dollar around 322/322.30 levels in a constrained spot market which was largely inactive.

One-week forwards were quoted close to 324 to the US dollar, market participants said.

Sri Lanka rupee was depreciated from 309.50/60 on December 30, 2025 long before the Middle East War, though it is now a convenient excuse for macro-economists to escape accountability.

Hit Wicket with Fx Swaps and Excess Dollar Purchases

The rupee was also aggressively depreciated from 292 to the US dollar to 309 over 2025 by purchasing dollars for new money (monetizing the BoP) and not giving dollars (convertibility) when the unsterilized liquidity came back as imports.

The central bank had a chance (perhaps the last chance) to allow the rupee to appreciate in February and restore market confidence in one shot, as private credit collapsed after a shock from Ditwah, and a 460 dollar balance of payments surplus developed, but it was ruthlessly monetized and left unsterilized.

Amid strong public opposition to central bank printing money through conventional means against domestic assets to increase the cost of cost of living and trigger external trouble, the agency resorted to printing money through swaps which were left unsterilized.

Banks brought offshore dollars, they had collected during a credit contraction, back to for the central bank to monetize.

Meanwhile finance companies also borrowed abroad and swapped with banks, reminiscent of the swaps that were used by hedge funds to hit East Asian currencies.

The central bank then denied convertibility (refused to give dollars to the new rupees created), depreciating the currency.

In April the central bank sold dollars to the market on a net basis providing some (weak-side) convertibility.

It should not have bought in the first place at depreciated prices (strong side convertibility when there was no ‘strong ‘side) signaling the market to depreciate.

The Middle East war had little to do with the current trouble, though such shocks tend to expose weaknesses in the operating framework.

The Reserve Bank of India – the original bad boy central bank of South Asia – is also grappling with a similar problem. Macro-economists in India have imposed draconian exchange controls, taxed gold and imposed trade controls after gaining control of the Reserve Bank of India.

Defaulting on the note issue

When a reserve collecting central bank denies convertibility to newly created rupees, which boomerang as imports, it defaults on its own note issue.

The central bank’s default on the note-issue then becomes a default on the other payments, including government debt as time goes by.

This column had warned that the external default from forex shortages created by the central bank’s 5 percent inflation target and deeply flawed operating framework, can happen regardless of whether taxes improved budgets.

The rupee depreciated recently amid monthly budget surpluses, an amazing situation after several years of currency stability, which has now been lost.

For decades macro-economists who printed money (by monetizing new government debt or debt from past deficits held in banks) to keep rates down had blamed budget deficits to escape accountability for their actions.

In the first two months of 2026, there was a 170 billion rupee budget surplus in Sri Lanka.

By forcing the government to borrow abroad (create a surplus in the financial account) after depreciating the rupee and destroying capital (bank savings and EPF balances) macroeconomists have scapegoated a ‘current account deficit’ or trade deficit resorting to Mercantilism to escape accountability.

Exchange rate as the first line of defence, promoted by the International Monetary Fund, is also an institutionalized excuse for a reserve collecting central bank to default on its note issue and escape accountability.

A reserve collecting central bank resorting to ‘exchange rate as the first line of defence’, after issuing new money is the same as a person dishonoring cheques. (The origin of bank notes were cheques in any case).

Surviving by Escaping Accountability

Sri Lanka’s exchange controls also show that the central bank is completely unaccountable for printing money and creating external trouble and has been so for decades, but has survived to create new trouble and new IMF programs.

Sri Lanka’s external problems come from rejecting classical economics, mainly the price specie flow mechanism of Hume and by the central bank behaving like a rogue note issue bank described by Adam Smith.

When the inflationist 5-percent inflation targeting operating framework is used to keep rates down for a sufficiently long period the country can default on its external debt, regardless of improvements in the budget.

The central bank has several tools in its arsenal to trigger the next sovereign default.

The first tool is the single policy rate enforced with excess liquidity (mid-corridor or floor system), which was also used in the first sovereign default.

Political Ravishment of the Rupee

In the current episode of external trouble excess liquidity was created by money printed through swap liquidity (monetizing foreign assets of banks) and over purchases of dollars for new money (monetizing the balance of payments).

The second key tool is to use the central bank’s money monopoly, block the Treasury from buying dollars to repay debt and make it hostage to central bank reserves and new dollar debt.

However, the central bank is singularly unqualified to collect reserves as it creates new money in the process of collecting reserves, unlike the Treasury.

If the new rupees are not mopped up by selling down the central banks’ bond stock outright (or selling to the Treasury for new rupees as a back-to-back transaction), the rupee depreciates when the new notes turn into imports through private credit.

This is the main tool through which the country is forced into a ‘debt trap’ by inflationist macro-economics.

The central bank has also blocked the Treasury from charging taxes in dollars, using the ancient privilege given by kings to favoured note-issue banks called ‘Government Acceptance’.

This is the third tool through which reserve collecting central banks in defaulting countries force the government into a ‘debt trap’ and eventual default.

However, there is already a legal tender law, and this ancient privilege, which blocks the second source of non-debt dollar inflows to repay debt, is not needed to force people to use the central bank’s unsound, inflating, depreciating money. (Sri Lanka central bank warns of fines, imprisonment for breaking money monopoly)

This column had pointed out that Argentina routinely brings debt down to 60 percent of GDP, (to the level of Germany) and then defaults by keeping rates down and resorting to exchange rate as the first line of defence. Mexico went into a credit crisis with a budget surplus in the 1990s.

Sri Lanka now has very high income tax levels, which are uncompetitive with countries with monetary stability, and has undermined the growth framework, simply because the central bank rejects classical economics and insists on high inflation and depreciation.

This is a problem that started with the first currency crisis that the central bank created in 1952.

Inflation Politics of Independent central banks

Inflation politics of ‘independent’ central banks came as full employment policies in the 1960s, the post 2000 reflation mania which ended with the housing bubble, and the abundant reserve regime (floor or single policy rate) that followed.

In Sri Lanka it is seen as the potential output targeting, the 5-percent inflation (the central bank labours under the belief that inflation rather than stability brings growth despite triggering serial currency crises and a sovereign default) and the single policy rate.

There can be no policy of ending stability and going on a growth path, budget surplus or not.

The persistent inflation and the destruction of real wages by macro-economists who run abundant reserve regimes have made countries ungovernable. In the UK the Bank of England operating framework has led to six prime ministers in 10 years  amid what what the British media quaintly calls the ‘cost of living crisis’ . There could be another.

In the US, Trump has been elected twice. In Europe nationalist parties are on the rise. But like the Gotabaya Rajapaksa administration, they are also falling as seen in Hungary. The florint depreciated steeply in the last election cycle.

This is a much worse situation than in the 1970s when central banks ran un-anchored policy for 10 years.

Now bad policies of ‘independent central banks’ have run for around 25 years and there is no political pushback unlike in the late 1970s and early 1980s.

The situation is perhaps closer to what was seen in the 1930s which led to rise in Hitler and other fascist parties in Europe after the Fed invented the policy rate and triggered the Great Depression which then led to peacetime depreciation and the birth of Keynesianism and ‘macro-economic policy.’

Defaulting with Budget Surpluses

A root cause of the current external problems in Sri Lanka lies in the last phase of the IMF program where the central bank was expected to collect reserves without selling down its bond stock (i.e a reducing its domestic assets through a falling ceiling for net credit to government), unlike in previous phases of the program.

The May 2025 rate cut and the introduction of the single policy rate, then further reduced the ability to collect fx reserves.

The effect of the rate cut and single policy rate was covered up with swaps, mi-stating gross reserves and misleading the parliament on net reserves. The Committee on Public Finance has questioned both actions.

RELATED : Sri Lanka central bank warned local fx swaps are a ‘hot money operation’ by COPF members

RELATED : Central bank swaps symptomatic of Sri Lanka’s IMF return tickets and default: Bellwether

These events have shown the danger of giving ‘independence’ to a central bank that believes inflation rather than monetary stability leads to growth.

It is however still possible to pull the country out of the default track.

The central bank has to extinguish the excess liquidity either by terminating swaps, or by selling down its bond stock allowing an interest rate structure compatible with debt repayments to re-emerge.

RELATED : Sri Lanka should terminate CB swaps, lock in foreign reserves bought outright

It has to give up its monopolies and privileges, which pushes the Treasury into a debt trap and denies it non-debt inflows of dollars to service debt.

The new IMF program has to force the central bank to sell down its bond stock in proportion to its reserve target, through deflation policy.

If not, to compensate for lack of deflationary policy enabling the CB to build reserves through current inflows, Treasury has to be allowed to buys current dollars from its rupee revenues like the CPC or anyone else.

If not, Sri Lanka can default with budget surpluses.