ECONOMYNEXT – Sri Lanka’s state funds are enhancing with folks’s incomes recovering to nearly pre-crisis ranges, however the brand new Worldwide Financial Fund mortgage exposes the fragility of the versatile inflation concentrating on, versatile change charge regime.
With doable headwinds from renewed inflationary coverage from the Fed, and the Might charge minimize, it’s not in any respect a rosy 2026 that Sri Lanka is going through.
This column was written within the final week of December and revealed within the January 2026 situation of Echelon Journal
The brand new IMF loans after Ditwah additionally smacks of the Yahapalana-era Energetic Legal responsibility Administration legislation which led to a frenzy of international borrowings to repay maturing debt, the as an alternative repaying debt with present inflows by sustaining financial stability.
Sri Lanka’s central financial institution’s present management by appreciating the foreign money from 300 to 360 to the US greenback and maintaining it round 300 supplied a powerful basis for non-inflation development and for folks to select up their lives and feed themselves.
Nonetheless, the regular depreciation of the rupee amid sturdy financial fundamentals particularly after the Might charge minimize, has uncovered the fragility and the hazard posed by the versatile change charge.
Fragility : Skinny Default Margin
This column warned in July that the Might charge minimize elevated default danger by scaling down the buffer, to repay debt. Any such ‘buffer’ was not previous collected reserves however the capability to gather {dollars} on an ongoing foundation, which was the rate of interest construction.
“Latest coverage actions by the central financial institution have decreased the buffer Sri Lanka had towards the subsequent default, with the most recent being the final charge minimize, which got here as deposit charges have been starting to rise,” this column warned in July.
“Whereas inflationary open market operations will result in zero reserves being collected and Sri Lanka dropping reserves, signalling might result in decreased fx collections and punishing of thrift.”
RELATED : Sri Lanka central financial institution skating on skinny default ice with newest charge minimize
This column additionally warned a number of occasions that reserves targets is probably not met if charges are minimize based mostly on 12-month historic inflation (econometrics), rejecting classical financial concept.
The IMF has since adjusted its reserve targets, although the central financial institution has been gathering internet reserves.
The Exterior Financing Hole comes from mis-aligned rates of interest
The 18th IMF program, with 200 million given within the type of a Speedy Finance Instrument as an emergency mortgage, has uncovered the fragility of the nation’s capability to repay loans at present rates of interest.
The IMF’s ‘exterior financing hole’ will not be an absolute worth decided by cost wants however an imbalance created by artificially low credit score which boosts home credit score and imports (present account outflows) and reduces the flexibility to gather {dollars} to repay debt (monetary account outflows).
The IMF loans and the additional finances assist loans will scale back the rate of interest correction and hold the import excessive.
That is precisely what occurred within the Yahapalana interval.
The Yahapalana-era international debt addition was pushed by charge cuts for versatile inflation concentrating on which boosted credit score and the depreciation that unsettled international traders.
It’s the truth is a variation of the non-existent ‘Switch Downside’ of Keynes.
The brand new IMF mortgage and the extra finances assist loans underline the issue.
Fragility : Rupee Depreciation from Arbitrary Interventions
The fragility of the present financial framework can be seen within the versatile change charge, a regime of advert hoc interventions gathering reserves in a pegged regime to construct reserves, however arbitrarily denying convertibility when rupees created by the central financial institution turns into imports as if a clear float was in operation.
It’s by way of personal credit score that the brand new rupees flip into credit score.
The yo-yo change charge regime has led to depreciation of the rupee with none inflationary coverage per se, besides the brand new rupees created by the acquisition of the {dollars}, which the founder governor of the central financial institution referred to as the monetization of a stability of funds surplus.
The rupee fell from 290 to 310 to the US greenback over 2025. There’s actually no restrict that the rupee can fall, if the central financial institution continues to buy {dollars} above the deflationary coverage from coupons on its bond portfolio.
In impact the depreciation is coming from an change charge coverage error involving rejecting classical economics and not likely financial coverage.
All financial and change charge coverage errors and flaws within the working framework, finally find yourself on the change charge and by extension the stability of funds.
The Catastrophe Impact
In 2004, when principally financial coverage errors have been driving the rupee down – on the time cash was printed to make up for misplaced revenues from gas taxes in addition to some sterilized foreign exchange gross sales – the rupee depreciated steeply.
This was the time when politicians and the media began the battle towards cash printing.
The rupee stopped depreciating in January after the tsunami. Although some folks attributed it to tsunami support, the true purpose was a collapse in personal credit score after the tsunami.
Graph HEADLINE : Catastrophe Stability
SUBSHEAD : The credit score shock from tsunami helped stabilize the rupee
Non-public credit score which was easing in December, collapsed in ensuing months. It took just a few months for consumption and funding to renew.
The tsunami killed 30,000 folks and there many individuals have been in shock with kinfolk and senior company figures who have been on vacation additionally succumbing to the tsunami.
The Ditwah cyclone has not delivered such a shock to the psyche of the folks, however has unsettled many.
With 1.7 to 2 million folks displaced, they are going to take time to renew their regular consumption patterns even once they return to their houses.
Car importers are already complaining of collapsed gross sales.
It’s possible that there’s an instantaneous credit score shock, which is able to ease as reconstruction begins.
Sweeping Subsidies
Not like in 2004, this time the federal government is giving sweeping reduction funds to Ditwah victims.
The funds are to come back from an overborrowed home ‘buffer’.
Nonetheless, any home buffers deposited in banks are more likely to be re-loaned to different debtors within the interbank market.
Withdrawing giant volumes deposits from banks is more likely to dislocate belongings and liabilities within the banking system, placing some stress on rates of interest.
Any try and suppress any spikes in charges, with liquidity injections might destabilize the exterior sector and the change charge.
The federal government needs to be cautious to not create an financial cyclone from catastrophe reduction because the working framework of the central financial institution is weak and charges have been minimize too low already.
Additional depreciation won’t assist the victims of Ditwah or the earlier victims of the 2022 foreign money collapse who can’t nonetheless feed themselves correctly.
That change charges are ‘market decided’ is a foolish declare that permits macro-economists to flee accountability for rejecting economics and operating flawed working frameworks.
Trade charges are the end result of financial coverage (clear floating change charges), change charges (exhausting peg), arbitrary and free-for-all arbitrary change charge and financial coverage actions in versatile change charge regimes.
Exterior Headwinds
There’s additionally the opportunity of a renewed commodity bubble from the Federal Reserve, de-stabilizing the world.
Since March 2022 the Fed had engaged in deflationary coverage (amount tightening) and in addition charge hikes.
Nonetheless, the Fed has now stopped amount tightening, amid nonetheless rising inflation, and there may be an try to take care of excessive ranges of extra liquidity.
The present working framework of the Fed has advanced because the firing of the housing and meals and vitality bubble in 2008 and the amount easing to cease the precise debt deflation (credit score contraction and dangerous loans) that normally follows stimulus.
The present working framework is a “made up as we go alongside” sort, because the Fed tumbled from commodity buble to the opposite rejecting classical economics, after the housing bubble burst.
The Federal Reserves’ commodity bubbles have had disastrous results on Sri Lanka’s stability of funds after the central financial institution was created.
After a full -blown stabilization disaster involving tax hikes and charge hikes nationalists got here out of the woodwork and minority oppression got here within the wake of the election that adopted.
The Fed for a few years didn’t have a typical deposit facility and its slim charge goal (single coverage charge) tended to blow asset value bubbles particularly after Greenspan got here. He normally tamped them down saying irrational exuberance for instance.
Till 2003 the Fed didn’t have an inflation concentrating on framework.
Fed is now reducing charges with every kind of ongoing bubbles in crypto, in gold and in addition shares, whereas unusual individuals are struggling inflation making an attempt to stave off a collapse.
Most meals and vitality commodities are nonetheless muted, or they have been till amount tightening was ongoing.
Nationalists are on the March in Europe underneath the inflation and instability of the ample reserve regime (single coverage charge). Battle drums are beating.
Not like within the First World Battle or World Battle II, Sri Lanka doesn’t have a strong financial regime to guard the financial system.
Nationalists got here out of the work within the stabilization disaster that adopted.
Below the present financial legislation, versatile inflation concentrating on/versatile change charge in 2025, a cyclone has triggered an IMF program.
“Cyclone Ditwah has worsened Sri Lanka’s short-term outlook, giving rise to an pressing BOP want, which if unaddressed, would lead to rapid and extreme financial disruption,” the IMF mentioned in approving the RFI mortgage.
The ‘pressing BOP want’ was estimated at 720 million {dollars}, the IMF mentioned.
The inflows will assist hold charges under the extent it might have in any other case been.
The Thirst for Inflationary Coverage
It was scary to see what number of macro-economists and others in numerous boards requested Central Financial institution Governor Nandalal Weerasinghe whether or not charges will probably be minimize, when Trump tariffs hit.
Fee cuts made on the concept ‘actual’ rates of interest being excessive have been excessive a return to precise inflationary coverage (selective convertibility can be a sort of inflationism because it results in depreciation) will result in a swift unravelling of the exterior sector and a second default.
Except there may be extra deflationary coverage, the Treasury can’t rely upon the central financial institution to repay debt.
The plain reality is until there’s a pegged change charge, the central financial institution has no method to acquire reserves. The extra the central financial institution leans in the direction of a float underneath its ‘versatile’ change charge: the much less it will likely be capable of acquire international reserves.
If the rupee continues to depreciate – particularly if/when the Fed fires a commodity bubble – President Anura Kumara Dissanayake could be historical past.
When the Fed fired a bubble round 1951, Ceylon, a rustic that survived two World Wars, and the Nice Melancholy with file international reserves underneath a foreign money board, went right into a tailspin from 1952 underneath the brand new central financial institution that led to avenue protests, police shootings, and a resigned Prime Minister.
Free the Hostage
Given the 5 p.c inflation goal and the depreciation seen in 2025 with a benign exterior atmosphere, the Treasury ought to urgently construct its personal sources of {dollars}.
The Treasury can buy its personal {dollars}. Greater than that the Treasury ought to cost taxes in {dollars} from those that will pay it.
In the mean time the Treasury is hostage to central banks financial coverage in getting reserves to repay debt. If not, the Treasury has to borrow finances assist loans or go to markets to repay debt.
If the well being ministry should purchase {dollars} for rupees to pay import payments on medicine, so can the treasury purchase {dollars} to repay mortgage instalments and coupons.
It’s so foolish that cash is borrowed from the IMF or the Treasury waits for the central financial institution to provide {dollars} that the financial authority buys for newly created cash.
The Treasury additionally doesn’t get greenback revenues on account of privilege given to the central financial institution to cost taxes in rupees and provides the rupees credibility (Authorities Acceptance).
It’s a privilege that needs to be eliminated forthwith. By debasing cash, from 4.70 to 310 to the US greenback since its creation, the central financial institution, particularly after 1980, has abused the privilege.
It’s all very foolish. All that is occurring as a result of the present financial legislation, made with IMF recommendation for financial coverage modernization (learn new and modern methods to print cash) doesn’t make up a cohesive entire.
The previous legislation – earlier than a few of the later amendments – no less than made as much as a cohesive entire.
The Treasury additionally has euro loans. The treasury needs to be allowed to gather taxes in any foreign money that it has loans in.
That is particularly so, as a result of the restructured sovereign bonds are amortizing. And it’s a good likelihood to do away with the international debt habit that began with foreign exchange shortages from versatile inflation concentrating on.
If there are any authorized impediments to the Treasury shopping for {dollars} or getting greenback taxes in international foreign money, they need to be eliminated.
Whereas fiscal enhancements assist, they won’t cease a second default, until the reason for the foreign money disaster and extreme international borrowings after the top of the civil battle is eliminated.
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