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Sri Lanka central bank swaps top $3.2bn by December

Sri Lanka's central bank engaged in swap transactions borrowing US dollars, reaching over $3.2 billion by December 2024. This borrowing has significantly increased the central bank's net short position by nearly $1.28 billion within two years, highlighting a growing reliance on such financial mechanisms to manage currency and liquidity challenges. The central bank used these swaps to support state banks' dollar needs, which have since been repaid, and to bolster gross reserves without raising domestic interest rates. However, the reliance on swaps, particularly with the People's Bank of China accounting for about $1.5 billion, raises concerns about monetary policy and financial stability.

Swaps can inject liquidity into the market, but if not managed carefully, especially after private credit growth, they can lead to excess credit, balance of payments deficits, and potential currency collapse. Historical instances, such as the 2018 currency collapse under an exchange rate defense policy and the role of swaps in the 1997-98 East Asian financial crisis, underscore the risks involved. The People's Bank of China has implemented rules to mitigate these risks, like preventing swap use when gross reserves fall below three months of imports.

Sri Lanka's central bank has also used borrowings, including from the Reserve Bank of India and the IMF, contributing to negative net foreign assets. The broader context of central bank independence and engagement in macro-economic policies, including those leading to taxpayer losses, frames the challenges of managing currency stability and economic policy in a globalized financial environment.

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