Just a few months ago, the Government was boasting about the level of foreign reserves it had accumulated and the stability it had provided despite Cyclone Ditwah.
Under Sri Lanka’s current monetary framework, the soft-peg exchange rate regime (managed floating exchange rate) may have achieved superficial economic stability in the short term due to the foreign currency loans obtained after Ranil Wickremesinghe became President, as well as foreign capital inflows seeking short-term gains.
In the aftermath of the 2022 foreign currency crisis, foreign investors mopped up undervalued shares, bonds, and real estate, driving them to historically high levels. However, the heterodox perspective emphasises that the memory of Sri Lanka’s historical defaults may trigger speculative capital outflows and depreciation of the rupee. That is exactly what is happening now.
In fact, Sri Lanka has a very low degree of monetary sovereignty due to its high level of foreign debt, particularly US Dollar-denominated debt, which constrains its public autonomy. Furthermore, periodic International Monetary Fund (IMF) interventions have also led to the deregulation of capital controls and Government regulations, increasing vulnerabilities within the Sri Lankan economy.
The combination of limited monetary sovereignty and IMF-enforced deregulation will continue the historical pattern of recurring cycles of accelerated external indebtedness, which have hindered development in Sri Lanka and reinforced its subordination to international creditors. These cycles have repeated over the decades because foreign capital inflows are not designed to finance productive capacity that enhances the country’s repayment capability, but rather to cover structural external imbalances related to trade deficits and capital flight.
Debunking neoliberal exchange rate theory
Most mainstream economists and economic analysts believe that State money creation (‘money printing’) causes inflation, which then leads to domestic currency depreciation. Others argue that trade deficits lead to falling domestic prices and currency depreciation, with these movements eventually restoring the trade balance to equilibrium.
The first approach argues that changes in the money supply cause movements in the price level, which in turn lead to exchange rate adjustments. The most common versions of this approach also include interest rates as determinants of exchange rates.
In short, an excess supply of money causes prices to rise, putting pressure on trade balances, which then leads the domestic currency to depreciate. This model is based on the assumption that trade flows drive currency prices and that trade flows are determined solely by price variables.
In contrast, Sri Lanka’s recent currency crisis clearly demonstrated that only an infusion of US Dollars was able to restore calm and stability to the foreign exchange market while also keeping inflation under control. As foreign reserves improved, the economy began to recover, capital controls started to loosen, and imports began to increase, along with capital flight.
However, this stability was short-lived. Once again, foreign reserves started evaporating, paving the way for speculative attacks on the rupee and rising inflation. This has been the recurring cycle not only in Sri Lanka but also in many Global South countries burdened with foreign currency debt.
It is portfolio capital flows, rather than trade flows, that dominate the foreign exchange market. Therefore, expectations regarding future currency price movements play a crucial role in determining current exchange rates. John Maynard Keynes argued that uncertainty played a central role in shaping the psychology of market participants when forming expectations.
The second approach argues that, once exchange rates are taken into account, the average price of goods and services worldwide should be equal. If this condition does not hold, it implies that goods are more expensive in one country than another.
According to this theory, a country that accumulates a trade deficit will eventually experience a fall in domestic prices and currency depreciation, thereby restoring balanced trade and equilibrium. In other words, the trade balance is assumed to drive exchange rates, with balanced trade emerging naturally as the equilibrium outcome.
However, this is not how the real world functions. Capital flows dominate trade flows, and countries can experience prolonged trade deficits, inflation, and exchange rate instability for decades. Sri Lanka, for example, has continuously recorded trade deficits for more than 45 years. Instead of balanced trade emerging as an equilibrium, the country has continually accumulated a massive stock of foreign debt.
Given Sri Lanka’s high level of foreign indebtedness, the possibility of another currency crisis remains significant. In fact, the rupee has been undergoing substantial depreciation over the past several months, with no clear signs of stabilisation.
Heterodox approaches to market behaviour and exchange rate forecasting
Exchange rate movements can significantly affect domestic policy objectives by influencing currency prices, inflation, foreign reserve levels, capital flows, and financial stability, as is currently unfolding in Sri Lanka.
Therefore, it is essential for central banks to understand the behaviour of foreign exchange markets because portfolio capital flows are the primary drivers of currency prices, while agents’ expectations are the major determinants of those capital flows. There are two major approaches to understanding market behaviour and exchange rate forecasting: fundamental analysis and technical analysis.
Fundamental analysis focuses on macroeconomic conditions and the long-term economic determinants of exchange rates. This approach evaluates variables such as inflation, interest rates, Gross Domestic Product (GDP) growth, debt-to-GDP ratios, external account positions, foreign debt levels, and political stability.
Fundamental analysis suggests that exchange rates tend to move towards levels consistent with underlying economic fundamentals over the long run. For example, a country like Sri Lanka, with persistently high inflation, large external deficits, and a high level of foreign debt, is more likely to experience currency depreciation over time. Thus, fundamental analysis reflects long-term economic realities, even if short-term deviations occur, as happened in Sri Lanka during 2024–’25.
Technical analysis, on the other hand, focuses primarily on historical price movements, chart patterns, momentum indicators, and market psychology. It assumes that trends and behavioural patterns tend to repeat themselves, making it possible to forecast exchange rate movements regardless of macroeconomic fundamentals.
In foreign exchange markets, expectations driven by behavioural patterns can become self-reinforcing. For example, if enough traders expect a currency to depreciate based on past experience, their collective actions may generate precisely that outcome. This is exactly what is happening in Sri Lanka at present: market sentiment has weakened and expectations of future rupee depreciation are becoming increasingly widespread.
According to the heterodox economist John T. Harvey and his psychological model of exchange rate determination, there is no expectation that exchange rate movements will automatically encourage balanced trade. Harvey argues that the structure of market expectations is shaped by experience, professional knowledge, and scholarly research, all of which exist within a specific social context.
Within that context, a country with a history of sovereign default receives disproportionate attention because of the dominant role such experiences play in the minds of market participants. As a result, the country may attract a speculative premium on foreign currency holdings.
According to post-Keynesian theory, financial liberalisation increases vulnerability within exchange rate systems. Regardless of whether the exchange rate regime is fixed or flexible, the ‘bandwagon effect’ plays a crucial role because currency-price divergence may occur when speculative behaviour drives the spot exchange rate away from the level consistent with underlying fundamentals or market expectations. These bandwagon effects can significantly influence currency prices through net capital flows.
Governance failure and policy credibility crisis
First, the Government blamed the Opposition, claiming that it was unnecessarily creating fear among the public. Then, it shifted the blame to the Middle Eastern conflict. Later, officials argued that the US Dollar was appreciating globally against most currencies, attempting to portray the situation as a common global phenomenon, even though the US Dollar Index remains well below its three-year high.
However, none of these explanations have been able to stem the outflow of portfolio capital from Sri Lanka. At the same time, the rupee has continued to depreciate at an uncontrollable pace. By now, the Government has lowered its credibility to such an extent that it has begun portraying rupee depreciation as beneficial for the economy.
What the Government fails to realise is that such statements are detrimental to market sentiment and contribute to shaping negative expectations regarding the future value of the rupee. Essentially, these statements signal to the markets that the Government has little understanding of what is happening, let alone the capacity to manage the situation effectively.
Conclusion
In conclusion, countries like Sri Lanka, which carry a high level of foreign debt, remain highly vulnerable to currency crises. Any negative economic shock can trigger renewed speculative pressure for currency devaluation and create a renewed dependence on US Dollar inflows. That is precisely what we are witnessing in Sri Lanka today.
In fact, much of the foreign capital that flowed into Sri Lanka after the 2022 crisis in search of short-term returns, particularly into the share market, bond market, and real estate sector, is now exiting the country. These capital outflows are placing severe pressure on foreign reserves while simultaneously accelerating the depreciation of the rupee. Essentially, market psychology is now playing a dominant role in determining the exchange rate, rather than the Central Bank itself.
Therefore, policymakers must recognise that there is no automatic tendency for exchange rate movements to adjust towards equilibrium or balanced trade. Market psychology and institutional weaknesses can seriously undermine domestic policy objectives. Central banks should therefore monitor not only macroeconomic fundamentals, but also market sentiment, capital flow dynamics, and speculative pressures when formulating exchange rate and monetary policy responses.
(The writer is a graduate of Monash University, Melbourne, Australia; an entrepreneur; and the author of the book ‘Wikalpa Maga – De-Dollarization’)
(The views and opinions expressed in this article are those of the writer and do not necessarily reflect the official position of this publication)