Sri Lanka faces tough choices to meet IMF dollar reserve targets

As an IMF team arrives in Colombo to assess Sri Lanka's economic performance, attention has turned to the country's foreign exchange reserve accumulation. Rebuilding dollar reserves acts as a critical financial shock absorber, but recent performance has lagged behind targets promised under the bailout programme.

The delay raises key questions about whether Sri Lanka can still hit its full-year reserve target, and what trade-offs will be required to achieve it.

Mounting External Shocks Threaten Targets

Professor Rohan Samarajeewa cautions that the reserve shortfall itself is not the primary concern. Instead, the main threat comes from external shocks that derail fiscal and monetary projections.

According to Samarajeewa, previous events like Cyclone Ditwah required additional government spending, forcing modifications to primary balance targets. A similar situation is unfolding due to ongoing geopolitical volatility in the Middle East.

"Whereas a lot of people stopped looking at the Middle East issues after the MoU was signed, the issue is that diesel, for example, is more expensive now than before the MoU between Iran and the United States was signed," Samarajeewa said.

The hidden cost of reserve targets

Addressing whether the full-year target remains achievable, Advocata Institute Chief Executive Officer Dhananath Fernando noted that the Central Bank of Sri Lanka can continue buying dollars to meet the goal, but doing so carries severe economic trade-offs.

"It is possible, but depending on what we are going to compromise, because reserves and exchange rate and sometimes the inflation and interest rates all go hand in hand," Fernando explained.

He warned that aggressive dollar purchases by the Central Bank soak up market liquidity, creating a dollar shortage that drives up the exchange rate and elevates import costs. However, he noted the bank retains the operational capacity to buy heavily, having absorbed over USD 500 million from the market in August alone.

Controversial Import Surcharge Under Scrutiny

To curb foreign outflow, authorities introduced a 50% surcharge on vehicle imports. The measure violates commitments made to the IMF regarding new import restrictions.

Fernando described the policy as a mistake that backfired by fueling market anxiety.

"I think it's an unnecessary regulation to begin with because that's what created an extra demand for dollars in the market," Fernando said. "When you have such restrictions, people get worried that actually you don't have enough dollars in the market. So I think that's unnecessary and we really cannot continue with these type of regulations."

Allowing the rupee to depreciate

Instead of administrative import controls, Samarajeewa argues Sri Lanka must allow market mechanisms to curb demand, particularly regarding fuel imports. Fuel traditionally accounts for 20 to 25% of total imports, but Samarajeewa projects that figure could approach historic highs near 40%.

He noted that consumption patterns remain largely unadjusted, with petrol consumption down only 9% and diesel down 10%.

"One of the things that we can do is let the rupee depreciate, and then even that, we'll have to raise fuel prices," Samarajeewa argued. "That should prevent people from all crowding onto the Southern Expressway every time there's a long weekend. There doesn't seem to be any kind of rationing effect in this country."

Locked out of commercial markets

Borrowing through commercial debt markets remains off the table due to Sri Lanka's low credit rating. Samarajeewa highlighted that major agencies maintain Sri Lanka at CCC+, unlike peers such as Ghana, which have upgraded to the B range.

"Unless you go into the B range, the whole option of using commercial debt is not a viable one," Samarajeewa warned. "The government has to really move on getting a better credit rating, and to do that they have to build up the reserves."

Focus shifted to structural reforms

For Fernando, long-term stability requires shifting focus away from curbing foreign exchange outflows toward enabling structural inflows.

"It is mainly not the outflows or collection. It has to be the reforms and the regulatory framework, because when the reforms take place, the dollar inflow will basically improve," Fernando stated.

He stressed that bottlenecks limiting export growth must be removed to revive economic activity, noting that foreign exchange outflows can only occur sustainably when matched by strong inflows.

Two economists, one message. Hitting the reserve numbers is possible, but it is the easy part.

The hard part is earning a better rating, letting prices do their job, and driving the reforms that make the dollars flow, before the next shock arrives.