Wednesday May 27, 2026
Wednesday May 27, 2026
Wednesday, 27 May 2026 00:20 - - {{hitsCtrl.values.hits}}
By Devan Daniel
The Central Bank of Sri Lanka yesterday signalled confidence that recent distortions in the foreign exchange market were unlikely to recur after measures taken late last week restored liquidity and trading activity in the interbank market.
Speaking after the Central Bank’s monetary policy announcement, CBSL Governor Dr. Nandalal Weerasinghe said conditions in the market had normalised after discussions with bank treasurers and targeted steps to reactivate the interbank foreign exchange market, which had effectively frozen during last week’s panic-driven dollar demand.
“As a result, liquidity returned to the market, with active buying and selling in the interbank market. The market is now functioning normally,” Dr. Weerasinghe said.
The CBSL’s remarks suggested the Central Bank viewed last week’s rupee volatility as a temporary breakdown in market functioning rather than a broader macroeconomic dislocation.
According to the CBSL, customer dollar transactions became detached from underlying interbank pricing as importers rushed to secure dollars amid fears of further depreciation, while exporters delayed conversions and banks increasingly serviced only their own clients.
“We observed distortions caused by speculation, panic-driven import demand and excessive demand for dollars,” Dr. Weerasinghe said. “Normally, customer rates should remain within a reasonable spread around the interbank rate, but they had diverged significantly.”
While the interbank market rate had risen from around Rs. 320 to Rs. 330 during the height of the pressure, some customer transactions were reported at levels as high as Rs. 346 and Rs. 354.
The Governor said the core problem was the collapse of active trading between banks themselves, weakening price discovery and broader market transmission.
“What happened was that liquidity in the interbank market had dried up. Importers were demanding more dollars, exporters were delaying conversions, and banks were retaining inflows to service only their own clients without trading in the market,” he said.
“That was mainly because importers panicked. They approached banks willing to pay higher rates without looking at interbank market rates. If customers are willing to buy at those prices, banks naturally have little reason not to sell directly to them.”
“As a result, transactions did not take place in the interbank market. Banks were servicing their own customers without participating actively in the market.”
Dr. Weerasinghe said the CBSL’s actions were specifically aimed at restoring proper market transmission through a more liquid and active interbank market.
“We need to see active liquidity in the interbank market because that is essential for proper transmission across markets,” he said.
“Our actions were aimed at reactivating the interbank market so that it reflects broader market conditions. As long as the interbank market remains active and liquid, such distortions are unlikely to recur.”
The Governor stressed that the Central Bank’s direct intervention in the currency market had remained limited and was aimed only at smoothing excessive volatility.
“On Friday, there was a small intervention from our side to reduce volatility,” he said.
Dr. Weerasinghe also indicated that the CBSL remained prepared to deploy additional tools, including moral suasion, if market conditions deteriorated again.
“We preferred to use cleaner instruments as the first line of action, and that is what we have done here,” he said. “At present, there is no need for stronger measures because the market has already stabilised. If necessary, however, we can consider additional measures.”
The Governor also rejected criticism from some monetary commentators that earlier reserve accumulation operations by the CBSL had contributed to rupee weakness by injecting excess liquidity into the banking system.
“It is a very basic issue. Everyone understands how money growth and liquidity operate,” Dr. Weerasinghe said.
At the same time, he confirmed that the CBSL had already been absorbing excess liquidity from the banking system through overnight operations and short-term auctions.
“Since the end of April, we have activated overnight liquidity absorption operations to absorb excess liquidity from the market,” he said, adding that the CBSL would continue three- to seven-day term operations as part of broader liquidity management.
Deputy Governor Dr. Chandranath Amarasekera said the Central Bank’s decision to tighten monetary policy reflected a combination of worsening external supply conditions arising from the Middle East conflict and continued strength in domestic demand.
“If we look at the expectations surrounding the Middle East war at that time, obviously that has changed and we now have more information than we had in March,” Dr. Amarasekera said.
He said strong credit growth, import demand and broader economic activity showed that demand-side pressures in the economy remained firm despite rising external risks.
“That is why the Central Bank decided to tighten monetary policy,” he said. “The objective is to contain future inflation expectations and prevent second-round inflationary effects through this policy action.”
He said the combination of external supply shocks and strengthening domestic demand required tighter monetary conditions to prevent inflationary pressures from becoming entrenched.
The CBSL’s remarks also come amid growing debate over whether earlier reserve accumulation operations and rising excess liquidity had contributed to pressure on the rupee.
CBSL data shows excess liquidity in the banking system increased from Rs. 175.2 billion at end-2025 to Rs. 280.75 billion by 20 February 2026 following net foreign exchange purchases and swaps undertaken during the reserve rebuilding process.
However, the timing and character of the rupee’s sharp depreciation appeared to coincide more directly with the escalation of the Middle East conflict and the resulting disruption in market behaviour.
During the period of volatility, importers accelerated dollar demand amid fears of further depreciation, exporters delayed conversions, and interbank liquidity weakened sharply as banks increasingly prioritised servicing their own clients rather than actively trading among themselves, according to the CBSL.
At the same time, several broader macroeconomic indicators remained relatively stable. Inflation stood at 5.4% in April within the Central Bank’s target range, gross official reserves remained above $ 7 billion, and Sri Lanka’s IMF-supported reform program continued.
The developments have intensified debate over the challenges of operating a flexible monetary framework in a shallow and sentiment-driven foreign exchange market while simultaneously rebuilding reserves, managing inflation, supporting economic recovery and maintaining financial stability.
Economists note that while currency-board-style monetary regimes can impose stricter discipline on liquidity creation and exchange rate management, the adjustment to external shocks under such systems can also be significantly harsher, often transmitting through abrupt interest rate increases, tighter domestic liquidity conditions and weaker economic activity. Most economies therefore operate under more flexible central banking frameworks rather than pure currency boards.
Economists also note that sterilising excess liquidity carries costs, as central banks typically absorb liquidity through deposit operations and short-term instruments that increase interest expenses within the financial system.
Currency market participants say Sri Lanka’s ongoing debate over monetary discipline, reserve accumulation and exchange rate management remains important, but caution that such discussions need to be conducted carefully to avoid amplifying panic, distrust and destabilising expectations in an already shallow foreign exchange market.
“When CBSL purchased dollars from the market, they should have sterilised the excess liquidity, that is the argument. But if bank’s preferred lending at a higher rate than parking the rupees at the Central Bank? Which means, then, the CBSL would have to tighten rates to kill demand for credit,” one market participant said.
