Sri Lanka cash short banks sharply increased their reliance on central bank funding as overnight liquidity conditions deteriorated. Official data show emergency borrowing surged on January 8, underscoring renewed pressure within the domestic banking system and reviving concerns over interest rates and currency stability.
Sri Lanka cash short banks lean heavily on central bank credit
Sri Lanka’s banking sector experienced renewed liquidity strain this week as central bank lending to commercial banks surged to 48 billion rupees on January 8, up sharply from 19 billion rupees the previous day. Market participants indicated that state-owned banks were facing an acute cash shortage, forcing heavier dependence on central bank credit lines.
The spike in borrowing has revived scrutiny of the government’s earlier strategy of building a so-called domestic buffer by over-borrowing through bond issuances and depositing funds into the banking system. This approach was implemented when public debt management fell under the central bank, with the stated objective of moderating market interest rates. However, economists have repeatedly warned that such buffers cannot sustainably suppress rates without distorting liquidity conditions.
Analysts tracking Sri Lanka’s monetary framework since 2015 argue that the buffer strategy has historically resulted in central bank accommodation, currency depreciation, and rising inflationary pressures. They point out that over-borrowing continued even as tax revenues improved and the fiscal deficit narrowed, injecting excess liquidity into the banking system rather than reducing overall debt stress.
When government funds are deposited in commercial banks, those institutions typically recycle the liquidity by lending to customers, placing funds in the interbank market, or investing in Treasury bills. While deposits held directly at the central bank can support foreign reserve accumulation by tightening domestic liquidity, withdrawals reverse that effect. Once credit expands and imports rise, foreign exchange must be supplied to prevent depreciation, placing pressure on reserves.
The situation becomes more complex when government deposits are withdrawn from state banks to meet expenditure needs such as disaster relief. In such cases, affected banks first reduce interbank lending and then seek short-term funding from peers. While the withdrawn funds may re-enter the banking system through payments, recipient banks may prefer extending private credit or purchasing Treasury securities rather than lending back to institutions that lost deposits.
This dynamic can ultimately trigger lender-of-last-resort support from the central bank, resulting in additional money creation. Excess liquidity parked at the central bank reached 216 billion rupees on January 8, levels comparable to those seen during periods of economic stress in late 2024 when liquidity absorption became increasingly difficult.
State banks that previously invested heavily in Treasury bills using buffer funds may now be forced to halt reinvestment. Unless other banks step in as buyers, yields could rise, pushing interest rates higher. If private credit demand remains strong, banks may show limited appetite for government securities, allowing newly created money to flow into imports and intensify exchange rate pressure.
Classical economic theory generally cautions against government borrowing through the banking system, given commercial banks’ access to liquidity facilities and the central bank’s tendency to print money to defend policy rates. Such practices are widely viewed as destabilizing for the external sector, which is why governments are typically encouraged to rely on market-based bond financing rather than monetary accommodation.
Sri Lanka’s adoption of a single policy rate since late 2024 has added another layer of risk, although extensive open market operations were avoided and interest rates were allowed to rise. Analysts note that domestic banks appear to operate without strict counterparty exposure limits when dealing with the central bank, increasing systemic vulnerability during periods of stress.
Historically, major natural disasters in Sri Lanka have tended to slow private credit growth and temporarily support the currency. Following the 2004 tsunami, private lending came to a standstill, allowing the rupee to appreciate in 2005. However, economists argue that the domestic buffer mechanism has altered this dynamic by re-introducing liquidity through monetary channels.
Currency instability remains a persistent challenge, driven by attempts to accumulate reserves while simultaneously maintaining policy rates through liquidity injections. Calls have intensified for stronger legal frameworks to restrain inflationary monetary operations, particularly after episodes of high inflation, import controls, labor migration, and political upheaval.
Recent rupee weakness has occurred even as the current administration emphasized fiscal discipline as a stabilizing factor. The depreciation has already filtered into domestic prices. State-run Ceylon Petroleum Corporation raised fuel prices this week despite global crude benchmarks easing in December, while the Ceylon Electricity Board has sought an 11 percent tariff increase, highlighting the broader economic consequences of liquidity-driven currency pressure.