On 22 November 2024, the Sri Lankan Rupee was trading at around 290 to the US dollar. A year later it is trading at 308, a decline of around 6.2%. What caused this?
The currency will weaken in the foreign exchange market if there is new money created by the Central Bank. This process went on from around June 2024 to December 2024 when the Central Bank injected roughly Rs100 billion through open market operations into the inter- bank market. The CBSL claimed this was necessary to address liquidity imbalances among banks and argued that this did not equate to money printing.
During the first half of 2025, the CBSL also purchased $1 billion from the domestic market, creating additional liquidity. This was partly offset by sales of $750 million to the government but there was still a net addition to domestic liquidity.
In simple terms, when the Central Bank buys dollars, it pays with newly created rupees, adding money to the banking system. When it sells dollars, it absorbs rupees, removing money from the system.
Foreign exchange swaps and monetary imbalances
The Central Bank has also engaged in FX swap transactions with banks, with the outstanding swaps as at August 2025 standing at $3.68 billion. The FX obtained through swaps are included in the gross reserves reported by the Central Bank.
In a swap transaction, the CBSL temporarily borrows foreign currency from banks and in return provides them with newly created rupees. These are short-term arrangements; when the swap matures, the process is reversed, and the earlier impact on liquidity is unwound. A practical problem arises, however: if liquidity in the banking system is already tight, this reversal will tighten it further.
When an FX swap matures, the CBSL returns the foreign currency to the banking sector and absorbs the rupees that were previously injected. If the banking system is holding excess liquidity at this time, this absorption of rupees does not create stress in the money market. However, if the banking system is already short of liquidity, as is the case now, the reversal of the swap can tighten conditions further, making it difficult for banks to settle transactions and potentially causing interbank interest rates to spike.
To prevent such a disruption, the CBSL may step in and inject fresh liquidity through open market operations. This, however, reintroduces excess rupees into the system worsening the very imbalances the Bank is trying to manage.
If the swaps are instead rolled over rather than reversed, the initially injected rupees remain in circulation. These funds are then likely to be extended as credit by banks, which increases import demand and in turn, puts additional pressure on the exchange rate.
The new money created through these actions has accumulated in the banking system and is now being lent out. Private credit grew by Rs902 billion in the seven months to July 2025, with Rs201.5 billion lent in July, following Rs221.6 billion in June. Since then, credit growth has accelerated, reaching 22.1% in September 2025, on a year-on-year basis. In October 2025, private credit surged to a new high of Rs246.1 billion.
The money being lent out by the banking sector flows into both the domestic and foreign markets. In the domestic market it raises prices, which have increased by 2.1% in the year to October 2025. In the foreign market, it increases the demand for FX, which brings the currency under pressure.
What is the outlook?
It depends on whether credit continues to expand and on whether the Central Bank allows interest rates to rise naturally or intervenes to keep them low.
When demand for credit is strong, rates should rise. If that happens, borrowing will moderate and pressure on the currency will ease. If rates are held down artificially, imbalances can build up in the banking system as borrowing rises while saving is discouraged.
“If the banking system is already short of liquidity, as is the case now, the reversal of the swap can tighten conditions further, making it difficult for banks to settle transactions and potentially causing interbank interest rates to spike.”
Part of the recent increase in credit is likely to be temporary or seasonal. If this lending is repaid in 2026 rather than rolled over, currency pressures could ease. In addition, the recent cyclone has disrupted economic activity, which may also affect the pace of borrowing.
However, if short-term loans continue to be rolled over rather than repaid, pressure on the exchange rate is likely to persist.
The Central Bank has said it expects additional inflows in December from the IMF and the ADB. These inflows will reduce the immediate pressure on the currency and may slow the pace of depreciation but they will not alter the overall trajectory. For that to change, interest rates would need to rise.