Rupee depreciation’s double edge

By Dr. Kenneth De Zilwa – Global Business Cycle Economist

Colombo, May 20 (Daily Mirror) - Sri Lanka has done impressive work on its domestic finances. We achieved a primary surplus and collected nearly 5 trillion rupees in taxes. But this success is in rupees only. Our external balance sheet – the one measured in dollars – remains dangerously weak.

Official gross reserves stand at $6.76 billion (end‑April 2026). That is barely two months of imports. But even that number overstates strength, because we must subtract short‑term liabilities: $2.1 billion in debt payments due within a year, plus $765 million in forward dollar sales by the Central Bank. Net reserves are much smaller. We have strengthened the LKR balance sheet, but not the external one.

The IMF ties the Central Bank’s hands

Under the $3 billion IMF programme, the Central Bank must build reserves to $8.9 billion by end‑2026. Selling dollars to defend the rupee would break that target and agreement. So, the CBSL cannot intervene aggressively given this limitation. In April 2026, it was a net seller of dollars ($12.9 million) – the first time in 22 months. A small exception, but a sign of pressure building up in the external balance sheet.

Fuel bills are already hurting

The Ceylon Petroleum Corporation has spent nearly USD 1 billion on fuel imports in just four months of 2026 – two‑thirds of its entire 2025 bill. While vehicle imports too was elevated at USD 630 million for the period Jan-March 2026. The merchandise trade deficit for Q1 2026 widened to USD 2.31 billion compared to USD 1.5 for the same period 2025, up approx. 53% from a year earlier. Exports for the period grew only 3.4%, while imports surged 18.1%, mostly due to energy and vehicles. Overall the country’s terms of trade too witnessed a decline.

Dilemma of Gross figures -for remittances and tourism mislead

Headlines say remittances rose 24.5% to USD 3.06 billion (Jan–Apr 2026) and tourism earned USD 1.11 billion. But those are “gross” numbers. They do not deduct outward transfers by migrants (for education, loans, family abroad) or payments to foreign airlines, hotel profit repatriation, etc. No official net figures are published for either sector. The only reliable net measure is the current account balance. After a rare surplus of USD 0.6 billion in 2025, the current account is expected to swing back to a large deficit in Q1 2026 – it is likely to be over USD 1.5 billion. That is the real drain on reserves and increased external borrowing pressure. Therefore, it’s important to ensure Net figures rather than Gross figures are given to the public, for if not, it masks this deterioration and the underlying reality.

The Dollar is Falling against the Euro and Pound

An extraordinary global event is unfolding: the US dollar is depreciating sharply. The euro now buys 392 rupees, the pound 450 rupees - levels never seen before. A weaker dollar might seem helpful for our dollar debt, but because the rupee is effectively anchored to the dollar, the effect is the opposite.

How the USD Anchor Works (and why it hurts now)

The US dollar is the world’s primary reserve currency. Every other currency is priced through it using cross rates:

• EUR/LKR = (EUR/USD) × (USD/LKR)
• GBP/LKR = (GBP/USD) × (USD/LKR)

When the dollar falls against the euro and pound, the cross rates rise automatically, no matter what Sri Lanka does. We have no control over this. While the rupee depreciates i.e. USD appreciates, the euro and pound become more expensive in rupee terms overnight. As a result, our import bills from these countries, be it for food, medicines, and machinery, increase immediately. The same rupee now buys fewer euros and pounds. The dollar anchor, which once provided stability by keeping exchange rates predictable, now does the opposite. It channels global currency volatility directly into our economy and that volatility lands squarely on our firm level balance sheets. The national external balance sheet (NIIP) absorbs the first blow through higher import costs and a widening trade deficit and in turn current account. In such instances the firm’s balance sheets would need more working capital.

Why Depreciation Expands Money Supply (the channel most miss)

Here is the critical point that is often misunderstood. Rupee depreciation increases money supply. It does not tighten it. And this is not a one‑time event; it is a continuing process. Sri Lanka is structurally import-dependent. When the rupee depreciates, the cost of fuel, raw materials, machinery, pharmaceuticals, chemicals, and intermediate input goods rises immediately in local currency terms. A business that previously required Rs. 100 million funding lines from banks to finance imports may suddenly require Rs. 140–150 million for the same volume of goods. Therefore, depreciations create a shock to corporate balance sheets:

•  Inventories rise in rupee terms
•  Payables increase
•  Working capital gaps widen
•  Cash conversion cycles deteriorate

Firms respond by drawing larger overdrafts, expanding trade finance lines, and increasing short-term borrowing from commercial banks. Banks, in turn, accommodate this demand because they are tied to real import flows, collateralised trade transactions, and essential economic activity. This expands bank balance sheets through higher loans and advances, increasing domestic liquidity. This creates an immediate increase in money demanded which is funded viz a viz the money markets. The transmission mechanism is therefore:

Rupee Depreciation→Higher Import Costs→Higher Working Capital Demand→Bank Balance Sheet Expansion→Credit Growth→Money Supply Expansion

This is not speculative credit growth. It is survival-driven financing required to maintain production, trade, and supply chains in an import-dependent economy.

Then Comes the Vicious Cycle

Firms face an unavoidable choice when their costs rise with rupee depreciations they have to absorb the cost into their own balance sheets – which erodes profits, eats into equity, and raises the risk of loan defaults. Or pass the cost on to customers as higher money prices – which is inflation. Either path is damaging. If firms absorb in their balance sheets, the banking system takes strain. If they pass on, the general price level rises. Then workers demand higher wages, firms need even more working capital, banks lend more, money supply expands further, and the rupee comes under more depreciation pressure. The cycle feeds on itself.

This is why a currency depreciation can spiral into a large macro imbalance. The anchor is not just an exchange rate; it is the linchpin of domestic fiscal, credit, external balance sheets and inflation. Sri Lanka’s monetary challenge is therefore not a simple inflation-versus-growth trade-off. It is a balance sheet constraint problem. The economy requires credit expansion to sustain existing production under higher import costs, yet excessive credit growth can fuel inflation and external pressure if not properly absorbed by export capacity. At the same time, tightening too aggressively can weaken the very sectors that generate future dollars. This creates a policy dilemma.

The Real Problem: External Dollar Scarcity

At its core, Sri Lanka’s instability is not purely monetary. It is structural, and its Industrial. Weak net dollar generative ability, High import dependency, Large negative Net International Investment Position (NIIP, was negative USD 53bn, as at end December 2025), Persistent external liabilities i.e. borrowings, Limited export scaling capacity. In such an environment, monetary policy alone cannot resolve external imbalance, there needs to be an industrial policy that is supported by a progressive fiscal policy.

Limited External borrowing Space -Costs are already rising

Markets are pricing higher risk on Sri Lanka external Macro Linked and Governance Linked USD Bonds. Yields on restructured international bonds have risen, the 2035 bond to 9.06% (from 8.81%), the 2028 bond to 6.33% (from 6.02%). Any future foreign borrowing to refinance the negative current account and NIIP (Net External International Investment Position) will be more expensive

A Careful Way Forward

The Central Bank faces a delicate balancing act. Defending the anchor requires reserves, but those are low and IMF targets prevent aggressive selling. Allowing depreciation without intervention expands money supply and credit, fueling inflation and thus warranting a tightening cycle for shocks caused by depreciation due to external imbalances and lack of USD cashflows, making the external imbalance worse. The correct path is not to panic or to tighten monetary policy blindly (that would crush the real economy). Rather, it is to:

•  Focus on rebuilding net reserves through targeted and credible current account adjustment policies.
•  Keep monetary policy steady enough to support production and export competitiveness, and retain market share, while closely monitoring the working capital–money supply transmission channel. Misreading the link between depreciation, money supply, and working capital expansion would lead to policies that amplify instability. Prudence – and a clear understanding of how the anchor really works – is essential. The challenges are real, but so is the capacity to navigate them with careful calibration. The clock is ticking, but the room to act remains open.