FINANCIAL CHRONICLE – According to Evan Papageorgiou, the Mission Chief of the International Monetary Fund (IMF), the Sri Lankan Treasury has refrained from purchasing dollars as a standard practice, relying instead on the central bank for such transactions. He clarified this point during a press briefing following the approval of two reviews, stating, “The central bank serves as an intermediary for financial flows, maintaining close contact with financial markets, and as a result, the treasury does not engage in foreign exchange matters.” He emphasized that this is a commonplace arrangement among various countries, indicating there is nothing unusual about Sri Lanka’s approach.
When the central bank acquires dollars, it generates new money, which leads to the monetization of the balance of payments. This process, often described as a pegging operation, results in an increase in reserve money and contributes to excess liquidity in the market.
There have been suggestions to permit the Treasury to purchase its own dollars, as the central bank typically loses its capacity to gather reserves approximately 16 months to two years following the resolution of a prior crisis. This decline is attributed to its ongoing effort to achieve a 5 percent increase in the cost of living under a ‘flexible’ inflation-targeting framework.
Former Deputy Governor W A Wijewardene recently commented on this situation, noting that to reach inflation targets, the central bank has lowered policy rates by around 6 percentage points, encouraged banks to boost lending to the private sector, and expanded reserve money by purchasing foreign exchange from the open market.
Since Wijewardene’s retirement in 2011, Sri Lanka has experienced multiple currency crises both inside and outside of IMF programs. These crises have been linked to various factors, including gold, vehicle imports, current account deficits, the withdrawal of rupee bondholders, and external shocks.
Sri Lanka’s currency issues date back to February 1952, shortly after the establishment of the central bank, despite having maintained high reserves and currency stability following World War II. Notably, in 1949, the rupee was devalued to align with a crisis affecting the British pound.
Prolonged periods of unsterilized dollar purchases have led to increased living costs, making the credit system susceptible to currency pressures, depreciation, and unmet reserve targets. However, it is possible for the Treasury to purchase dollars without disrupting monetary policy through what is termed a ‘reserve money neutral’ transaction.
While a central bank without a policy rate can buy dollars and sell them to the Treasury without complications through unsterilized transactions, this flexibility is absent when a policy rate is in place.
In early 2025, concerns were raised that the central bank would struggle to accumulate adequate reserves under the existing IMF program, as it lacked a downward-sloping Quality Parameter Curve (QPC) concerning its domestic asset stock relative to reserve targets. IMF officials indicated that the central bank could opt to issue its own securities if necessary.
The current IMF program establishes reserve targets that have been lowered and now impose a fixed ceiling on the central bank’s domestic assets. By early 2025, it became clear that private credit was on the rise while interest rates were insufficient to support reserve accumulation. The central bank resorted to buy-sell swaps, thereby injecting additional liquidity into the system.
Moreover, the coupons on the central bank’s bond stock effectively absorb liquidity on a permanent basis, thereby ‘safeguarding’ some reserves. Analysts have warned that not only may reserve targets be missed, but the country could also face defaults even amidst budget surpluses if it continues to rely on the central bank’s dollar purchases while pursuing the current 5 percent inflation target. (Colombo/May 31/2025)
