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Though reserves are measured in months of imports, when a central bank sells foreign exchange to defend an exchange rate target, and sterilizes the sales with printed money to prevent interest rates going up, a rapid downward spiral starts in the economy.
In 2011 Sri Lanka sold more than two billion US dollars of foreign reserves and sterilized the sales, firing unsustainable domestic demand and imports.
Sri Lanka's external trade has now started to contract, signaling a slowdown in the economy, with imports falling 3.3 percent in March to 1,441 billion US dollars, while exports fell at a steeper 9.2 percent to 680 million US dollars.
Apparel exports fell mainly due to lower cotton prices, with apparel imports also falling 6 percent in March.
Sri Lanka's trade deficit expanded just 2.6 percent to 761 million rupees in March 2012, though the trade gap for the first five months was up 32.3 percent from a year earlier to 3.3 billion US dollars.
A trade deficit is generated when people in a country get money from foreign sources other than export of merchandise goods exports.
These include exports of labour (remittances), exports of investments (foreign direct or portfolio investments), exports of tourist services and net exports of debt (foreign loans).
In the first five months of the year Sri Lanka has received 1.96 billion US dollars of remittances, 1,078 billion US dollars of commercial bank borrowings and 1.162 billion US dollars of state borrowings, the central bank said.
In the first quarter 238 million US dollars of FDI had come in.
When, remittances, FDI, portfolio investments or foreign borrowings are spent, then generate imports expanding the trade gap, but create no pressure on the exchange rates, unlike sterilized sales of foreign currency.
Sri Lanka's rupee has depreciated from around 110 to 131 rupees in the past year.
Data revealed in parliament showed that last year Sri Lanka's state-run Petroleum utility Ceylon Petroleum Corporation has also increased its borrowing by about a billion US dollars to manipulate prices.
Energy price deceptions leave more money in the hands of uses of petroleum who continue to spend, generating more imports than would have been possible if imported energy has been market priced, also contributing to a surge in non-market based imports.
Analysts have warned that if sterilized sales of foreign currency continue, it is possible for the exchange rate to fall even if both credit and imports both slow down.
Unsterilized central bank foreign exchange purchases, which are not matched by an equal amount of unsterilized sales, would also result in the exchange rate weakening.
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