ECONOMYNEXT – Sri Lanka is now at a dangerous phase where growth is picking up and the macro-economist are looking to deny monetary stability to the general public and business with high inflation targets and currency depreciation.
The fall of the rupee 2025, amid record current account surplus, the holy grail of the Mercantilist macro-economists, has exposed a deep flaw in the operating framework of the central bank, which then leads to high prices, voter unhappiness and political unrest.
The Holy Grail of Inflationist Macro-economists
Inflationist macro-economists wax lyrical on current account surpluses because countries with inflationary policy usually cannot achieve that.
The current account surplus simply means that Sri Lanka is repaying debt (or building reserves) and there is a deficit in the financial account.
If Sri Lanka got a lot of Foreign Direct Investments and the government was a net borrower for deficit financing, or there were net inflows to the stock market, Sri Lanka would be running current account deficits as the capital flows are spent domestically.
Singapore for example had persistent current account deficits in its high growth years after Goh Keng Swee’s Free Trade Zones started to attract large amounts of foreign investments.
Singapore started to run current account surpluses only after the Goh Keng Swee established the Government Investment Corporation (GIC) in 1981 and started to take provident fund money convert them to dollars and invest them outside the country and also the extra foreign reserves of the Monetary Authority of Singapore.
Singapore’s non-marketable Reserves Management Government Securities (RMGS) is a result of this operation.
As outward investments gathered pace, the current account turned into a surplus.
This knowledge is absent among Cambridge-Harvard economists (Keynesians and Post-Keynesians and the reflationists) due to the rejection of classical economists that happened in English speaking universities after the Great Depression and BoP troubles became commonplace.
It was possible for Singapore (and other East Asian nations that do not reject economics) to enable large capital outflows running deflationary or neutral monetary policy without a policy rate. Large capital outflows may be to build reserves, outward FDI or to buy assets in the foreign countries.
Sri Lanka’s central bank also deserves credit for halting inflationary open market operations and making it possible to repay debt and finance the outflows from the stock market and the repayment of private debt and that of the central bank by allowing overnight and other interest rates to move up.
Deliberate Monetary Debasement
However, the depreciation of the rupee by over-purchasing dollars has exposed a serious flaw in the operating framework of the central bank, which can prove to be the death knell of the current administration as IMF-backed operating frameworks have been, for many post-independent elected governments.
RELATED : Sri Lanka’s exchange rate depreciation by ‘Political Ravishment’
Central banks are supremely unqualified to build reserves, since when it purchases dollars new rupees are created, which as the founding Governor John Exter pointed out is ‘actively inflationary.’
That is why the money has to be extinguished pretty fast through sell-downs of central bank held treasuries or terminating buy-sell swaps if the central bank wants to keep the dollars.
If they are not returned when the new rupees turn to imports through the credit system (the exchange rate is not defended) the rupee falls.
President Anura Kumara Dissananayake in his budget speech called for exchange rate stability, just like Singapore’s leaders did. It was ignored and the central bank continued to make purchases above its deflationary policy.
COPF member Harsha de Silva, made a similar call in 2018 – he actually asked the central bank to allow inter bank rates to move up to the ceiling rate of the corridor to protect the exchange rate and reserve losses- in a public forum.
RELATED : Sri Lanka’s Dr de Silva re-kindles debate on Ricardo’s evil and Penelope’s web of Dr Smith as rupee falls
It was also ignored since the Yahapalana administration had given ‘central bank independence’.
In fact, the central bank bought bonds outright during the Yahapalana administration jettisoning a ‘bills only’ policy that only allows short term rates to be manipulated.
That is the height of irony since the entire doctrine of central bank independence that stems from the Fed Treasury Accord of March 1951, was to end Fed long bond purchases and return to a ‘bills only’ policy.
Nationalism
The Yahapalana administration paid the price in the electorate in the inflation and stabilization crisis that followed.
It is very silly for the parliament to give ‘independence’ to a central bank that is asking for 5 percent inflation a year.
Many Sri Lankan families are now operating in precarious financial situations struggling to pay school fees, income tax and hospital bills.
In common parlance, many people are in fact ‘running on a rim’ after a decade of flexible inflation targeting and potential output targeting destroyed the rupee from 113 to 310 through four currency crises.
Many Sri Lankans are barely eking out a living (marginal income brackets) and it will be very simple to bring them out to the streets again by destroying money.
Now the government has to raise fuel prices and electricity prices, even when US Fed policy is relatively benign fuel prices are stable to falling, and get into political difficulties.
RELATED : Sri Lanka electricity price hike request on a depreciated rupee as oil, coal prices fall
This is the fate of all countries that go to the International Monetary Fund repeatedly, rejecting classical economics.
“In 1980, the Rupee has declined in value from 15.445 rupees per US dollar on 31 December 1979 to 18.060 rupees on 30 November 190, a fall of 16.9 percent in 11 months,” Singapore’s economic architect Goh Keng Swee told J R Jayewardena in a policy paper written in 1980 as the country faced external instability shortly after radical economic reforms.
“Unless the process is stopped and reversed, the country can find itself caught in the vicious spiral of increasing domestic money stocks, increasing demand for imports, depreciating exchange rates, higher rupee cost of imports and greater demand for Central Bank credit creation.
“In the case of Sri Lanka, a depreciation of the rupee must mean that administered prices must be increased and this is never a popular political measure,” Goh told JR.
“Most of the products whose prices are administered are either wholly imported or contain a high import content.
“All wheat from which four and bread are produced is imported. The same holds true of kerosene and milk powder. Bus fares are largely determined by the rupee price of imported oil and spare parts. Fertilizers are also mostly imported.”
Hence this depreciation has to be nipped in the bud.
Otherwise, what happened to J R Jayewardene, Dudley Senanayake as well as Ranil Wickremesinghe will happen to Anura Kumara Dissanayake.
Any radical stabilization crisis involving depreciation, sudden rate hikes (as opposed to early small rises in rates that dissipates off any credit bubbles) after a credit bubble will bring out the nationalists and minorities will pay the price.
After the Yahapalana stabilization crises and depreciation both Muslims paid the price. Christian churches were also bombed by a supposed ‘mastermind’.
Nationalists are already on the march.
Elected governments should be kicked out for their wrong policies not for cost of living rises coming from a bank of issue destroying money by resorting to high inflation and putting the people in difficulties.
Early Warnings
In December the IMF gave an emergency loan and said there was an external payment for which about 700 million dollars in donor funding was needed.
It also shows that country is also running on a ‘rim’.
The almost magical performance of Sri Lanka though missing the central banks inflation target can turn out to be another failed IMF program where there are street protests.
Since people are already in difficulties it will not require Iran style deprecation to make people unhappy.
There cannot be growth without monetary stability, only depreciation, high inflation, suffering, forex shortages, social unrest, political instability and a second default.
If the central bank resumes inflationary policy and narrowly targets the policy rate abandoning the scarce reserve regime, a second default will happen.
External financing gaps financed by the IMF are a consequence of rate cuts. The latest one is also a consequence in part of the May 2025 rate cut and any suppression of rates that will happen 2026.
If rates are cut in historical inflation, Sri Lanka will never be able to stand on its own feet as it did before 1950.
As this column has pointed out before, the dependence on central bank reserves and the practice of the Treasury not buying dollars to repay debt interest (unlike other import payments made by other ministries) and the lack of dollar taxes is what pushes Sri Lanka into a debt trap and what the IMF calls the ‘external financing gap’
There is no external financing gap, neither is there a ‘balance of payments deficit’. All that happens is a run down of reserves if money is printed to keep rates down. The balance of international payments always balances.
Denying stability for Stimulus
During the war, people blamed the war for the country’s ills.
But the collapse of the country after the war through four currency crises by rate cuts for ‘growth’ in 2011, potential output (another label for growth in 2015, 2018 and 2020 was much worse than anything that happened during the war.
Treasury officials have already revealed to the COPE how loan repayments are made on a ‘rim’.
RELATED : Sri Lanka to seek central bank dollars for debt repayment if IMF tranche delayed
That need not be so if the Treasury bought dollars and charged dollar taxes (starting from the Port City). All this borrowing from domestic and foreign lenders does not have to happen.
What foreign funds does it to keep interest rates lower than they would if debt was settled without them. The external financing gap is a result of rate cuts.
Stability may not be everything but without stability everything is nothing
Sri Lanka’s current troubles came from noises about growth made from early 2025.
With growth starting from the stability provided by the central bank, there was talk on how to boost growth and end the stabilization phase.
The IMF and World Bank were also saying that.
It is a serious mistake to think that rate cuts boost growth. Rate cuts – in a reserve collecting central bank – will reduce the ability to generate reserves by boosting credit.
The reason many IMF programs fail in the second year comes from trying to boost growth with monetary policy.
That is why the Germans said stability may not be everything but without stability everything is nothing.
It comes from mistaken ideas that were taught in English speaking universities in the US, except University of Chicago and London School of Economics where Hayek taught and a few other universities.
Since the 1960s (full employment policies) and the 1980s (post -IMF Second Amendment) the knowledge that depreciation comes from anchor conflicts was replaced with 17the century classical Mercantilism of the trade deficit.
In neo-Mercantilist terms, the trade deficit was replaced with the current account deficit.
Sri Lanka’s rupee is now depreciating amid record current account surpluses, showing the fallacy of the doctrine.
The depreciation amid record currency account surpluses shows the danger of rejecting classical economics and of Hume, Ricardo and Adam Smith and embracing the statistics of John Williamson.
Peacetime credit growth is faster than in war time that is why, central bank inflationary policies are amplified in peacetime.
The Argalaya took place as the central bank printed money during and after the Coronavirus pandemic to keep rates down.
The 1948 uprising came after the collapse of the British railway bubble and reduced export revenues from the collapse of coffee prices triggered tax increases.
The 1953 Hartal came and the shooting of protests that led to the resignation of Prime Minister Dudley Senanayake came from the suppressed rates of 1952 amid the bubble that was formed by the Fed before rates were hiked through the Fed-Treasury Accord.
The 1950 War Bonds bubble and Dudley
Sri Lanka has to be doubly careful of US monetary policy. At the moment oil and other commodity prices are stable. But as the Fed cuts rates, and also if there is active quantity easing commodity prices will go up creating further trouble.
When that happens, unless the rupee is appreciated, this government is history.
That is what happened to Dudley in 1953.
Since macro-economists tell whoppers all the time, it is generally called the Korean war boom, when in fact it was the rise in private credit amid a wartime obligation to defend the price of securities by abandoning a ‘bills only policy’ that led to rising commodity prices.
Sri Lanka initially got high prices for its exports as the bubble took off and later frequently traded export prices fell but rice prices did not, pushing subsidy costs. When they were withdrawn people took to the streets.
In December 1950 President Truman called for voluntary price controls and in January of next year ceiling prices were set by the ‘Office of Price Stabilization’.
Though macro-economists call it the Korean War bubble blaming deficits, in fact President Truman (and John Snyder who opposed the rise in rates to protect war widows) had ramped up taxes including through the introduction of PAYE tax and the small deficit (compared to World War II) was bridged and by 1951 budgets were in surplus.
As then Fed Governor Marriner Eccles later said it was the purchase of War bonds by the Fed that was causing the ‘inflation and price controls’ not Korean war deficit spending, which was non-existent anyway by that time.
Be that as it may it led to record earnings for Sri Lanka from commodity exports.
With record inflows purchased by the central bank excess liquidity went up like in the first quarter of 2025.
Exter called in the monetization of the balance of payments.
Exter then raised reserve ratios from 10 to 14 percent (when the central bank was created a 10 percent reserve ratio was mandated according to American and Latin American practice, unlike the self-correcting currency boards.
He also asked banks not to convert dollars and managed to keep domestic prices down even as traded commodities (prices of imported and exported went up).
The Original 1953 Aragalaya
The following year however some export prices like rubber fell (it is true that rubber demand went up partly for the Korean war also) but rice prices remained high.
Sri Lanka at the time was generally a free trading nation and export of commercial crops at good prices more than paid for rice imports.
There were several war time restrictions on the country as well some exchange controls stemming from the Sterling Area due to Bank of England money printing.
Sri Lanka however had a lot of reserves (though the current was devalued in 1949 along with one of the Sterling crisis).
As the cost of rice subsidy went up and the government started development projects (Laxapana etc) the deficit went up.
The central bank then bought Treasury bills and also made provisional advances printing money, triggering a balance of payments crisis.
Later like the Fed, the central bank stopped supporting the prices of Treasury bills and the government cut rice subsidies.
There was a leftist protest. Ten people were shot, and Prime Minister Dudley Senanayake resigned.
A country which was flushed with dollars amid deflationary policy and was contemplating relaxing controls inherited from the Sterling Area then started tightening them.
A full IMF-style stabilization program went into effect under the new government with tax hikes on income and also some exports and the budgets turned into surplus in the next two years.
But the government was turfed out and nationalists – who are always there – gained public acceptance – rose into prominence and the Sinhala only act was enacted.
1952 In Japan
1953 is important for another reason.
Exactly what happened to Sri Lanka happened to Japan a little earlier.
Japan hit the brakes also at the time than Sri Lanka and there were report of a businessman committing suicide.
Hayato Ikeda, who was industries minister was forced to resign in 1952 after he had said that it cannot be helped even if 10 small businessman commits suicide but inflation had to be ended.
He was a former Finance Minister who had worked with Joseph Dodge in the Dodge Line stabilization so he knew that inflationary policy was deadly.
Prime Minister Shigeru Yoshida faced a no-confidence motion with Ichirō Hatoyama backed by socialist parties opposing him. However Hatoyama was a liberal and he formed the democratic party, which later merged with the Liberal party.
The rest is history as they say.
Ikeda came back later as Prime Minister and Japan saw massive growth.
It is very easy to artificially boost credit with central bank rate cuts, but after the train has been set above the market speed, it is very difficult to slow it down without a crash.
And if it is a country with a reserve collecting central bank, the consequences are severe.
Dudley Senanayake was busted twice by the central bank.
In the 1960s when he was re-elected, with plans to remove controls, he had to go to the International Monetary Fund.
By then macro-economists had ended up getting powers to print money for up to 15 years, for rural credit re-finance.
A fully fledged import control law was enacted in 1969 – earlier control came from a World War era defence law which was used by the British for among other purposes to limit imports from Japan which joined Germany with nationalists gaining political power in both countries.
JR Jayewardene was the un – luckiest of them all. He created the central bank and closed the currency board in 1950.
After he became President he did the most radical economic reforms imaginable.
After the IMF’s second amendment he paid a terrible price with severe depreciation and social unrest.
Election violence and authoritarianism was used to remain in power.
Ranil Wickremesinghe to his credit, had free and fair elections and got kicked out post-haste whenever the central bank depreciated the rupee.
He came back – midway to run the stabilization crisis after Gota era rate cuts – and got kicked out like John Kothelawala (and H W Jayewardene) after fixing budgets.
The same thing happened to Mangala Samaraweera who raised taxes and fuel prices after the 2015/16 currency crisis.
Will Anura go the Dudley Way?
President Anura Kumara Dissanayake is now in exactly the same position as Ranil Wickremesinghe was in 2015 and also in 2018.
The economy was recovering, private credit was picking up.
In 2015 rates were cut despite the 100 day program pushing up budget deficits on the claim that inflation was low. At the time US policy was overnight and oil prices were actually falling after quantity tightening in 2014.
The higher budget deficit required higher rates, but the central bank printed money under flexible inflation targeting and mid corridor rate targeting ending the scarce reserve regime.
If the central bank did not cut rates and printed money and maintained stability by allowing rates to go up a little, Wickremesinghe may have had a chance to liberalize trade, though it was engaging in socialist actions like price controls and started the NMRA.
The corruption scandals also took a toll. That is a perfectly legitimate reason to lose power.
In 2018 when budgets were tightened and fuel was market priced, rates were cut again on claiming inflation was low and monetary policy must be loose because fiscal policy was tight.
There is no loose or tight monetary policy. Monetary policy consistently must be aimed at stability amid all external or domestic shocks, positive or negative.
By 2019 time the semi-socialist Yahapalanaya administration was thoroughly discredited by two back-to-back currency and stabilization crises from potential output targeting, flexible inflation targeting and REER targeting.
So Gotabaya Rajapaksa came to power.
The 2020-22 currency crisis was triggered with nationalists in power.
Macro-economists who advised him advocated further rate cuts and money printing to a greater degree than under the Yahapalanaya administration.
General Tendency to Depend on Inflation than Stability
All of this did not happen in isolation. It is not to say that macro-economist only in the central bank are responsible.
In seminars people are asking for rate cuts from Sri Lanka’s central bank Governor for Trump tariffs and Ditwah. It is very silly.
If there is a slowdown in credit, interbank rates will fall automatically under a scarce reserve regime.
This country cannot access capital markets, and has to repay debt. Rate cuts will boost credit further and lead to a default since the Treasury can only get dollars from borrowings due to privileges given to the central bank.
The stimulus mania and abundant reserve regime (which is not far from MMT) came from the US. This also spread to the ECB and devastated Europe where nationalism is also on the rise.
The ECB is beginning to see the light, but not much.
The seeds for potential output targeting were laid several years before the default when the IMF gave technical assistance to calculate the number.
Now in deflationary policy Sri Lanka is growing faster than potential output.
Macro-economists usually claim that Sri Lanka collapses and goes to the IMF because the government does not do reforms and liberalize the economy.
This government has not done much liberalizing to boost real growth, it is true.
But JR did but he had to do several IMF programs and had severe instability even so. That is easily forgotten.
Macro-economists will easily blame this administration for not doing reforms. To get results in time for elections these must be done early – that is another story.
It is one thing for a government to get kicked out for wrong economic plans, heavy state intervention or excessive controls or corruption or some other blunder.
But it is unfortunate for a government to get kicked out for rising cost of living or currency depreciation, brought about by an independent central bank.
In the final analysis, it is up to the parliament to control the central bank through a tight anchor as democratic countries did before the policy rate was invented and independent central banks started full employment policies (potential output targeting).
Sri Lanka’s parliament has so far failed to do so, and the country, its people and non-nationalist politicians in particular, have paid the price. (Colombo/Jan13/2026)
Continue Reading
Leave a Reply