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.

Fuel subsidies are not social protection

By Dhananath Fernando

Originally appeared on The Morning

This column previously warned that when prices lie, crises follow. Sri Lanka learnt that lesson the hard way in 2022. Yet today, we are once again moving towards the same dangerous path by moving away from cost-reflective fuel pricing.

The Government has now effectively admitted that fuel is being subsidised by around Rs. 100 per litre for diesel and around Rs. 20 per litre for petrol. Sri Lanka consumes roughly 180 million litres of diesel a month and a similar volume of petrol. Even if this subsidy applies only to fuel sold through the State-owned Ceylon Petroleum Corporation (CPC), the cost is staggering. The monthly subsidy bill could easily exceed Rs. 15 billion and amount to Rs. 150–200 billion annually.

To put that into perspective, Rs. 200 billion is equivalent to building nearly two expressway phases of Rambukkana to Galagedara or financing several major infrastructure projects. Instead, we are distributing that money through subsidised fuel largely to those who consume the most energy.

The reality is simple. The non-poor consume far more fuel than the poor. Around 70% of Sri Lanka’s fuel consumption comes from higher-income groups and commercial users who are relatively capable of absorbing price increases. In effect, the subsidy becomes a transfer of public money to people who can already afford to pay market prices.

The bigger issue

The President recently stated at a meeting that, according to CPC calculations, diesel prices should be around Rs. 720 per litre, while it is currently being sold at around Rs. 392. Even after accounting for the estimated Rs. 100 subsidy, there still appears to be a significant gap between the actual cost and the selling price.

The bigger issue, however, is not merely the subsidy itself but the pressure it creates across the entire economy. The President himself acknowledged that Sri Lanka’s monthly fuel import bill, which was previously around $ 200–300 million, was now expected to rise towards $ 500 million.

Artificially low prices encourage higher consumption, especially among those who can afford it. The likely Government strategy may be to hold prices down temporarily in the hope that global oil prices will eventually decline, allowing losses to be recovered later. Unfortunately, this is exactly the same mistake Sri Lanka made before the economic crisis.

Fuel and electricity were both sold below cost for prolonged periods based on political calculations rather than economic reality. Once subsidies are introduced, politics makes it extremely difficult to reverse them. Politicians facing elections and public pressure continue postponing necessary price adjustments, and temporary subsidies slowly become permanent fiscal burdens.

Severe consequences

The consequences do not stop there. Fuel and vehicle-related taxes remain among the Government’s largest sources of revenue. With vehicle imports already constrained, the resulting tax shortfall will eventually need to be filled either through new taxes, lower tax thresholds, or wider tax collection efforts.

It is far more transparent and economically rational to allow consumers to pay the true market price for fuel at the point of purchase rather than recovering the same money later through additional taxes on income, consumption, or businesses.

Sri Lanka’s agreement with the International Monetary Fund clearly emphasises the importance of cost-reflective pricing for fuel and electricity. Even if the Government argues that subsidies can be financed through alternative revenue streams, the signal sent to investors, businesses, and international lenders is deeply concerning. It suggests that Sri Lanka is beginning to drift away from the very stability framework that restored confidence after the crisis. The same concerns apply to delays in electricity tariff revisions.

There is also a dangerous monetary risk beneath the surface. Subsidising fuel for those who do not need support eventually creates pressure on the Government to seek financing elsewhere. Historically, that ‘elsewhere’ has often been the Central Bank.

Today, with greater Central Bank independence, direct monetary financing is no longer easily possible. But political pressure can quickly emerge to weaken those safeguards. Once people are convinced that printing money can keep fuel prices low and distribute more subsidies, the pressure to dilute hard-earned reforms becomes politically attractive. That is precisely how Sri Lanka entered the spiral that led to the 2022 collapse.

Without some level of demand contraction through market pricing, fuel consumption will continue increasing, placing greater pressure on the dollar market. Sri Lanka will then face two painful choices: allow the rupee to depreciate sharply or spend down scarce foreign reserves defending the currency.

Both options carry severe consequences. A weaker rupee pushes inflation and fuel prices even higher, creating a vicious cycle. Meanwhile, depleting reserves damages investor confidence, weakens creditworthiness, and raises concerns about debt sustainability.

None of this means high fuel or electricity prices are desirable. Prices should come down. But sustainable price reductions can only come through productivity improvements, competition, efficiency gains, and better management, not through unsustainable subsidies.

At the same time, rising energy prices do hurt the poorest households disproportionately. The solution, however, is not universal subsidies that benefit the wealthy most. The correct approach is targeted social protection. Sri Lanka must strengthen its social safety nets and increase direct cash transfers for the poorest families rather than subsidising fuel consumption for those who can comfortably afford market prices.

In simple terms, subsidies should protect the poor, not cheap fuel consumption for the rich.

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Tariff reform vs. the high-tariff lobby

By Dhananath Fernando

Originally appeared on The Morning

There was a recent news story that the Government is considering a new tariff policy. That may sound technical. It is not. It goes to the heart of how expensive life is in Sri Lanka.

A tariff, in simple terms, is a tax imposed by a government on goods imported from another country. The definition is straightforward. The system is not.

Millions of products cross borders every year. In Sri Lanka, each of these items is taxed at different rates at the point of entry. Every product that crosses the border is classified under what is known as an HS Code – the Harmonised Commodity Description and Coding System developed by the World Customs Organization (WCO).

At the global level, goods are identified using a six-digit code. Countries can then add additional digits to create more detailed classifications. That is where complexity begins. With eight or 10 digits, categories become narrower, rates become different – and discretion enters the system.

There are generally two types of tariffs. The first is an ad valorem tariff – a percentage of the value of the good. For example, a vehicle may be taxed at 20% of its declared value. The second is a specific tariff – a fixed amount per unit, such as a certain number of rupees per pair of shoes or per kilo of cement.

Not all tariffs are created equal. In principle, tariffs discourage trade. Governments justify them either as revenue measures or as tools to protect domestic industries. But when tariffs become excessively high, they stop being revenue instruments. They become barriers. Products simply do not enter the market because, after taxes, they are no longer affordable.

The type of tariff also matters. A specific tariff can disproportionately hurt lower-income consumers. Imagine a flat Rs. 500 tax on a pair of shoes. A pair worth Rs. 1,000 faces a 50% tax. A pair worth Rs. 30,000 faces less than 2%. The burden falls heavier on those buying lower-value goods. That is not progressive policy; that is distortion.

Sri Lanka’s deeper problem, however, is structural. We have operated for decades with a highly complex, cascading tariff system. Multiple rates across thousands of HS codes. Para-tariffs layered on top of Customs duties. Different treatment depending on how a product is classified.

Complexity creates discretion. Discretion creates room for corruption. When tariff rates differ significantly between similar HS codes, the official determining the classification holds enormous power. A small change in classification can mean a large difference in tax payable. That gap becomes fertile ground for rent-seeking.

But that is only one side of the story.

The real push for high tariffs does not primarily come from customs officials. It comes from vested interests within the private sector.

There are companies in selected industries that mainly serve the domestic market. If cheaper or better-quality imports were allowed to enter freely, many of these firms would struggle to compete. Instead of improving productivity or innovating, they lobby for protection.

Construction materials are a clear example. Tariffs in some segments go as high as 70% or 80%, often through para-tariffs such as Commodity Export Subsidy Scheme (CESS) and Ports and Airports Development Levy (PAL).

Over time, the high-tariff lobby has become highly organised. It operates almost like a cartel. It finances political campaigns across party lines. It frames the narrative around ‘saving dollars’ and ‘protecting local industry’ while consumers quietly pay the price. Many of these protected industries function as monopolies or oligopolies, operating in near-cartel structures with limited competition.

To further entrench protection, many of these products are placed on what is known as the ‘negative list.’ Even when Sri Lanka signs a free trade agreement, items on the negative list are excluded from tariff reductions. In effect, the agreement becomes hollow for those sectors.

The proposed new tariff policy seeks to address this. It is expected to introduce a simplified structure, perhaps four tariff bands such as 0%, 10%, 20%, and 30%, and to remove para-tariffs like CESS and PAL. If implemented properly, this would be one of the most significant trade reforms in decades.

But reform in Sri Lanka is never a straight road.

Lobbying groups typically use three tactics to dilute such reforms. First, they demand long phase-out periods of three to five years, arguing that the industry needs time to adjust. In practice, those years allow political pressure to build and reforms to stall.

Second, they push to expand the negative list, adding more items under protection so that even with a simplified tariff structure, meaningful competition never materialises.

Third, they invoke anti-dumping measures to reintroduce barriers through another door, effectively recreating protection under a different label.

Many governments have attempted tariff reform. The fact that we are still debating simplification after decades is itself evidence of how strong vested interests are.

Moving towards a four-band tariff system and eliminating para-tariffs is commendable. But it must be done decisively. Without expanding the negative list. Without excessive phasing. Without hidden backdoors.

Every delay strengthens cartels. Every compromise keeps prices high. And every year of hesitation quietly squeezes consumers, especially the poor, by denying them access to affordable goods and better living standards.

Tariff reform is not a technical adjustment. It is a test of political courage. The question is simple: do we design policy for protected producers, or for the broader public?

The answer will determine whether Sri Lanka remains a high-cost economy trapped by interests or becomes a competitive one driven by opportunity.

Tourism, like cricket, needs better fundamentals

By Dhananath Fernando

Originally appeared on The Morning

Sri Lanka tourism is a lot like Sri Lanka cricket. For cricket, everyone has an opinion. Who should be captain, what the team should look like, what the game plan should be. Tourism is the same. Almost everyone has a different idea of how to ‘fix’ it.

And, like cricket, tourism is emotionally connected to the hearts and minds of people. That is why we get disappointed so easily after even a small setback, and why we bounce back so quickly too. The love for the game and the industry is real.

Tourist arrivals are now picking up and we are hitting record highs. But estimated earnings are declining. We need to remember that ‘earnings’ are an estimate. We calculate earnings by multiplying the number of arrivals by average length of stay, and then by average spending per night. The most sensitive part of that equation is average spending, which is based on surveys of tourists, on what they spend on categories such as accommodation, travel, shopping, and so on.

A few months ago, the Sri Lanka Tourism Development Authority (SLTDA) with Australia’s Market Development Facility (MDF) launched results of a survey with a sample of about 11,000 inbound travellers and 5,000 outbound travellers, covering about 50 countries.

According to those results, average spending per tourist is now $ 148, down from the earlier $ 171. That shift alone helps explain why earnings can fall even while arrivals rise. The same survey shows that about 18% of visitors are repeat visitors and 58% are women. Of total spending, 55% goes to accommodation. Interestingly, 46% of travellers booked through Online Travel Agents (OTAs) and 62% are non-package travellers.

In this context, another SLTDA study has made headlines: out of about $ 3 billion in earnings in 2024, around $ 900 million is said to have “leaked,” and the Government is now trying to prevent this leakage. According to the study, around $ 500 million is leaking through inbound travel operators and another $ 250 million through accommodation. Based on these findings, there is a renewed push for measures to minimise leakage.

The obsession with leakage

The intentions are good. But the problem is the way we are diagnosing the disease. In my view, there is a poor understanding of monetary economics behind this obsession with ‘leakage.’

Yes, OTAs charge commissions. Yes, some payments are settled overseas, so not every tourism dollar will enter Sri Lanka through our banking system. But the idea that regulating OTAs or tightening rules on parts of the tourism value chain will meaningfully ‘save’ dollars is not first principles thinking. Oversight matters. Compliance matters. But oversight is not a monetary strategy.

Here is why.

Leakage of dollars is largely a function of excess rupees in the system, not simply the behaviour of tourism stakeholders. When we create excess rupees, people will try to convert those rupees into dollars. The most common way this happens is through imports.

Let’s simplify it. When we buy a mobile phone, we are effectively buying dollars with rupees. We pay the shop in rupees. The shopkeeper goes to the bank, buys dollars using those rupees, and pays the overseas supplier. The transaction is initiated by rupees. If we have excess rupees the demand for USD is higher.

Now imagine we ban mobile phones, thinking those dollars will stay in the country. They will not. The bank will sell those dollars to someone else who wants to import something else, because banks are in the business of converting currencies, and because demand for dollars does not disappear simply because one item is restricted. If there is excess rupee liquidity, the dollars will find a way out through whatever channel is available.

The same logic applies to tourism. Even if you restrict OTAs or tighten certain import segments, there will be no ‘dollar saving’ if the rupee side remains loose. Any dollars entering the market will still leave as long as there is excess rupee liquidity chasing foreign exchange. Restrictions shift routes. They do not remove the pressure.

At the same time, we should be honest about why some businesses prefer to keep foreign currency outside Sri Lanka. It is not only about commissions or convenience. It is also about the difficulty of moving money across borders when regulations are heavy, approvals are unclear, and conversion rules are tight. If you are running a cross-border business, you will naturally park funds where transactions are smoother and risk is lower. That is exactly what is happening.

There is another reality we cannot ignore: there is a limit to how much import content we can cut in tourism without damaging the product.

A visitor expects a basic standard. Rooms need air-conditioning. Air-conditioners are imported. Tourism transport needs reliable vehicles and fuel. Vehicles and fuel are imported. There is a minimum quality bar in a competitive global market, and trying to cut our way below that bar will not save us; it will simply push tourists elsewhere.

Even in services, ‘local only’ is not always practical. World-class restaurants and wellness experiences often depend on specialised inputs and, sometimes, specialised talent. In some cases, salaries have to be paid in foreign currency.

You cannot run a top-tier Japanese restaurant or a great Thai experience with good intentions alone. We need talent from those countries to be located here for an authentic experience. If we attempt to ‘save dollars’ by lowering quality, we will end up losing the very customers who bring the dollars in the first place.

So what should we focus on?

Instead of hunting ‘leakage’ like it is the main villain, we should focus on value creation. If tourists see value, they spend more. Higher spend improves earnings, supports better jobs, and creates stronger businesses that can invest in quality.

The path to stronger tourism earnings is not to squeeze the system tighter; it is to make Sri Lanka a place where people are happy to spend, and businesses are confident to bring money in and reinvest.

And this is where monetary stability becomes central. If we stabilise the monetary system, avoid excess rupee creation, and reduce unnecessary friction in capital flows, tourism earnings will naturally improve. Yes, there will always be some money that is paid abroad, just as Sri Lankans will always spend money abroad too. That is normal in an open economy.

The solution is not to treat tourism stakeholders as the problem. The real fix is to get the monetary foundations right and make Sri Lanka easy to do business with. Otherwise, we will keep arguing about captains and game plans while losing the match in the middle overs.