The Sri Lanka FX swaps warning from the Committee on Public Finance has intensified debate over the central bank’s reserve management practices. Lawmakers and analysts are questioning the implications of domestic swaps on stability and transparency heading into 2025.
Sri Lanka FX swaps warning draws scrutiny over reserve risks and liability gaps
Sri Lanka’s reserve management strategy has come under heightened scrutiny following a Sri Lanka FX swaps warning issued by members of the Committee on Public Finance, who described ongoing local currency swap operations as a form of “hot money activity.” Their concern stems from persistent challenges faced by the central bank in building and retaining international reserves, particularly as the economy moves toward 2025 with elevated external pressures and fragile recovery signals.
In recent parliamentary discussions, COPF members revealed that domestic inflationary swaps executed with local banks are not categorized as reserve-related liabilities by the central bank when calculating its Net International Reserves. This omission has sparked debate, as many analysts argue that liabilities tied to foreign exchange obligations—whether domestic or external—affect the institution’s ability to meet settlement requirements during stressed periods. Several experts have also raised further questions about the interpretation of reserve money figures, noting that specific excess rupee reserves used for transactional clearing appear to be excluded from official disclosures.
The central bank’s Director of Economic Research, Sujatha Jegajeevan, outlined that foreign obligations such as remaining funds due to the International Monetary Fund from the 2016 program, swap liabilities to the Reserve Bank of India, and a cross-border arrangement with the People’s Bank of China are indeed counted as liabilities for NIR calculations. According to her presentation, gross reserves stand at 6.2 billion dollars while the corresponding NIR number is listed at 3.4 billion dollars. Key liabilities include around 1.36 billion dollars owed under the PBoC swap, approximately 880 million dollars linked to the RBI facility, and 580 million dollars in outstanding IMF obligations.
However, the issue arose when COPF Chairman Harsha de Silva pressed on whether domestic forex swaps with banks such as HSBC or Standard Chartered were considered in the same manner. Despite being denominated in foreign currency, these are still treated as domestic liabilities and therefore not deducted, a position the central bank defended by asserting that only external liabilities are included for NIR purposes. Governor Nandalal Weerasinghe added that the swaps under discussion are short-term instruments with maturities under one year and that the bank does not engage in long-term domestic swaps.
COPF members argued that short-term swaps can distort the reserve picture by creating temporary inflows that present an inflated sense of stability. Ravi Karunanayake described these practices as akin to hot money operations, suggesting they mask deeper vulnerabilities. De Silva recalled past instances where temporary swaps were used to “window dress” reserve levels, warning that the central bank must avoid repeating those patterns if it intends to maintain credibility and stability.
Governor Weerasinghe defended the approach by emphasizing that Sri Lanka has achieved genuine reserve accumulation in recent years through net purchases from the market. He cited figures showing net purchases of 1.8 billion dollars in the first year, 2.8 billion the following year, and around 1.4 billion dollars by late 2025. While acknowledging that swaps supplement reserve buildup, he described them as an additional liquidity tool for banks rather than a structural dependence.
The governor further explained that domestic swaps serve as a mechanism for providing short-term rupee liquidity, allowing commercial banks to secure funds for lending when necessary. He argued that denying banks this option would force the central bank to engage in heavier market intervention, which could result in distortions of its own. Yet analysts counter that swaps create rupee liquidity that fuels credit expansion and imports beyond the economy’s current inflow capacity, thereby reducing the central bank’s real ability to accumulate dollars. When the rupee begins to depreciate due to liquidity-driven pressures, the central bank must absorb the impact by redeeming new liquidity, resulting in reserve losses.
The broader criticism extends to whether swap-generated dollars are ever fully retained. If banks or customers import goods using liquidity created through swaps, the demand for foreign currency increases while the supply remains relatively fixed. This mismatch eventually worsens depreciation pressures, leading to accounting-related foreign exchange losses for the central bank. Critics note that such losses ultimately fall on taxpayers through diminished seigniorage profits or higher recapitalization needs.
Historical examples support these vulnerabilities. During the East Asian crisis, short-term swaps played a notable role in destabilizing exchange rates as central banks attempted to manage interest rates and liquidity simultaneously without allowing natural market adjustments. Analysts argue that the same inherent risk applies if Sri Lanka continues relying on swaps while resisting interest rate movements.
John Exter, the founding governor, previously warned that outright purchases of foreign currency by a central bank represent monetization of the balance of payments surplus, a process he described as actively inflationary. If a central bank wishes to retain such reserves permanently, it must sterilize the liquidity created by either contracting domestic assets or allowing market rates to adjust. When excess liquidity persists, swaps only exacerbate the difficulty of accumulating and holding foreign reserves.
As the debate intensifies, policymakers are emphasizing the need for transparency and sustainable reserve practices. Many analysts stress that the country’s ability to protect the poor, maintain exchange rate stability, and support long-term economic recovery depends on ensuring that reserve numbers reflect genuine, not temporary, positions. With the Sri Lanka FX swaps warning now part of the national conversation, pressure is mounting on authorities to reassess how swap liabilities interact with reserve strategies and whether the current methodology adequately reflects financial realities.