Sri Lanka rupee depreciation accelerated in December 2025 as the central bank’s foreign exchange operations reshaped liquidity conditions. Official data show large-scale dollar purchases that expanded domestic money, weakening the currency despite strong external balances.
Central bank actions deepen Sri Lanka rupee depreciation despite external surpluses
Sri Lanka’s currency ended 2025 under renewed pressure after the central bank bought approximately US$250.8 million from market participants in December while selling back only US$28.3 million. This imbalance injected new rupee liquidity into the financial system and coincided with a near three-rupee slide against the US dollar, leaving the year-end spot rate just below 310.
While authorities and some commentators have argued that the exchange rate is determined by market forces, the data reveal a more interventionist reality. Central bank dollar purchases differ fundamentally from those made by private citizens or the Treasury. When the monetary authority buys foreign exchange, it creates new domestic money, a process long described by monetary economists as the monetization of balance-of-payments inflows. This expansion of liquidity keeps purchasing capacity intact, sustaining imports and domestic demand rather than restraining them.
Analysts argue that this dynamic places the central bank at a disadvantage when building reserves. Unlike a private individual holding foreign currency or the Treasury using dollars to retire external debt, central bank purchases do not immediately dampen consumption. As a result, upward pressure on the exchange rate that would normally arise from a surplus is neutralized, and depreciation risks persist.
A durable appreciation, or even stability, requires that excess liquidity created through reserve accumulation be withdrawn via deflationary measures. In Sri Lanka’s case, this has not consistently occurred. Coupon income on government securities held by the central bank can support reserve accumulation without further money creation, and the unwinding of buy-sell swaps could also strengthen net reserves. However, when dollar purchases exceed the pace of liquidity absorption, the rupee weakens.
December’s depreciation occurred despite record current account surpluses, undermining the traditional argument that deficits alone drive currency stress. In 2025, that explanation offered little cover. Instead, critics point to a long-standing policy framework marked by conflicting anchors. Sri Lanka formally operates an inflation-targeting regime, which requires a cleanly floating exchange rate to function effectively. Under such a system, international transactions do not alter reserve money, allowing interest rates to regulate liquidity.
In practice, efforts to manage the exchange rate while also targeting domestic inflation blur these boundaries. When authorities intervene to push the currency down in order to buy reserves, they introduce an external anchor into what is presented as a flexible system. This hybrid approach, often labelled a flexible exchange rate, has been criticized for diluting accountability. When depreciation follows, it is frequently attributed to market forces rather than policy choices.
The consequences extend beyond financial markets. Currency weakening feeds directly into higher energy and food costs, straining household budgets and public finances alike. State-owned utilities, including petroleum and electricity providers, face rising input costs when the rupee falls. Price adjustments then cascade through the economy, eroding purchasing capacity and heightening social tensions.
In early 2025, tighter liquidity conditions helped avert a more severe crisis. Money creation from late 2024 was allowed to unwind, and the central bank largely maintained a scarce reserve environment, relying on overnight facilities at the upper policy rate. Prime lending and deposit rates adjusted upward, encouraging savings and moderating credit growth. These steps reduced the likelihood of a disorderly correction often seen in economies with soft pegs and frequent rate interventions.
External shocks also played a role. Cyclone Ditwah struck in December, and Sri Lanka’s experience suggests that natural disasters can temporarily strengthen the currency if they slow private credit expansion. Historical parallels, including the post-tsunami period in 2005, show that abrupt demand slowdowns can ease import pressure and stabilize exchange rates.
Market psychology further amplifies swings under flexible regimes. During depreciation phases, importers tend to hedge early while exporters delay conversions, and banks manage open positions defensively. When conditions stabilize, these behaviors reverse, supporting the currency. Recent increases in Treasury bill yields may also help by absorbing liquidity and discouraging excessive credit growth, thereby limiting further rupee weakness.
Ultimately, the December episode underscores a central tension in Sri Lanka’s monetary policy. As long as reserve accumulation, interest rate objectives, and exchange rate management pull in different directions, Sri Lanka rupee depreciation risks resurfacing even in periods of external strength. Sustainable stability will depend on clearer policy alignment and consistent liquidity discipline.