Sri Lanka as a nation, through its Treasury is going with a begging bowl for ‘budget support’ and other dollar loans to the International Monetary Fund, the Asian Development Bank, and foreign governments to find dollars to repay debt.
If not, the Treasury supposedly has to get ‘reserves’ from the central bank. Or so the macroeconomists tell you. When reserves go down, and foreign and local investors get jittery.
“Additionally, the receipt of approximately $350 million from the IMF’s fourth tranche significantly contributed to alleviating dollar liquidity pressures, thereby supporting the maintenance of the treasury’s cash flow,” Sri Lanka’s Mid Year Fiscal Review said. “This sequence of events highlights the critical dependence on external financial support to sustain external debt service commitments and underscores the importance of strategic liquidity management in the context of limited foreign exchange reserves.”
This is completely untrue. It is what macroeconomists have led Treasury officials to believe over the years.
The Treasury has been run for many years by macroeconomists seconded by the central bank. That may have something to do with the belief as well. They are not necessarily evil, but having rejected economic theory, and placing their beliefs in the political policy rate and ‘monetary policy’, they may genuinely believe it.
In truth the Treasury is sitting on massive streams of dollar revenues which are blocked due to the central bank’s money monopoly.
The Forex Monopoly
The reason the Treasury, and the unfortunate nation at large, has to beg for dollars, or depend on monetary reserves which are linked to the note-issue, is because macroeconomists have blocked the agency from other avenues of getting dollars and given a foreign exchange monopoly to the central bank.
As part of moves to prevent the second default, an important economic reform, perhaps the most vital economic reform, is to liberalise the money monopoly and allow the Treasury to charge taxes in dollars.
This would be a key step that the parliament can take to de-risk the country from the next default and protect the people that the parliament represents.
Given that rate cuts and open market operations for flexible inflation targeting and potential output targeting achieved something in eight years that Vellupillai Prabhakaran could not do in 30 years, it is essential that the country be de-risked from spurious monetary doctrines.
Many countries with similar flaws in their operating frame work to Sri Lanka have gone into serial default after the IMF’s Second Amendment.
Dollars, Dollars Everywhere, But Not a Cent for the Treasury
This column has said multiple times that there is no difference between rupees and dollars as long as the central bank does not run inflationary policy.
It is very silly that the Treasury has to borrow dollars from foreign sources to repay debt. Indeed, it is silly that the Treasury has to even borrow from domestic sources in dollars to repay debt, though there is no harm since people save in dollars.
All the Treasury has to do is to charge taxes in dollars from those who can pay it. Then the Treasury can get dollars directly instead of depending on the central bank and the banking system.
Taxpayers who can pay in dollars include exporters, tourist hotels, BPO companies, and also freelancers, provided tight rules now imposed to protect the monopoly of the central bank are changed. The Airport and Aviation Services and Sri Lanka Ports Authority can also pay value added tax in dollars in addition to other levies. Banks are uniquely positioned to pay their taxes in dollars as they are the gatekeepers of rupee credit.
The Exclusive Privilege That Drives Default
The reason that the Treasury, as the agency of the parliament which sanctions taxes, is as helpless as a newborn babe in getting dollars, is because the central bank stands in its way. And the reason the central bank stands in its way lies in the mists of the forgotten origins of central banks in Europe and the Americas.
Most Western central banks started as private banks of issue. One of the main ways new note-issuing banks got credibility for their notes over other competitors — of which there were many in many countries — other than through a forced legal tender law, which was a later development, was an exclusive privilege that Kings gave for taxes to be paid in the notes of the new bank that found his favour.
That action created an immediate demand for the notes. It is the privilege of ‘Government Acceptance’. It is through this exclusive privilege that Sri Lanka’s Treasury is being strangled of foreign currency.
It is not a serious problem if the central bank maintained a fixed exchange rate and did not have an inflation bias or a political policy rate, or was made accountable for convertibility through the gold standard or a fixed exchange rate or an appreciating one.
But now the Treasury is dependent on the ‘reserves’ of a note-issuing bank with a political policy rate that is increasingly reluctant to run deflationary policy to generate the dollars needed to service debt and is intent on pushing up the costs of living.
Since money was fixed to gold — or silver as the case may have been — and the original central banks did not have a political policy rate, it was not a problem for a Treasury or anyone else as long as convertibility was maintained. In fact, the US government, before the political policy rate and open market operations, at one time paid interest on its debt in gold (through the so-called Gold Clause). These practices were stopped after the Federal Reserve was set up, which invented inflationary open market operations, and triggered the Great Depression.
As part of interventions and controls that follow economic crises, macroeconomists misled President Franklin D Roosevelt into removing the Gold clause. New Dealers were arch macro economists and interventionists.
In the age of inflation, macroeconomists both in Sri Lanka and elsewhere have managed to persuade parliament that these exclusive privileges are normal.
Why The Urgency?
Sri Lanka’s central bank, by depreciating the currency in 2025 amid record current account surpluses, showed that there has been not much improvement in its operating framework.
That is why there are street riots in some countries at the seventh review of IMF programmes as the currency depreciates in the first recovery after a 4-year IMF programme, even if there is no default.
Any resumption of actual inflationary policy — term, or outright purchases of bills — will make it impossible for the central bank to collect reserves. Even though Cyclone Ditwah could temporarily dampen credit, the danger remains that inflationary policy could resume.
If the central bank fails to conduct sufficient deflationary policy by selling down part of its bond stock, and there is a strong likelihood that it will given the fixation on 5% inflation, things could unravel very fast.
Sri Lanka has the example of 1952, when a central bank which had essentially outperformed most Sterling area countries after 18 months of deflationary policy suddenly got into trouble. Further out, the Bank of England got into trouble firing a commercial crisis in 1825, barely four years after suspending payments. At the time the cabinet refused to allow the central bank to float. Members of parliament ripped the bank to shreds.
Supremely Unqualified
A central bank is supremely unqualified to collect reserves which it then promises to give to the Treasury in large quantities. A central bank with inflationary open market operations is even more so.
A central bank buys dollars against notes and in loose terms prints money in the process, unlike the Treasury or any other person who purchases a dollar to buy reserves or hides dollar notes under the mattress.
The founding Governor of the central bank, John Exter, called this process ‘monetising the balance of payments.’
The purchase of dollars against circulating mediums is not a final transaction. The previous owner of the dollar now owns a rupee note and effectively has a lien on the dollar in the central bank reserves since it is a circulating medium.
Since it is a circulating medium, either the first owner or a second person who is paid with it for a domestic good or service, or takes credit from a bank where the first owner has deposited the note, will end up importing goods or services with it, eventually putting pressure on the currency.
If the central bank does not return the dollars when it hits the forex market, no power on earth can stop the rupee from depreciating.
Deflationary Policy
For the central bank to hold the reserves permanently, or own them outright so to say, and dollars that do not boomerang on itself, dollars have to be purchased for an asset that is not a circulating medium (rupee note).
For example, if a bank that sells dollars to the central bank was given a Treasury bill or a bond coupon in return, the central bank can hold the dollars in its reserves permanently. If a seller of dollars was given any other asset in the central bank, other than a newly created circulating medium, the agency can keep the reserves permanently. That is why the central bank has to run deflationary policy, sell some debt paper to banks, and neutralise the rupees created when purchasing the dollars by ‘monetising the balance of payments.’
“All the Treasury has to do is to charge taxes in dollars from those who can pay it. Then the Treasury can get dollars directly instead of depending on the Central Bank and the banking system.”
The Treasury, on the other hand, can buy dollars and build an external reserve without creating new money or ‘monetising the balance of payments’.
In the British Colonial period, that is why a sinking fund was built to settle debt. The colonial government did not depend on the currency board, even without a policy rate, to give it reserves to repay debt.
The IMF’s Assessing Reserve Adequacy (ARA) metric is based on completely mistaken principles. The way to go is to build an external fund, either sinking funds for specific loans or a sovereign wealth fund.
There is another contradiction. The central bank usually advises businesses not to borrow in foreign currency unless that business has dollar revenues. As a result, exporters and hotels are allowed to borrow dollars. But the Treasury borrows heavily in dollars, while the central bank’s money monopoly prevents the Treasury from getting tax revenues in dollars.
It is a dangerous and self-serving control against the people, which puts the entire nation at unnecessary risk, just so macroeconomists can preserve their monopoly. The central bank has enjoyed the privilege of government acceptance for 75 years, and it has strangled the exchequer of foreign currency.
And the people have suffered. They suffered terribly. It is up to the parliament to break this monopoly and with draw the privilege before the next default hits the country from the 5% inflation target and the single policy rate.
The people of this country have to be given a chance. The chance that was lost in February 1952 with the onset of inflationary policy.