Sri Lanka’s recent central bank strategy, which includes injecting excess liquidity into the banking system, has sparked significant concern among analysts and economists who fear the potential long-term effects on financial stability. The central argument by Dhananath Fernando of the Advocata Institute and other experts is that while Sri Lanka’s banking sector is recovering, overreliance on liquidity injections could create unintended financial distortions that undermine CBSL’s achievements in restoring monetary stability since the 2022 crisis.
The injections of funds, while aimed at addressing temporary liquidity mismatches between banks, could cause challenges in the future. For instance, excess liquidity typically encourages banks to increase lending without adequately assessing risks, a practice that can lead to “bad behavior” in the sector, according to Fernando. When banks have ample access to low-cost funds from the central bank rather than from interbank markets, it can lead to credit allocation issues, artificially suppressed interest rates, and an increased risk of inflation, especially if this money leaks into the broader economy rather than remaining in interbank transactions.
Critical Analysis of CBSL’s Approach
Fernando argues that the recent actions echo strategies that led to financial crises in other countries. He references the Federal Reserve’s open market interventions during the 1920s in the U.S., which were initially seen as benign but ultimately fueled a financial bubble and the Great Depression. Sri Lanka’s experience with past inflationary policies, particularly during the 2021 currency crisis, has shown that heavy injections of unbacked funds can lead to credit expansion, increased imports, and ultimately, a balance of payments crisis. This backdrop makes Fernando’s argument particularly relevant for CBSL as it manages its current monetary policy.
CBSL’s Defense and Policy Alternatives
CBSL defends its actions, stating that the injections aim to correct liquidity imbalances, especially given that foreign banks are holding large amounts of rupees in CBSL accounts due to concerns about interbank lending risks. These foreign banks’ cautious behavior limits liquidity circulation in the interbank market, prompting CBSL to step in. However, Fernando argues that more restrained and targeted approaches could maintain liquidity without leading to excess reserves.
He suggests several alternatives for CBSL to support financial stability without increasing systemic risk:
- Lowering the Standing Deposit Facility Rate: A slight reduction here could incentivize banks to lend to each other in the interbank market rather than keeping excess reserves with CBSL.
- Using Foreign Exchange Transactions: CBSL could manage liquidity by purchasing foreign currency, thereby bolstering the country’s foreign reserves. These reserves can later serve as a buffer against exchange rate pressures should the rupee face devaluation.
- Resorting to the Standing Lending Facility: By offering banks funds at a penal rate, CBSL could encourage only urgent, short-term borrowing, reducing the likelihood of over-dependence on central bank resources.
The Need for Prudent Fiscal Management
Fernando’s recommendations stress that CBSL should avoid injecting liquidity that may lead to “money printing” effects, where an artificial increase in money supply risks inflation and currency depreciation. Analysts warn that if CBSL’s liquidity injections are not swiftly managed by pulling funds back out via Treasury bill sales or foreign currency transactions, the excess money could spill into the broader economy, sparking inflation and undermining CBSL’s goal of price stability. This risk is particularly high in a country like Sri Lanka, where past monetary crises have left the economy highly sensitive to shifts in inflation and currency value.
CBSL’s Track Record and Looking Forward
While CBSL has largely been credited for restoring relative stability since late 2022, Fernando and other economists believe maintaining this stability will be a delicate balance going forward. They argue that liquidity management should be approached cautiously, with an emphasis on ensuring long-term stability rather than short-term rate adjustments.
The recent debate has underscored the importance of responsible monetary policy, with Fernando and others encouraging CBSL to focus on strategies that support a stable, functioning financial system without introducing risks that could threaten the gains achieved over the past two years.
