ECONOMYNEXT – Sri Lanka’s central bank should terminate its inflationary swaps and lock in foreign reserves represented by excess liquidity instead of temporarily mopping up excess liquidity overnight to push up interest rates.

Falling short term rates will lead to a quick credit recovery from Ditwah without formal rate cuts and discourage speculative capital flows.

The converse will lead to permanent monetary stability.

Last year a combination of rising overnight rates and rising bill rates in December by the Public Debt Management Office’s market driven auctions, helped in maintaining some degree of stability despite denied convertibility through highly discretionary exchange rate policy.

The central bank started deflationary open market operations on February 13, mopping up 20 billion rupees, when overnight excess liquidity went up to 297 billion rupees.

Slowdown

Some of the liquidity came due to a slowdown in credit which automatically reduces imports and is a reflection of the current status of the balance of payments.

Since such liquidity from dollar purchases which comes from the central bank preventing appreciation of the rupee is a reflection of slow credit and is not inflationary per se immediately.

It should lead to fall in interest rates and a quicker recovery in credit. There is no need to ‘cut rates’ when credit falls and liquidity builds up as long as there is a fixed exchange rate (a monetary rule).

Its inflation and economic hardship and the voter angst against the democratically elected government comes from preventing appreciation of the rupee back toward 300 to the US dollar, from the destruction of the value of the monetary unit that came from the denied convertibility in 2025.

The people have to depend on the kindness of the central bank whether the value of the monetary unit is kept or not (flexible non-rule).

If there was a clean float and no reserve target (a consistent monetary rule), then people do not have to depend on the kindness or lack of it of a central bank for their economic well-being.

Ditwah aid will go and rupee can depreciate

A part of the liquidity came from central bank purchases of Ditwah aid and remittances.

Again, if the central bank did not purchase dollars excessively to collect reserves in December, the rupee would have gone back to 300 to the US dollar and the government’s economic credentials would have been better and the well-being of the people would have been better. (See the problem with discretion?)

Ditwah money will eventually be spent by their recipients and they will trigger imports. If the central bank does not give the reserves (defend the currency against this liquidity created from monetizing the balance of payments surplus) the rupee will fall.

Sri Lanka has precedents in 2005.

Democracy and Bad Money

The fall in the value of the monetary unit has nothing to do with the government (except in so far as the 5-7 inflation target the central bank has persuaded the elected government to allow using econometrics and empirics and rejecting classical economic theory), but when the value of the monetary unit is destroyed and they suffer, people blame the government.

The ultimate political responsibility of an inflationist ‘independent’ central bank lies with the government in a democratic society, even though the agency not accountable. The government pays the price, and is accountable.

For example, the 2019-2022 administration paid the price for its potential output targeting through rate cuts. The next government paid the price for correcting policy (that stabilization crisis that follows rate cuts)

Unfortunately, the operating framework has not improved and in fact deteriorated with the single policy rate.

Democracy vs Inflationism

That is why ‘central bank independence’ is anti-democratic when the monetary authority is driven by inflationist ideology developed in the stimulus-happy West (potential output targeting, flexible high inflation targeting, REER targeting, full employment).

The problem in democracy and governance can clearly be seen: fiscal rules for the elected government (extremely good), but flexible non-rules for the un-elected central bank, which has potential output written into its new controversial law and does inflationary swaps (extremely bad).

The current auction – like system through which dollars are bought are also a deterioration of the operating framework of the central bank – but that is another story.

Some dollars also came through foreign purchases of rupee bonds.

Any purchase of bonds by foreigners will lead to easing g-sec yields (a real capital flow) and if the dollars are purchased by the central bank it will lead to a temporary fall in overnight rates also by expanding reserve money by monetizing the balance of payments.

Inflationary swap rupees will also create depreciation pressure in 2026

The third way liquidity was built, not just in December but throughout the year was through inflationary swaps.

The Committee of Public Finance has already taken up the matter, in a battle between democracy and inflationary operations.

The liquidity from inflationary swaps has little to do with current balance of payments but represents dollars in bank balance sheets collected in the past and are placed in say NOSTRO accounts offshore.

However as soon as these deposits are monetized by the central bank, the liquidity will turn into rupee credit and imports.

If the dollars are not given back, (the temporary reserves or ‘hot money’ reserves as the parliament committee has called it), then the rupee will also depreciate.

The parliament has created the money monopoly and it cannot afford to give discretion or flexibility to the central bank triggering social and political unrest.

Remember in the Aragalaya people wanted to burn down the parliament and 225 members, not the central bank and aggressive macro-economic policy, which was the culprit.

If there was free banking, and if there was no rupee monopoly parliament can allow an independent or discretionary or flexible or whatever type of central bank.

People will move their money from the depreciating money and denominate savings and salaries in some currency with a better operating framework. Inflation and interest rates will collapse and the country will grow fast with no external crises.

But there is a monopoly here, which the central bank is very keen on enforcing despite a 5 percent inflation floor rate, except for NRFC deposits which are now being monetized (deposit dollarization).

Repo Operations

The central bank started overnight repo auction (a deflationary operation) from February 13, 2026 when excess liquidity hit 297 billion rupees from balance of payments developments and inflationary swaps.

The overnight withdrawals have since gone up to 75 billion rupees, 7.64 percent.

Term operations also started in February 25, at 7.74 percent.

While these deflationary operations are well-intentioned and have no negative effects, and will not distort credit markets unlike inflationary OMO and swaps, they will not ultimately help retain reserves permanently.

Terminate the Swaps

What the central bank has to do is lock in the reserves from Ditwah purchases and any foreign purchases of bonds permanently by terminating the inflationary swaps.

The dollars in banks came from Sri Lanka’s high savings rate which has led to foreign reserves in private banks through a small gap (a little economic freedom given to people) in the central bank’s money monopoly.

Unfortunately, because the parliament has permitted inflationary swaps, and the savings of the people through the chink in the money monopoly has ended up depreciating the rupee.

In 2018, the emblematic year when tax hikes and market pricing of fuel ended up in depreciation and massive forex losses for the Ceylon Petroleum Corporation, privatization proceeds from Hambantota port were also monetized through buy-sell swaps.

The central bank is mounting a ‘speculative attack’ on its own currency through buy-sell swaps.

Make no mistake. The repo operations are well-intentioned. They may help reduce short term inflation.

But they will not help collect permanent reserves. Permanent central bank forex reserves come from permanent deflationary operations.

A problem

There is another problem from keeping up the single policy rate. Artificially keeping rates high will only encourage more hot money into rupee securities.

Some East Asian nations remove the floor rate and deflationary term operations when there is a slowdown in credit, which allows rates to fall faster and credit recovery.

Some East Asian nations do not have a policy rate in any case (Singapore, Hong Kong, Brunei).

Speculative capital inflows stop immediately as short term rates fall towards zero.

The policy rate (overnight or term) perpetuates a horrific ‘transmission mechanism’ completely out of step with the balance of payments and leads to massive crises.

That was the problem with Thailand’s Bangkok International Banking Facility (BIBF), which led to large capital inflows (due to the policy rates) and current account deficits and the ultimate collapse from buy sell swaps with speculative capital.

RELATED : Thailand currency crisis, central bank blunder explained to Sri Lanka

Hong Kong (which has vastly more foreign short-term capital than BIBF) but no true policy rate did see the currency collapse.

Neither did Singapore – which however had restrictions on foreign lending in domestic currency which prevented Soros-style swaps for many years – unlike Hong Kong which was completely free.

The converse is also true. When funds flow out, rates have to rise and domestic credit has to slow so that imports will reduce to pay for the capital outflows.

The East Asian crisis was not the result of the BIBF, as claimed by financial media, but the increasing reliance on the policy rate in the 1990s after the US started to change rates by press conference and the ‘transmission mechanism’.

Long term rates are governed by different fundamentals to short term rates. The transmission mechanism of the 1980s and 1990s is a horrific distortion.

The Reserve Bank of India and the rupee since 2011 is a cautionary tale.

Follow Countries that do Not go the IMF

If Sri Lanka’s parliament succeeds in keeping the value of the monetary unit strong, interest rates will eventually fall as domestic capital destruction stops.

Interest rates are function or capital, classicals have pointed out  ad nauseum, not reserve money as post 1923 central bankers believe or John Law believed.

Sri Lanka cannot have a single policy rate, an IMF reserve target and repay foreign debt. That way lies the second IMF-second-amendment, or peacetime Latin America-Poland default.

If Sri Lanka wants to grow, avoid social unrest, the practices of countries that do not go to the International Monetary Fund should be followed.
Or follow those that change the operating framework back to classical rules (Hume, Ricardo) after facing an external crisis.
The classical economists knew something, though they may not have known how to do econometrics (Theil was born in 1924).

They had reasoning powers and knew how the real world worked and the consequences of manipulating rates for political purposes of the central bank (policy rate) or any others at the expense of monetary stability. (Colombo/Feb26/2026)