By Asoka S. Seneviratne –

Reassessing the Role of CBSL, Fiscal Policy, and External Stability in Sri Lanka’s Recovery “The exchange rate is the price of a country’s economic credibility.” — Rudi Dornbusch

After publication of my article “A Blueprint For Rupee Stability: Why Domestic Discipline Isn’t Enough To Save The Rupee” many questions were raised, arguing that the SLR depreciation arose from the inherent nature of IMF adjustment programs or from incomplete policy coordination within the framework. Indeed, these are very relevant and useful questions that need inquiry.

Sri Lanka’s economic collapse in 2022 marked one of the most severe macroeconomic crises in the country’s post-independence history. (i) Foreign reserves evaporated, (ii) sovereign debt obligations became unsustainable, (iii) inflation surged to unprecedented levels, (iv) shortages paralyzed daily life, and (v) public confidence in economic management deteriorated rapidly. In response, Sri Lanka once again turned to the International Monetary Fund for stabilization support, initiating a difficult but necessary process of macroeconomic adjustment and institutional reform.

Since then, the country has made notable progress. (i) Inflation has fallen sharply from crisis-era levels; (ii) monetary financing has been curtailed; (iii) interest-rate stability has improved; (iv) official reserves have gradually recovered; and, most importantly, (v) fiscal consolidation measures have begun to restore a degree of international confidence. To many policymakers and external observers, these developments suggest that Sri Lanka has moved from crisis toward stabilization.

Despite these achievements, ongoing depreciation pressures on the Sri Lankan Rupee (SLR) have fueled growing public concern and policy debate. This has raised a fundamental question that warrants deeper examination: if the IMF framework is designed to restore macroeconomic stability, why does the SLR continue to weaken? Is depreciation inherent in the IMF adjustment framework, or does it instead reflect weaknesses in the implementation and coordination of domestic economic policy?

This question cannot be answered by simplistic political narratives or emotional public discourse. The issue is far more complex. In my view, exchange-rate behavior is not determined solely by monetary policy, nor can it be understood only through reserve accumulation or inflation control. Rather, exchange-rate stability depends on the interaction between domestic macroeconomic management and the economy’s external earning capacity. This is the naked truth.

Sri Lanka’s experience reveals an important structural reality. While substantial effort has been directed toward stabilizing the domestic rupee-based economy  (i) through tighter monetary policy, (ii) fiscal consolidation, and (iii) inflation reduction, far less progress has been made in transforming the external dollar-generating capacity of the economy. This is the naked truth as well. In effect, the country has partially stabilized its internal balance sheet without fully stabilizing its external balance sheet.

This distinction is critically important because no country can permanently defend its currency unless its external earning capacity expands in line with domestic economic activity. Sustainable exchange-rate stability requires a delicate balance among (i) imports, (ii) exports, (iii) reserves, (iv) capital inflows, (v) productivity growth, and (vi) investor confidence. When these variables become misaligned, depreciation pressures inevitably emerge even within IMF-supported programs.

Therefore, the purpose of this article is not to criticize the IMF framework itself, nor to assign responsibility solely to the Central Bank of Sri Lanka or the Ministry of Finance. Instead, the objective is to examine whether Sri Lanka’s present exchange-rate challenges arise from the inherent nature of IMF adjustment programs or from incomplete policy coordination within the framework.

The article argues that SLR depreciation is not an unavoidable outcome of IMF-supported reform. Rather, it emerges when domestic recovery, monetary easing, fiscal policy, reserve management, and external-sector reforms are not synchronized within a coherent national macroeconomic strategy. The central challenge facing Sri Lanka today is therefore not merely stabilization, but the creation of a sustainable economic model capable of simultaneously protecting both the rupee economy and the dollar economy.

Understanding the IMF Framework Beyond Austerity

The IMF framework is often misunderstood in Sri Lanka as a narrow programme focused only on (i) taxation, (ii) expenditure cuts, and (iii) debt restructuring. In reality, modern IMF-supported stabilisation programmes are designed as comprehensive macroeconomic adjustment frameworks intended to restore overall economic equilibrium. Their primary objective is not simply to reduce inflation temporarily or rebuild reserves mechanically, but to create a sustainable relationship between domestic economic activity and external financing capacity.

At the heart of every IMF programme lies the recognition that (i) persistent fiscal deficits, (ii) excessive monetary expansion, (iii) weak reserves, and (iv) external imbalances cannot coexist indefinitely without destabilizing the economy. Therefore, the IMF framework seeks (i) to coordinate fiscal policy, (ii) monetary policy, (iii) exchange-rate management, (iv) reserve accumulation, and (v) structural reforms into one integrated adjustment process.

Sri Lanka’s recent stabilization efforts demonstrate both the strengths and limitations of this framework. Considerable success has been achieved in controlling inflation and restoring a degree of fiscal discipline. However, stabilization of the external sector has progressed more slowly because structural weaknesses in exports, productivity, investment, and foreign exchange generation remain unresolved. This asymmetry between internal stabilization and external transformation is central to understanding continuing SLR depreciation pressures.

The Two Balance Sheet Trap

Sri Lanka’s crisis exposed on the basis of  “Two Balance Sheet Trap”  that I explained in my previous article as mentioned at the beginning. One balance sheet operates internally through the rupee economy, while the other operates externally through the dollar economy. Although interconnected, these two systems do not always stabilize simultaneously.

The domestic balance sheet includes government borrowing, domestic liquidity, inflation, credit growth, wages, and interest rates. The external balance sheet consists of foreign reserves, export earnings, tourism receipts, remittances, external debt obligations, and import financing requirements.

Before the crisis, Sri Lanka attempted to maintain domestic growth through excessive borrowing and monetary expansion despite a weakening external position. The result was a widening imbalance between domestic demand and external earning capacity. Once external financing dried up, the entire system collapsed in 2022.

After 2022, policymakers focused heavily on stabilizing the domestic balance sheet through higher interest rates, reduced money printing, and fiscal tightening. These measures succeeded in reducing inflation and restoring a degree of monetary discipline. However, the external balance sheet remained fragile because the country’s ability to generate sustainable dollar inflows did not improve at the same pace.

As domestic recovery gradually resumed, import demand began rising faster than export growth. This naturally generated renewed pressure on the exchange rate. Thus, Sri Lanka’s present challenge reflects not merely a currency issue, but a structural imbalance between the internal economy and the external economy.

Monetary Easing and External Fragility

One of the most debated policy questions concerns whether monetary conditions were eased too early after inflation declined. From a domestic perspective, lower interest rates were necessary to revive economic activity after a severe recession. Businesses required credit relief, households needed financial breathing space, and economic contraction could not continue indefinitely.

However, within an IMF-supported adjustment framework, monetary easing must be carefully synchronized with external-sector recovery. If interest rates fall before reserves become sufficiently strong and export growth becomes sustainable, domestic demand can recover faster than the economy’s foreign exchange earning capacity.

This appears to be one of the key challenges Sri Lanka faced. Lower interest rates stimulated consumer demand and import-related activity at a time when reserve buffers remained relatively fragile. Vehicle-import demand, consumption-related imports, and private credit growth gradually increased pressure on the foreign exchange market.

In such circumstances, even if inflation remains under control, the exchange rate can weaken because external demand for dollars rises more rapidly than dollar inflows. This demonstrates an important macroeconomic principle often overlooked in public debate: low inflation alone does not guarantee currency stability. The timing and sequencing of monetary easing, therefore, become critically important within the IMF framework.

Exchange-Rate Flexibility and Policy Credibility

The IMF generally supports flexible exchange-rate regimes because rigid pegs often lead to reserve crises and abrupt devaluations. Flexible exchange rates allow economies to absorb external shocks more gradually and reduce the need for unsustainable reserve defence.

However, flexibility should not be misunderstood as acceptance of uncontrolled depreciation. A successful floating exchange-rate regime still requires credible macroeconomic management, reserve adequacy, investor confidence, and strong institutional communication. In Sri Lanka’s case, market expectations play a major role in determining exchange-rate behaviour. If economic agents believe that reserves remain fragile or that future import demand will exceed dollar inflows, depreciation expectations become embedded within the system itself.

Once these expectations become entrenched, they influence savings behaviour, investment decisions, and capital flows. Businesses may delay conversion of export proceeds, households may prefer dollar-denominated assets, and investors may hesitate to commit long-term capital. Thus, exchange-rate stability ultimately depends not only on monetary policy, but also on confidence in the broader economic trajectory of the country.

Reserve Accumulation Versus Reserve Sustainability

One of the most important lessons from Sri Lanka’s experience is that reserve accumulation alone does not guarantee long-term exchange-rate stability. The quality and sustainability of reserve accumulation are equally important.

During the post-crisis period, reserves improved through a combination of debt suspension, import restrictions, bilateral arrangements, tourism recovery, and temporary inflows. While these measures provided valuable short-term breathing space, they did not necessarily represent deep structural transformation of the economy.

Sustainable reserve strength requires continuous foreign exchange generation through exports, remittances, tourism, and productive foreign direct investment. Temporary reserve improvements cannot permanently stabilise the rupee if the country continues to depend heavily on imports without proportionate export expansion. As the economy gradually normalises and imports increase, reserve pressures can quickly re-emerge unless structural export capacity expands significantly. Therefore, reserve management must be understood within the broader context of long-term external sustainability rather than short-term numerical accumulation.

Export-Dollar Repatriation and Domestic FX Liquidity

Another critical but often under-discussed issue concerns export-dollar repatriation. Even when exports increase, the domestic foreign exchange market can remain weak if export proceeds are retained offshore or delayed outside the local banking system. This creates an important paradox. A country may record respectable export earnings on paper while simultaneously experiencing shortages of dollar liquidity within the domestic financial system. When this occurs, the exchange rate comes under pressure despite nominal export performance.

Sri Lanka therefore faces the challenge of balancing export-sector flexibility with the need to maintain sufficient domestic FX circulation. This issue is not about imposing punitive restrictions on exporters. Rather, it concerns ensuring that export-generated foreign exchange contributes effectively to domestic economic stability.

Many countries operating under IMF-supported frameworks implement mechanisms that encourage timely repatriation and conversion of export earnings. Such measures help strengthen domestic FX liquidity, improve reserve accumulation, and stabilise exchange-rate expectations. Without adequate circulation of export dollars within the domestic economy, the rupee remains structurally vulnerable.

Fiscal Policy, Growth, and External Constraints

Economic recovery naturally creates political pressure for higher growth, rising wages, infrastructure expansion, and import liberalisation. However, every growth strategy must ultimately be evaluated against the country’s external financing capacity. Sri Lanka historically relied on consumption-driven growth financed through external borrowing rather than productivity-driven export growth. This model generated persistent trade deficits and increasing vulnerability to external shocks. Within the IMF framework, sustainable growth requires alignment between domestic expansion and external earning capacity. If economic growth generates import demand faster than export earnings increase, external imbalances inevitably reappear.

This is why macroeconomic coordination between the Ministry of Finance and CBSL becomes essential. Credit growth, wage policies, import liberalisation, and public expenditure must all be calibrated against reserve adequacy and Balance-of-Payments sustainability. Otherwise, economic recovery itself can unintentionally recreate the very pressures that contributed to the original crisis.

Toward a Coordinated Macroeconomic Strategy

Sri Lanka’s post-crisis experience demonstrates that macroeconomic stabilization cannot succeed through fragmented policymaking. Monetary policy, fiscal management, trade policy, reserve management, and investment strategy must operate within one coherent national framework.

According to my experience in working with numerous developing economies, a major weakness is the absence of institutional coordination between key economic agencies. (i) Central banks focus on inflation,(ii) Finance ministries focus on growth and revenue,  (iii) Trade authorities focus on exports, (iv) while investment agencies pursue capital inflows independently. In the absence of strategic coordination, policy inconsistencies emerge.

Sri Lanka now requires a more integrated approach to economic governance. Policymakers must align domestic growth ambitions with external-sector realities. Exchange-rate management cannot be separated from (i) export policy, (ii) reserve strategy, (iii) productivity improvement, and (iv) investment planning.

Countries that successfully recovered from major financial crises did not rely solely on monetary adjustment. They combined macroeconomic discipline with export transformation, institutional coordination, and long-term productivity growth. The experiences of countries such as South Korea, Vietnam, Botswana, and even post-crisis Asian economies demonstrate that sustainable exchange-rate stability cannot be achieved through monetary policy alone. It requires continuous coordination between fiscal policy, monetary policy, external-sector management, trade competitiveness, and investment strategy.

This is the fundamental reason why the establishment of a statutory Macroeconomic Policy Coordination Committee (MPCC) deserves serious consideration in Sri Lanka. Such an institutional mechanism could structurally link the CBSL’s Monetary Policy Board with the Treasury’s fiscal planners, while also integrating external-sector analysis, reserve management, trade policy, and medium-term growth strategy into one coordinated national framework.

Sri Lanka’s long-term currency stability — whether under a managed flexibility regime or a broader external-sector stabilization framework — will ultimately depend on whether such policy coordination can be institutionalized effectively and sustained consistently beyond short-term political cycles.

Summary & Conclusion

The continued depreciation pressures on the Sri Lankan Rupee should not be interpreted simplistically as evidence that the IMF framework has failed. Nor should depreciation be viewed as an inevitable consequence of IMF-supported adjustment. Rather, Sri Lanka’s experience demonstrates that exchange-rate stability depends on the successful coordination of domestic stabilisation with external economic transformation.

The country has made substantial progress in reducing inflation, restoring monetary discipline, improving fiscal credibility, and rebuilding reserves. However, long-term currency stability requires much more than internal macroeconomic adjustment. It requires sustainable export expansion, stronger reserve quality, productive foreign investment, improved productivity, disciplined import management, and effective circulation of export-generated foreign exchange within the domestic economy.

The central lesson is clear. No country can permanently stabilise its currency merely by stabilising its domestic economy. Sustainable exchange-rate stability requires simultaneous strengthening of the external earning capacity of the nation.

The IMF framework provides the institutional architecture for such transformation. However, its success ultimately depends on the quality, sequencing, and coordination of domestic policymaking. Sri Lanka’s future economic stability will therefore depend not only on IMF support, but on the country’s own ability to integrate monetary policy, fiscal policy, reserve management, trade strategy, and structural reform into one coherent national development framework along MPCC.

*The writer, among many, served as the Special Adviser to the Office of the President of Namibia from 2006 to 2012 and was a Senior Consultant with the UNDP for 20 years, and a Senior Economist with the Central Bank of Sri Lanka (1972-1992). He can be reached at asoka.seneviratne@gmail.com