Sri Lanka’s state finances are improving with people’s incomes recovering to almost pre-crisis levels, but the new International Monetary Fund (IMF) loan exposes the fragility of the flexible inflation targetting, flexible exchange rate regime.
With possible headwinds from renewed inflationary policy from the Fed, and the May rate cut, it is not at all a rosy 2026 By Bellwether that Sri Lanka is facing.
The new IMF loans after Ditwah also smack of the Yahapalana-era Active Liability Management law, which led to a frenzy of foreign borrowings to repay maturing debt, instead of repaying debt with current inflows while maintaining monetary stability.
Sri Lanka’s central bank leadership, by appreciating the currency from 360 to 300 per US dollar and keeping it around 300, provided a strong foundation for non-in-flationary growth and allowed people to rebuild their lives and feed themselves.
However, the steady depreciation of the rupee amid strong economic fundamentals, especially after the May rate cut, has exposed the fragility and the danger posed by the flexible exchange rate.
Fragility: Thin Default Margin
This column warned in July that the May rate cut increased default risk by thinning out the buffer to repay debt. Any such “buffer” was not based on past collected reserves but the ability to collect dollars on an ongoing basis, which was the interest rate structure.
“Recent policy actions by the central bank have reduced the buffer Sri Lanka had against the next default, with the latest being the last rate cut, which came as deposit rates were beginning to rise,” this column warned in July. “While inflationary open market operations will lead to zero reserves being collected and Sri Lanka losing reserves, signalling may lead to reduced FX collections and punishing of thrift.”
This column also warned multiple times that reserves targets may not be met if rates are cut based on 12-month historical inflation (econometrics), rejecting classical economic theory.
“The 18th IMF programme, with $200 million given in the form of a Rapid Finance Instrument (RFI) as an emergency loan, has exposed the fragility of the country’s ability to repay loans at current interest rates.”
The IMF has since adjusted its reserve targets, though the central bank has been collecting net reserves.
The External Financing Gap Comes From Misaligned Interest Rates
The 18th IMF programme, with $200 million given in the form of a Rapid Finance Instrument (RFI) as an emergency loan, has exposed the fragility of the country’s ability to repay loans at current interest rates.
The IMF’s “external financing gap” is not an absolute value determined by payment needs but an imbalance created by artificially low credit which boosts domestic credit and imports (current account outflows) and reduces the ability to collect dollars to repay debt (financial account outflows). The IMF loans and the extra budget support loans will reduce the interest rate correction and keep the import high.
This is exactly what happened in the Yahapalana period.
The Yahapalana-era foreign debt addition was driven by rate cuts for flexible inflation targetting which boosted credit and the depreciation that unsettled foreign investors. It is in fact a variation of the non-existent ‘Transfer Problem’ of Keynes.
The new IMF loan and the additional budget support loans underline the problem.
Fragility: Rupee Depreciation From Arbitrary Interventions
The fragility of the current monetary framework is also seen in the flexible exchange rate, a regime of ad hoc interventions collecting reserves in a pegged regime to build reserves, but arbitrarily denying convertibility when rupees created by the central bank turn into imports as if a clean float was in operation.
It is through private credit that the new rupees turn into credit.
The yo-yo exchange rate regime has led to depreciation of the rupee without any inflationary policy per se, except the new rupees created by the purchase of the dollars, which the founder governor of the central bank called the monetisation of a balance of payments surplus.
The rupee fell from 290 to 310 to the US dollar over 2025. There is really no limit that the rupee can fall, if the central bank continues to purchase dollars above the deflationary policy from coupons on its bond portfolio. In effect, the depreciation stems from an exchange rate policy error involving the rejection of classical economics rather than from monetary policy alone.
All monetary and exchange rate policy errors, along with flaws in the operating framework, ultimately surface in the exchange rate and, by extension, the balance of payments.
The Disaster Effect
In 2004, when mostly monetary policy errors were driving the rupee down — at the time money was printed to make up for lost revenues from fuel taxes as well as some sterilised forex sales — the rupee depreciated steeply.
This was the time when politicians and the media started the battle against money printing.
The rupee stopped depreciating in January after the tsunami. Though some people attributed it to tsunami aid, the real reason was a collapse in private credit after the tsunami.
Private credit, which was easing in December, collapsed in the ensuing months. It took a few months for consumption and investment to resume.
The tsunami killed 30,000 people, and many people were in shock with relatives and senior corporate figures who were on holiday also succumbing to the tsunami.
The Ditwah cyclone has not delivered such a shock to the psyche of the people, but has unsettled many.
With 1.7 to two million people displaced, they will take time to resume their normal consumption patterns even when they go back to their homes.
Vehicle importers are already complaining of collapsed sales.
It is likely that there is an immediate credit shock, which will ease as recon-
struction starts.
Sweeping Subsidies
Unlike in 2004, this time the government is giving sweeping relief payments to Ditwah victims. The funds are to come from an overborrowed domestic “buffer”.
However, any domestic buffers deposited in banks are likely to be re-loaned to other borrowers in the interbank market.
Withdrawing large volumes of deposits from banks is likely to dislocate assets and liabilities in the banking system, putting some stress on interest rates. Any attempt to suppress any spikes in rates with liquidity injections could destabilise the external sector and the exchange rate.
The government should be careful not to create an economic cyclone from disaster relief as the operating framework of the central bank is weak and rates have been cut too low already. Further depreciation will not help the victims of Ditwah or the previous victims of the 2022 currency collapse who cannot still feed themselves properly.
That exchange rates are “market determined” is a silly claim that allows macroeconomists to escape accountability for rejecting economics and running flawed operating frameworks.
Exchange rates are the outcome of monetary policy (clean floating exchange rates), exchange rates (hard peg), arbitrary and free- for-all arbitrary exchange rate and monetary policy actions in flexible exchange rate regimes.
External Headwinds
There is also the possibility of a renewed commodity bubble from the Federal Reserve, de-stabilising the world. Since March 2022, the Fed had engaged in deflationary policy (quantity tightening) and also rate hikes.
However, the Fed has now stopped quantity tightening, amid still rising inflation, and there is an attempt to maintain high levels of excess liquidity.
The current operating framework of the Fed has evolved since the firing of the housing and food and energy bubble in 2008, and the quantitative easing to stop the actual debt deflation (credit contraction and bad loans) that usually follows stimulus. The current operating framework is a “made up as we go along” type, as the Fed tumbled from one commodity bubble to another, rejecting classical economics after the housing bubble burst.
The Federal Reserves’ commodity bubbles have had disastrous effects on Sri Lanka’s balance of payments after the central bank was created.
After a full-blown stabilisation crisis involving tax hikes and rate hikes, nationalists came out of the woodwork, and minority oppression came in the wake of the election that followed.
For many years, the Fed did not have a standard deposit facility, and its narrow rate target (single policy rate) tended to blow asset price bubbles, especially after Greenspan came. He usually tamped them down, saying “irrational exuberance,” for example.
Until 2003, the Fed did not have an inflation targetting framework.
The Fed is now cutting rates with all kinds of ongoing bubbles in crypto, in gold, and also stocks, while ordinary people are suffering inflation trying to stave off a collapse.
Most food and energy commodities are still muted, or they were until quantitative tightening began.
Nationalists are on the March in Europe under the inflation and instability of the abundant reserve regime (single policy rate). War drums are beating. Unlike in the First World War or World War II, Sri Lanka does not have a robust monetary regime to protect the economy.
Nationalists came out of the wood work in the stabilisation crisis that followed.
Under the current monetary law, flexible inflation targetting/flexible exchange rate in 2025, a cyclone has triggered an IMF programme.
“Cyclone Ditwah has worsened Sri Lanka’s short-term outlook, giving rise to an urgent BOP need, which if unaddressed, would result in immediate and severe economic disruption,” the IMF said in approving the RFI loan.
The ‘urgent BOP need’ was estimated at $720 million, the IMF said.
The inflows will help keep rates below the level it would have otherwise been.
The Thirst for Inflationary Policy
It was frightening to see how many macroeconomists and others in various forums asked Central Bank Governor Nandalal Weerasinghe whether rates would be cut when the Trump tariffs hit.
Rate cuts made on the idea that ‘real’ interest rates were high represented a return to actual inflationary policy (selective convertibility is also a type of inflationism, as it leads to depreciation) and will lead to a swift unravelling of the external sector and a second default.
Unless there is more deflationary policy, the Treasury cannot depend on the central bank to repay debt.
The plain fact is unless there is a pegged exchange rate, the central bank has no way to collect reserves. The more the central bank leans towards a float under its “flexible” exchange rate, the less it will be able to collect foreign reserves.
If the rupee continues to depreciate — especially if/when the Fed fires a commodity bubble – President Anura Kumara Dissanayake would be history.
When the Fed fired a bubble around 1951, Ceylon, a country that survived two World Wars, and the Great Depression with record foreign reserves under a currency board, went into a tailspin from 1952 under the new central bank that led to street protests, police shootings, and a resigned Prime Minister.
Free the Hostage
Given the 5% inflation target and the depreciation seen in 2025 with a benign external environment, the Treasury should urgently build its own sources of dollars.
The Treasury should buy its own dollars. More than that, the Treasury should charge taxes in dollars from those who can pay it.
At the moment the Treasury is hostage to the central bank’s monetary policy in getting reserves to repay debt. If not, the Treasury has to borrow budget support loans or go to the markets to repay debt.
If the health ministry can buy dollars for rupees to pay import bills on drugs, the treasury can also buy dollars to repay loan instalments and coupons. It is so silly that money is borrowed from the IMF, or the Treasury waits for the central bank to give dollars that the monetary authority buys for newly created money.
The Treasury also does not get dollar revenues due to the privilege given to the central bank to charge taxes in rupees and give the rupees credibility (Government Acceptance).
“The government should be careful not to create an economic cyclone from disaster relief as the operating framework of the central bank is weak and rates have been cut too low already.”
It is a privilege that should be removed forthwith. By debasing money — from 4.70 to 310 to the US dollar since its creation — the central bank, especially after 1980, has abused the privilege.
It is all very silly. All this is happening because the current monetary law, made with IMF advice for monetary policy modernisation (read new and innovative ways to print money) does not make up a cohesive whole.
The old law, before some of the later amendments, at least made up a cohesive whole.
The Treasury also has euro loans. The treasury should be allowed to collect taxes in any currency that it has loans in.
This is especially so, because the restructured sovereign bonds are amortising. And it is a good chance to get rid of the foreign debt addiction that started with forex shortages from flexible inflation targetting.
If there are any legal impediments to the Treasury buying dollars or getting dollar taxes in foreign currency, they should be removed.
While fiscal improvements help, they will not stop a second default, unless the cause of the currency crisis and excessive foreign borrowings after the end of the civil war is removed.