When the central bank began buying bonds to target an output gap as part of an inflationary strategy in August 2019, Sri Lanka’s total official foreign exchange reserves plunged to 2,267 million US dollars in October 2021, down 73 percent from August 2019 statistics.
September’s total of 2,704.2 million dollars was reduced by 436.7 million dollars in October. The initial estimate for September reserves of 2,581.3 million US dollars has been revised upwards.
When compared to a year earlier, when the so-called Modern Monetary Theory accelerated money supply, foreign reserves were down about 65 percent in October.
Despite having a reserve-collection soft-peg, the central bank lost its ability to collect currency reserves in August 2019, when it started creating money to make up for a deficit in output.
October’s reserves represent around 1.4 months’ worth of average imports from August to October. However, the central bank has an undrawn 1.5 billion US dollar swap with the People’s Bank of China that it may use to make some international payments.
As a consequence of low interest rates and money creation, Sri Lanka’s imports have grown, surpassing the pre-pandemic year of 2019 when the economy benefited from tourism revenue.
Sri Lanka has a soft peg to the US dollar of 203, allowing for the conversion of most imports as well as 6.0 percent sterilized interventions.
Despite the weak peg, the central bank has tightened a surrender requirement, forcing liquidity infusions to sterilize interventions.
A surrender requirement will create money at 6.0 percent on a pegged regime that is already weak.
Instead of purchasing dollars to inject liquidity and relax the system when a peg is weak, a central bank should sell dollars and remove liquidity to tighten the credit system and drive rates up until reserve depletion is no longer occurring.