Why is the Sri Lankan Rupee depreciating?

By Dhananath Fernando

Originally appeared on The Morning

Why has the Sri Lankan Rupee depreciated over the last few days? Many people want to know the reason. Many also want to predict where the exchange rate will stabilise.

In simple terms, the exchange rate is the price we pay in rupees to buy one US Dollar. It is similar to buying a cake of soap from a shop. If the price of soap increases, we say soap has become more expensive. Likewise, when the price of a US Dollar increases in rupee terms, we say the rupee has depreciated.

Like any other good, the price of the US Dollar is determined by demand and supply.

On the supply side, dollars come into the banking system through merchandise exports, service exports, tourism earnings, worker remittances, foreign direct investments, and other capital inflows.

The real trick is in understanding the demand side. Dollars are demanded for merchandise imports such as raw materials, fuel, vehicles, and medicine. Dollars are also needed for outbound tourism expenditure, foreign salaries, profit repatriation, and outward remittances. In addition to importers and individuals, the Central Bank too buys dollars from the market to build reserves.

So, when the demand for dollars exceeds the supply of dollars, the rupee depreciates. In other words, the price of the dollar goes up.

But there is one important point many people miss. Demand for dollars is created through rupees. If there is more rupee liquidity in the banking system, and if that liquidity is converted into credit, it can create more demand for imports and therefore more demand for dollars.

How USD demand is created: Story of excess credit

Everyone who goes to a bank to buy dollars either pays in cash or obtains a loan from the bank.

If banks lend from depositors’ money, it does not necessarily create excess demand. This is because someone has already saved money by reducing consumption. That saved money is then lent to someone else with interest. In that case, overall demand in the economy does not increase in the same way.

But the situation is different when the Central Bank buys dollars from the market to build reserves.

The Central Bank does not collect deposits from the public like a commercial bank. When the Central Bank buys dollars, it pays rupees into the banking system. In simple terms, it creates new rupees.

One may then ask: is it wrong for the Central Bank to buy dollars and build reserves? The simple answer is no. The Central Bank must build reserves, especially after a crisis. It has to buy dollars from the market to do so.

However, when the Central Bank buys dollars, new rupees enter the banking system. Over the last three years, the Central Bank has bought a cumulative $ 6,528 million from the market, injecting rupees into the banking system in the process.

Once this additional rupee liquidity is in the banking system, banks cannot earn much by simply keeping it idle. They have two options:

They can deposit the money back at the Central Bank and earn interest – This is linked to what we call the overnight policy rate. At present, if banks deposit excess money at the Central Bank, they earn about 7.25% interest.

They can lend this money to customers – These loans can take many forms: letters of credit for imports, credit cards, housing loans, overdraft facilities, business loans, and other forms of credit.

When banks extend loans using this additional rupee liquidity, credit in the economy expands. Part of this credit eventually moves into imports because people and businesses buy more goods, many of which are imported. This creates additional demand for dollars.

According to the Central Bank’s Annual Economic Review 2025, private credit expanded sharply. Credit growth increased from around 25%, and in value terms, credit expanded from about Rs. 790 billion in 2024 to about Rs. 2,000 billion in 2025. This means the economy created more demand for dollars through credit expansion.

When the economy is growing strongly, new rupee liquidity may not immediately create trouble because the new money is also used to produce and consume more goods and services. But when credit expands faster than dollar inflows, the economy becomes vulnerable. Usually, the pressure becomes visible after an internal or external shock.

In simple terms, while Sri Lanka had excess dollars in the market for some time, excess rupee liquidity and credit expansion continued to create demand for imports. That import demand eventually created pressure on the exchange rate.

Speculation effect

The second reason for the recent depreciation is speculation.

When the currency starts to depreciate, those who bring dollars into the market may hold back, expecting the rupee to depreciate further. Exporters, remitters, and others who have dollars may delay conversion.

At the same time, those who need dollars try to buy them as early as possible to avoid a further loss. Importers and businesses rush to cover their dollar needs.

As a result, demand increases while supply is delayed. This can push the exchange rate up quickly.

If this continues, informal markets can also get activated. When people feel they cannot access dollars easily through the formal banking system, or when they expect the rupee to depreciate further, they may start looking for dollars outside the formal market.

That creates another problem. The informal rate can move above the official rate, more dollar holders may delay bringing money into the formal system, and confidence in the exchange rate can weaken further.

Fuel price adjustments and vehicle import ban

Adjusting diesel prices to market prices is essential to contain dollar demand. Fuel is one of our largest import items. In March, fuel accounted for about 23% of our imports. Therefore, fuel prices have to reflect market costs.

If fuel prices are kept artificially low, consumption does not adjust. People continue to consume fuel as if global prices have not changed. But the country still has to find dollars to pay for those imports. That is how a fuel subsidy becomes an exchange rate problem.

There is another argument that vehicle imports should be banned again to save dollars. This sounds attractive, but it does not solve the real problem.

If vehicle imports are banned while excess rupee liquidity remains in the banking system, banks will lend that money to other sectors. Credit may then move into construction, electronics, consumer goods, or other import-heavy categories. So while vehicle imports come down on one side, imports in another category can increase.

Therefore, banning one import item does not necessarily reduce overall import demand. It only shifts demand from one category to another.

If the objective is to reduce overall import demand, the real tool is interest rates. When market interest rates increase, banks have a better incentive to deposit money at the Central Bank instead of lending aggressively to customers. Higher interest rates also discourage people and businesses from taking new loans. Consumption slows down, credit slows down, and import demand comes down.

Of course, this is not painless. When interest rates go up, the economy slows. Businesses face pressure. Small and Medium-sized Enterprises (SMEs) face a difficult time. Borrowers feel the pain.

But this is the difficult choice in economic management. Either we adjust early through prices and interest rates, or we are forced to adjust later through a currency crisis.

The real reasons for exchange rate depreciation are a mix of global shocks, credit expansion, and speculation. The tools available are also clear: fuel prices must be cost-reflective, and interest rates must be used when credit expansion creates pressure on the currency.

Both actions are politically unpopular. But if we fail to adjust to reality, the reality we will face later will be far more unpopular.

Living according to a government’s will

Originally appeared on The Morning

By Dhananath Fernando

• Cost of living and the freedom of choice

Jeewan Thondaman, the political leader representing the estate electorate in Sri Lanka, was questioned recently on what development means for the estate sector. He said: “One politician visits the estates and says he built five houses and another one says he built 10. Merely building houses is not development.”

Then the TV anchor probed him on what development really is. “Giving the opportunity for people to build their own house in a land they own, as per their preference and aspirations, is development,” he replied. He went on to say that “if politicians build houses for the estate sector, regardless of the number of houses built, estates would never be developed”.

Politics aside, the young politician’s views on choice are highly commendable. Most often, people do not realise the importance of the ability to choose from a wide range of options. Especially in countries like Sri Lanka, we expect all things to be provided by the government. We like to eat what the government tells us to eat, we want to get educated on what the government says is good for us, we strive to get a job from the government as they see fit, etc.

The ability to choose is often tested in terms of marriage and relationships. Imagine if the government decided to select partners for us. We can all picture what chaos it would be. Similarly, when the government decides which food we should eat, which fertiliser we should use, and which job we should do, the results are not that different.

Availability of a range of options and increasing choices as much as possible is one key parameter on consumer convenience. The same concept works for essential commodities as well at a time when the national conversation is on rising food prices.

Let’s first understand the reason for rising food prices.

The recent food price hikes are caused by multiple reasons. One is rising global food prices and commodity prices with economies opening up after lockdowns. As a result, a barrel of Brent Crude oil, which was priced at about $ 42, is now at $ 83. So, a fuel price hike can be expected, which will, in turn, have a knock-on effect on many consumer goods.

Sri Lankans will be affected more significantly due to the Sri Lankan rupee depreciating in comparison to the US dollar. Excessive printing of money under Modern Monetary Theory (MMT) has further contributed to the depreciation of the currency. As this column highlighted many times, excessive printing of money, which increases the money supply, will also increase the demand for imports. A lot of the money printed will be used to purchase imported goods, which will worsen the balance of payment (BOP) crisis. A worsening BOP crisis will also increase the shortage of USD, thus increasing the price for a US dollar in LKR terms, or the exchange rate.

An increasing exchange rate will cause the prices of all imported goods to increase as the market adjusts, and keeping the exchange rate fixed without really having sufficient US dollars doesn’t make any sense. Simply, we have imposed a price control on the USD, which has created shortages just as with milk powder and liquified petroleum (LP) gas. Price controls also led to shortages.

If the Central Bank has unlimited USD supply, we can keep the exchange rate without fluctuations, but as per official data, our reserves are at a historically low level. So the Government and also our people are in a very unfortunate situation without having adequate tools to arrest the rising prices.

In a situation like this, some recommendations have been floated, such as increasing wages or Lanka Sathosa distributing essential goods.

On the question of increasing wages, the private sector has to have increased profits and revenue if they were to consider a salary hike. The government sector, which is about 18% of our labour force, cannot have a salary hike without further borrowing from the Central Bank. If the Central Bank further borrows on behalf of the Government, the prices will further increase. So, the only way to overcome this is to fasten our seatbelts and make sacrifices on our real consumption.

Sathosa has no other magic formula to reduce the prices unless a subsidy or budgetary support is provided, and obviously someone has to bear that cost of such a subsidy. Removing price controls is indeed a move in the right direction, but ensuring the market has enough competition across sections is also important in bringing down prices.

One good example is the wheat flour market, where there are only two players in the market. There is a very high tariff on imported milled wheat instead of raw wheat. So this acts as an entry barrier for other industry players to enter the market. As a result of such a lack of competition, the two existing players set the market price and the barriers to entry allow ample space for rent-seeking activities.

It’s the same for cement and industries like LP gas. In most cases, these industries are protected from competition. Protection from competition is directly undermining consumer choice. If Sri Lanka is serious about bringing down prices, our only solution is competition and expanding consumer choice.

At present, though, it seems that sacrificing consumption will be the only option we have and it will not be easy, specifically for the poor, where a higher percentage of income goes for purchasing food. This is going to be a truly difficult time period for such families. So the only option available is increasing the range of options available by increasing competition. Then, people can adjust their choices so that they have room to explore alternatives without experiencing the effect of higher prices. The only way to do it is to remove all barriers to market entry in order to pick the supply side up and iron out market distortions.

Different households will adjust in different ways to price hikes. For example, some households will reduce the quantity of milk powder used per cup. Some households may decide that only kids should be fed with milk powder and adults give up milk powder and shift to plain tea. Some families may adjust with frequency. Instead of having milk tea seven days a week, some will skip two to three days based on their affordability. Some families or businesses who have a higher degree of dependence on milk powder will use the same quantity, but they will reduce their entertainment expenses or other expenditure categories to keep the milk powder consumption going.

In simple terms, each household and individual, based on their circumstances, can decide what is the best choice for them. So even when making “sacrifices in consumption”, the freedom to choose is vital. With people making choices, there will be new market opportunities where suppliers will consider more options to supply alternatives to the  market and capture a different market segment.

Freedom of choice matters both in hard times and good. It is a fundamental pillar in a market system where people have the option of adjusting for higher prices by managing the cost of living to a certain extent. Competition in the market is what fuels the choice for consumers. Sri Lanka has to set the fundamentals right. For example, we cannot develop the estate sector by just building houses. We need to provide them the opportunity and choice to build a house as per their preference. This can only be done by allowing the market forces to work and establishing freedom of choice for people. While the importance of having the freedom to make individual choices is fundamental, the Central Bank can ensure that the rate of money supply increase is limited by using monetary policy. Finally, MMT does not work as it is claimed by those innocent of simple monetary economics. As our currency is not an internationally accepted currency, money printing by the Central Bank leads to inflation.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.