The dollar myth we keep getting wrong

By Dhananath Fernando

Originally appeared on The Morning

There is a persistent belief among Sri Lankans that because we import more than we export, we borrow dollars at high interest rates to bridge the gap. 

Many still assume that our external debt is simply the result of financing this trade deficit. The same fear resurfaces every time global oil prices rise. If fuel becomes expensive, people assume we must borrow more dollars to pay for imports. 

This is a compelling story. But it is largely wrong. Let’s take this myth apart step by step. 

It is true that Sri Lanka runs a deficit in merchandise trade. When we look at physical goods such as tea, apparel, rubber, coconut, and fuel, we import more than we export. In January for instance, the country exported goods worth $ 1,148 million and imported goods worth $ 1,803 million. That leaves a merchandise trade deficit of $ 654 million. 

But this is only one part of the picture. 

The flow of dollars into and out of a country is not limited to goods. There is also trade in services, including, but not limited to IT, logistics, insurance, and tourism. Even in a simple tea export, the value recorded at the port is only the ‘free on board’ price. Insurance and freight are counted separately as services. 

In January, Sri Lanka exported $ 734 million in services and imported $ 328 million, generating a surplus of $ 406 million in the services account. When you combine goods and services, the overall trade deficit shrinks significantly, to around $ 248 million. 

But the story does not end there. 

The current account also includes income flows. This is where remittances play a major role. In January this year, Sri Lanka received $ 740 million in inflows such as worker remittances, while outward payments including interest and other transfers amounted to $ 122 million. This leaves a net income surplus of $ 617 million. 

When you combine goods, services, and income, Sri Lanka actually recorded a current account surplus of about $ 369 million for the month.  

This is the critical point – the economy, in that month, generated more dollars than it spent. Therefore, the idea that we automatically borrow to bridge the import-export gap is misleading. 

Now consider a scenario where global fuel prices spike to around $ 120 per barrel due to the Middle Eastern tensions. Yes, the cost of fuel imports will rise. But that does not mean the country will automatically face a dollar shortage. 

Why? Because the economy adjusts. 

If more dollars are spent on fuel, there is less capacity to spend on other imports. Consumption shifts. If tourism declines, dollar earnings fall, but so do the associated dollar expenses. If remittances decline, household consumption reduces accordingly, lowering import demand. 

In short, both inflows and outflows adjust. The total volume of dollar transactions may shrink, and people will feel the pressure, but this does not automatically translate into a balance of payments crisis. 

Crises emerge not from price movements, but from policy failures. 

The real risk arises when domestic policy distorts this natural adjustment. When the Central Bank expands the money supply excessively – beyond what the economy can absorb – it artificially boosts demand. That demand spills into imports, increasing the need for dollars without a corresponding increase in inflows. 

This is why Central Bank independence matters. Its primary objective must be price stability. The moment it tries to chase short-term growth through money printing, the result is temporary expansion followed by currency pressure and instability. 

Similarly, fiscal discipline is critical. A large budget deficit injects excess liquidity into the economy, driving consumption and imports. Reduce the deficit, and the pressure on the external account eases naturally. The trade deficit is not an isolated problem. It is deeply linked to fiscal and monetary choices. 

This is also why price adjustments, including fuel pricing, are essential. Prices carry information. They signal scarcity. When prices are artificially suppressed, consumption does not adjust, and imbalances widen. Allowing prices to reflect global realities ensures that the economy self-corrects. 

The lesson is simple. 

Sri Lanka’s vulnerability does not come from importing more than it exports. It comes from how we manage our policies in response to that reality. External shocks such as oil price increases are inevitable. But whether they turn into crises depends entirely on our internal discipline. 

If we get the fundamentals right, the economy will adjust. If we don’t, even a small shock can push us back into instability. 

The real battle is not in global markets. It is at home, in our policy choices. 

Sri Lanka’s economic turnaround: The power of policy, not politics

By Dhananath Fernando

Originally appeared on the Morning

The Central Bank of Sri Lanka (CBSL) released its Annual Economic Review for 2024 a few weeks ago. At first glance, the dashboard of key macroeconomic indicators paints a remarkably positive picture – so positive, in fact, that some may wonder if the numbers have been massaged. But scepticism fades when you step into a grocery store or speak with a small business owner. The improvement in economic stability and the business environment is palpable.

What is particularly striking is that the new Government, while not having introduced bold new reforms, has also not derailed the stability programme set in motion over the past two years. This continuity, though passive, has helped preserve the gains made.

Amid the political contestation over who deserves credit for the economic stabilisation, one truth stands out: Sri Lanka’s turnaround is rooted not in politics, but in the application of sound economic policy.

Let us not forget the chaos of the recent past. During the Covid-19 crisis and its aftermath, policies such as import controls, arbitrary currency pegging, and a misplaced reliance on Modern Monetary Theory (MMT) for deficit financing led us to the brink of collapse. We banned imports of everything from vehicles to turmeric and foreign reserves fell to critically low levels. In 2022, inflation peaked at a staggering 70% and we defaulted on our sovereign debt.

In contrast, 2024 tells a very different story. Imports have been liberalised, the Sri Lankan Rupee has appreciated, and annual inflation has dropped to just 1.2% – a sharp fall from the 42% recorded in 2022. Foreign reserves have risen to $ 6.1 billion and investor confidence is slowly returning.

If import bans and deficit monetisation were truly effective tools for reserve accumulation and currency stability, today’s numbers should be worse, not better. What changed is not just the numbers but the mindset.

The real driver behind this turnaround has been institutional reform and disciplined economic policy-making. The passage of the CBSL Act of 2023, which established the institution’s independence – though not perfect – was instrumental. It marked a break from the belief that the CBSL should finance the Government or steer economic growth through monetary accommodation. Restoring the CBSL’s credibility and prioritising price stability has laid the foundation for today’s macroeconomic stability.

However, we are far from the finish line. Stability is a prerequisite, not a destination. Without deeper structural reforms, this fragile recovery can quickly unravel.

Reforms in land use, labour markets, and immigration are essential for long-term growth. The Economic Transformation Act, parts of which are yet to be implemented, must be expedited to attract foreign investment and create job opportunities for Sri Lankans.

Meanwhile, we must interpret some headline statistics with caution. For instance, Sri Lanka’s per capita GDP is now estimated at $ 4,500 – a significant increase. But this is partly due to demographic shifts; population growth has slowed, with increased emigration and declining birth rates. The Department of Census and Statistics now estimates the population at just over 21 million. Additionally, a stronger exchange rate and subdued inflation have boosted the dollar value of nominal GDP.

Yes, economic growth in 2024 stands at 5%, but we must be mindful of the base effect. Following two consecutive years of contraction, this figure reflects a rebound from a low base, not a high-growth trajectory.

Still, the numbers on inflation, reserves, and interest rates underscore a clear commitment to macroeconomic stabilisation. Even the returns to the Employees’ Provident Fund (EPF) have improved, an indirect benefit of preserving the value of money, or what economists call ‘sound money.’

The bottom line: this recovery is the result of disciplined policy, not political manoeuvring. But policy cannot stand alone. Without a resilient institutional framework, good policies can be reversed with the next election cycle. We often adopt ‘scientific policy’ only when a crisis forces our hand. That culture must change.

As the country prepares for the upcoming Local Government Elections, it is crucial for the Government to demonstrate that it is serious about reforms and institutional strengthening. Assuming that 2025 will bring equally good numbers by doing more of the same is not just naive, it is dangerous. Without changing gears, we risk reversing the progress made and returning to instability.

Consumers rear-ended by reer depreciation?

Originally appeared on Echelon

By Ravi Ratnasabapathy

What really is driving the currency weakness? The Central Bank must consider both fundamentals and monetary factors.

Sri Lanka’s currency has fallen rapidly over the last two months, raising fears of yet another crisis. Sri Lanka’s Rupee depreciation over the past six months against the US Dollar is at a much higher rate than the historic annual average of around 10% over the last couple of decades. A stable exchange rate reduces transaction costs and uncertainty in international trade, thereby stimulating trade. It is one of the most important macroeconomic variables in the economy; it affects inflation, exports, imports and economic activity. Budget deficits are the source of much instability. The painful tax increases that addressed this issue were expected to result in stabilisation of interest rates, exchange rates and inflation. The recent depreciation of the currency is therefore puzzling and worrying.

The problem seems to be in the new inflation targeting regime based on the Real Effective Exchange Rate. What this means is that Sri Lanka will target an inflation-adjusted exchange rate index relative to competitors to keep the Rupee competitive. It appears that the depreciation of other currencies has led the Central Bank to loosen monetary policy, causing the currency to fall. What are the implications of such a policy?

Export growth is correctly identified as critical for development, and the Central Bank objective seems to be to keep the exchange rate competitive; but is this necessary? Previously, competitive exchange rates were seen to be crucial for exports, but a recent paper published by the World Bank in 2015 (Depreciation without Exports? Global Value Chains and the Exchange Rate Elasticity of Exports) suggests this is changing (although the view is not universal; other studies seem to contradict this).

The paper finds that the emergence of global value chains (GVCs) has resulted in a decline in the effect of real exchange rates on export performance. This has been linked with the emergence of GVCs through the following three mechanisms:
1. Firms need to import to be able to export; therefore, their exports contain not just domestic but also foreign inputs.
2. Stable supplier-buyer links are valuable, so the cost of switching suppliers in case of a real exchange rate change in a given partner’s country becomes non-negligible.
3. Large leading firms account for an increasingly larger portion of world trade, and these firms may find it easier to hedge against real exchange rate changes along their production network.

The study finds that when firms’ share of imported intermediates is greater than 30 percent, the effect of real exchange rates on export participation fades. Thus, as countries become more integrated in global production processes, currency depreciation only improves the competitiveness of a fraction of the value of final goods exports. The objective of Sri Lanka’s new export strategy is to integrate to GVC. If this paper is correct, the currency may not play a significant role in improving our entry into GVCs.

As yet, Sri Lanka is not well integrated into global value chains; so does the currency depreciation help existing exports? This does not appear to be the case.

“It appears that the depreciation of the other currencies has led the Central Bank to loosen monetary policy, causing the currency to fall. What are the implications of such a policy? ”

A Central Bank staff research paper by U P Alawattage in 2005 titled Exchange Rate, Competitiveness and Balance of Payment Performance examined the effectiveness of the exchange rate policy in Sri Lanka in achieving external competitiveness since the liberalisation of the economy in 1977. It analyses quarterly data covering the period of 1978:1 to 2000:4 and finds that the Real Effective Exchange Rate (REER) does not have a significant impact on improving the trade balance, particularly in the short term.

The other major concern is the impact of the currency on domestic prices and confidence. For small economies, changes in the exchange rate can have an important influence on prices. It not only affects prices of imports but also import-competing goods, and local goods that are tradeable internationally. When the currency depreciates, local prices of these goods and services tend to rise quite quickly, and by a similar amount as the depreciation of the exchange rate.

When import prices rise, demand is driven towards domestically produced goods and services. In the absence of offsetting factors, this results in more pressure on local production capacity and a bidding up of prices. This leads to increased demand for labour and capital pushing wages and interest rates.

The direct effect of the currency depreciation will generally contribute to an overall price level increase in proportion to the share of tradeable goods and services in GDP. Published as a Central Bank study in 2017, a paper by S M Wimalasuriya titled Exchange Rate Pass-Through: To what extent do prices change in Sri Lanka? suggests that the exchange rate pass-through into import prices is around 50%; that is, import prices increase by about 0.5% (and those of other consumer prices by 0.3%) as a result of a 1% depreciation of the Nominal Effective Exchange Rate.

Therefore, the overall cost of living will rise further. Tax increases – VAT from 11% to 15%, PAL from 5% to 7.5% – and the currency depreciation over the last couple of years has already added significant costs to household budgets. Add to this increases in fuel, gas – all necessary due to increases in global prices – and the combined burden is huge. To add even further inflation through currency depreciation will impoverish many and increase popular discontent. Pursuing unpopular policies is sometimes necessary but the combination of depreciation amid fiscal tightening looks dangerous and perhaps even unnecessary.

Exchange rates can move for a range of reasons, which can be simplified into two categories: “real” factors, or in other words, changes in relative fundamentals; and “monetary” factors. “Fundamentals” would, for example, include changes in the terms of trade and productivity, while “Monetary” factors are changes in the money supply.

In practice, policymakers may find it difficult to distinguish how much of a movement in the exchange rate is due to changes in the fundamentals and how much may be inflationary (or deflationary), although in the current situation, monetary factors seem to be the cause.

Thus, in Sri Lanka, where inflation expectations are not well anchored, the prudent monetary policy response would be to tighten rates, at least until there are grounds for being more confident that it was the fundamentals that had changed. The immediate political considerations suggest the same action.

A currency’s exchange rate contains important information about the country’s monetary position and the credibility of domestic monetary policy. The popular perception of the current stance is that it is either weak or out of control. For businesses, it is creating a new level of uncertainty, which is not being helped by ad hoc administrative measures (increasing LC margins on cars for example) to arrest some of the effects. For consumers, it fuels inflation, adding to the woes of fiscal tightening.

The Central Bank should revisit its inflation-targeting regime and tighten rates to stabilize the currency.