ECONOMYNEXT – Sri Lanka’s central bank has sold 356.1 billion rupees of foreign exchange (about 1.1 billion US dollars) to the government to repay debt, in 2025, in unsterilized reserve sales, official data showed.
The central bank had also created 530.3 billion rupees of new money purchasing dollars on a net basis (about 1.7 billion US dollars at an average exchange rate of 301 rupees), effectively monetizing a balance of payments surplus, data from a market operation report for 2025 showed.
An unsterilized purchase of dollars creates liquidity and makes overnight rates fall, and will eventually trigger imports though consumption and investment credit. Since Sri Lanka has a high private savings rate, credit is required to turn all dollar receipts to imports and consumption alone is not sufficient.
An unsterilized dollar sale to repay debt, will reduce liquidity and push up overnight rates, reversing the effect of dollar purchases and strengthening the currency.
However if inflationary open market operations are deployed to narrowly target overnight rates (soft-pegging or flexible exchange rate_, more credit is financed with non-existent deposits and there is excess demand for dollars.
Currencies fall (there is monetary depreciation) in countries with central banks that attempt to narrowly target short term rates after defending a peg (flexible exchange rates) and lead to loss of confidence and eventual sovereign default.
Deflationary Policy
The central banks also allowed 6.7 billion rupees worth Treasury bonds – bought violating a long-held ‘bills only policy’ during previous crises to target gilt rates – to expire without renewing, deliberately deflating or mopping up some money and helping retain reserve.
In addition to dollar sales for debt repayment, new money cash from fx purchases were also deflated by 189.5 billion rupees of coupon payments made by the Treasury to the central bank’s rupee bond portfolio.
Any mopped money reduces domestic investment credit and imports, triggering a balance of payments surplus (inflows of dollars exceed outflows due to mopped up money) which can be monetized by purchasing dollars by the central bank at a fixed exchange rate.
Any over-purchases however, lead to monetary depreciation and inflated prices of imported and exported traded goods, which will lead to eventual social unrest as food and energy prices go up.
The depreciation in 2025 has already led to fuel price rises, despite falling global energy commodity prices from better US monetary policy and a led to request by the CEB to raise energy prices despite reduced coal prices.
Net currency withdrawals, which can come from a demand for money in the economy, and expand notes in circulation, was 210.2 billion rupees.
Depreciation which inflates money prices of traded goods in the first instance, can also increase the demand for base money. Classical economic analysts have noted that in periods of hyper-inflation which accompanies severe monetary depreciation, shortages of notes have occurred.
Inflationary Policy
The central bank in 2025 had also increased buy-sell swaps effectively monetizing bank dollar balance sheets (and not current inflows or a BOP surplus) creating 258.6 billion rupees in new money.
When banks give the rupees to customers through loans or to the government as taxes or bond purchases and the central bank does not return dollars to importers or the government at the same rate, there is monetary depreciation even if there is no excessive inflationary policy.
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Sri Lanka’s rupee depreciated rapidly in 2025, in what analysts called political ravishment or a flaw in the operating framework, due to not returning to private importers dollars at the same rate as they were bought, despite broadly deflationary policy, other than swaps.
The world was hit by currency depreciation between World War I and World War II (monetary instability without war) as the indiscriminate open market operations and the policy rate invented by the Fed spread, after triggering the Great Depression. Keynesian stimulus and the age of inflation followed.
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Sri Lanka’s Treasury should buy its own dollars – like any other importer, or a student who pays exam fees – repay debt instead of depending on the central bank for ‘reserves’ – an action which does not create new money, instead of giving the central bank a monopoly in supplying it with dollars, analysts have said.
Unlike the Treasury which can buy dollars from existing reserve money, the central bank is ‘supremely unqualified’ to collect dollars since creates new money, and also does not return them at the same rate, deprecating the currency, analysts have pointed out.
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The overall rejection of economics including the falling knowledge about operating frameworks of note-issue banks after World War II in particular, and blaming trade deficits for monetary depreciation, has been described by some classical economists as a ‘decline in reason’.
Sri Lanka was hit by inflation higher than advanced nations from monetary depreciation that started after the International Monetary Fund’s second amendment to its articles in the early 1980s triggering social unrest and discrediting the deepest economic reforms ever made in the nation.
Latin American nations as well as countries like Poland which had heavy foreign debt, then started to default. (Colombo/Jan06/2026 – graph data corrected)