In October 2024, Sri Lanka’s central bank increased its forex market purchases to 189.5 million US dollars, up from 96 million dollars in September, according to official data. Since late 2022, the bank has adopted a deflationary approach, leading to balance of payments (BOP) surpluses amid weak private credit and net repayments of state energy enterprise credit.
In such a policy context, where the central bank mops up liquidity through dollar purchases and generates a BOP surplus, it can choose to let the exchange rate either appreciate, depreciate, or hold steady. Recently, the bank allowed currency appreciation—a shift from typical IMF program expectations, which often discourage appreciation in deflationary environments to maintain “competitive exchange rates.”
This currency appreciation has created a virtuous cycle of declining consumer prices, increased disposable income, and higher retail sales, amplified by wage increases from some companies. As economic capacity utilization rises, these factors are expected to drive future investment credit demand.
In October, alongside forex interventions, the central bank injected liquidity through open market operations (OMOs) at rates near its interest corridor’s lower end. This move has sparked concerns of potential policy missteps reminiscent of 2015 and 2018, when similar OMOs contributed to external instability during private credit recovery phases.
Debate continues over the practice of money injection in primary vs. secondary market purchases of government securities. Analysts recall 2018 as a cautionary year, marked by budget deficit reduction and market-priced fuel, but currency pressure arose from substantial OMO purchases of Treasuries aimed at rate targeting, ultimately causing currency depreciation.
Private credit is now showing steady recovery. However, not all new credit immediately drives unsustainable imports unlinked to dollar inflows; such credit may need several lending cycles to significantly impact imports. Conversely, specific credits—such as energy SOE loans for loss coverage or vehicle import loans—immediately impact the exchange rate. Government credit, primarily interest-bearing, does not exert similar pressure, provided debt rollovers proceed smoothly without rejected bids.
With SOEs managing positive cash flow in recent months due to a cost-based pricing formula and net debt repayment, interest rates have fallen without added money printing. Fiscal discipline has also improved, with primary surpluses reported, leaving only interest expenses contributing to the overall deficit.
