ECONOMYNEXT – Sri Lanka central bank’s local swaps are a ‘hot money operation’, members of the parliament’s Committee on Public Finance have warned, amid concerns over its inability to build reserves in 2025.
The COPF has also made a discovery that domestic inflationary swaps are not considered a reserve related liability that is deducted by the central bank when arriving at its own Net International Reserve (NIR) number.
Questions have also been raised by other analysts about publicly declared reserve money numbers where some excess rupee reserves which banks can use for final clearing of transactions appear to be excluded.
The central bank considers the remaining bailout loans from the International Monetary Fund from the 2016 program, loans from the Reserve Bank of India and a cross-border swap from the Chinese central bank as liabilities, Director of Economic Research Sujatha Jegajeevan said.
“When you take out the three major components you get the NIR as per the central bank definition,” Jegajeevan said.
The gross reserves were 6.2 billion dollars and the NIR was 3.4 billion, she said.
The PBoC swap is considered a liability, which was around 1.36 billion dollars, there was a liability to the RBI, that is around 880 million, and the IMF was owed around 580 million dollars, she said.
“So, do you have domestic swaps with domestic banks?,” COPF Chairman Harsh de Silva asked. “So that is not taken out?”
“That is not taken out,” she said. “Only external liabilities are taken out.”
“But, say, you have a swap with HSBC, or StanChart, or something. That is still a central bank liability, is it not?,” de Silva asked.
“But a domestic liability,” Jegajeevan said.
“But a domestic liability in forex,” De Silva pointed out. “But you still need forex [to settle it].”
Central Bank Governor Nandalal Weerasinghe said they were short term swaps of less than one year.
“If it is a domestic long term swap?” de Silva questioned.
“We do not have long term swaps,” Governor Weerasinghe said.
Hot Money Operation
“That is a more of a hot money type of operation,” COPF member Ravi Karunanayake pointed out.
“So that is even worse,” COPF chief de Silva commented.
“Yes, Exactly,” Karunanayake said.
De Silva pointed out that in the past short term swaps had been used to window dress reserve and claim high numbers by previous governors.
“The objective is to ensure that these are stable long term reserves?” de Silva said.
“If that is the case, even if you have swaps in the domestic market in USD should not that be removed from your calculation?”
“No, I think we can show separately,” Governor Weerasinghe said.
He said in the last three years there have been reserves built up through genuine flows. In the first year almost 1.8 billion was purchased, net basis from the market, last year 2.8 billion, and in 2025 around 1.4 billion by the time of the CoPF meeting in November.
That was the key way of building reserves, Governor Weerasinghe said. But on top of that the central bank wanted to build gross reserves with swaps.
Liquidity Injections
“This is another instrument for the banks,” Governor Weerasinghe said explaining the central bank’s position.”
“This is an instrument that we provide to the banks. If they need rupee liquidity, they can enter into a swap with the central bank and get their rupee liquidity for lending purposes in the local market.
“That is one of the instruments banks have been using for short term liquidity purposes. We cannot say not to that. If there is an opportunity, we should use that opportunity to provide liquidity to the banking system. That is another instrument in the market.
“That is for them to use and at least for us to build reserves on a short-term basis over and above (dollar purchases),” Governor Weerasinghe said.
“If you say that cannot be done, then we have to do more market intervention to fill that gap.”
Analysts have pointed out that the liquidity from buy-sell swaps boosts credit and imports over and above current inflows, which will reduce the ability for the central bank to purchase any dollars from the market.
To stop the rupee from depreciating, the central bank has to redeem the new liquidity, losing its foreign reserves on a net basis.
In addition, to the extent that the central bank does not return the swap dollars to banks and customers who import with the newly created money (liquidity) hit the forex market, the rupee will depreciate.
Then the central bank will end up with a forex loss, based on accounting standards, regardless of whether or not swap dollars are considered a ‘liability’ or not.
Eventually the tax-payer has to bail out the central bank or lose seiniorage profits.
Swaps allow a central bank to suppress interest rates even after running out of reserves, and making large losses when rates are eventually hiked and the currency is forced to float.
While the state agency ends up with a forex loss, commercial banks that make loans with the new central bank liquidity are protected against forex losses.
However, if the currency falls steeply, due to the extended credit cycle, killing people’s incomes and consumption, the resulting loss of revenues will lead to bad loans, especially among SMEs and excessively leveraged borrowers.
During the East Asian crisis, almost without exception, the currencies were hit by swaps.
East Asian central bank do not usually print money in the conventional sense and have negative domestic assets (through the sale of central bank bills) and foreign reserves bigger than the domestic note issue.
Analysts have pointed out that any dollars purchased by the central bank outright from the market are also not actually held outright.
The liquidity (bank notes) created by the central bank in the process of buying dollars from commercial banks is a zero coupon liability and part of the reserve money, whether or not it is officially considered reserve money since it is true ‘circulating medium’.
To retain (build reserves) permanently, some other central bank assets which are not circulating medium, such as its bond portfolio, or even a central bank bill has to be given to commercial banks, to stop the liquidity from creating credit, or ‘sterilized’ through deflationary policy.
John Exter, the founding Governor central bank outright purchases dollars, the “monetization the balance of payments” surplus, which he pointed out was “actively inflationary.”
If the central bank is already in a position to ‘monetize the balance of payments’ swap rupees will reduce the ability do collect and retain dollars.
If there is excess liquidity, unwinding swaps (deflationary policy) will reduce domestic credit and increase the ability of the central bank not only to buy dollars but retain it.
If there is no excess liquidity left in money market, any unwinding of swaps, will lead to a liquidity shortage, which will be filled with printed money against domestic assets (open market operations) if there is a policy rate, which will lead to a vicious cycle of reserve losses and more injections until rates are raised.
The only purchased dollars that the central bank can hold as ‘permanent’ foreign reserves without conducting deflationary policy is the reserve money which is not excess liquidity and becomes part of any real demand for money under a stable exchange rate (not harming the poor) or a jump in reserve money that comes from depreciation driven price increases. (Colombo/Dec06/2025)