Sri Lanka's central bank unexpectedly raised its policy rate by 100 basis points to 8.75% from 7.75% - its first increase in over three years - in a bid to shore up foreign exchange buffers and keep the country's IMF-backed stabilisation programme on track. The abrupt tightening comes as policymakers confront a jump in energy costs linked to the Iran war, a renewed rise in inflation and pressures on reserves that have prompted a mix of monetary and administrative measures.
The nation’s currency reserves have fallen to $6.7 billion, down from $7 billion at the end of March, a level officials say covers about 3.8 months of import needs. That deterioration in external buffers, combined with a rising import bill for the fuel-dependent economy, prompted the central bank’s policy pivot as authorities seek to prevent fiscal slippage under the $2.9 billion IMF programme, which includes strict targets on primary surplus, inflation and reserve accumulation.
Alongside the rate hike, the government and regulators have implemented administrative steps intended to lower demand for foreign currency and reduce import growth. Measures include a 40% increase in fuel prices, higher import duties on vehicles, rationing and energy-saving initiatives such as mid-week public holidays. Officials describe the package as an effort to compress domestic demand and cut the use of foreign exchange.
While these actions aim to protect gains in macroeconomic stabilisation and keep the IMF arrangement on course, market analysts warn the scale of the rate move could undermine the nascent recovery by constricting credit availability and deterring investment. Dimantha Mathew, head of research at First Capital, said: "We feel it’s a bit of an overreaction. In our estimates we were looking at about a 25 to 50 basis-point hike." He has reduced his 2026 growth forecast to between 2.5% and 3% from an earlier 3%-4%.
Other forecasters have also trimmed expectations. Colombo-based equity research firm CAL cut its growth view by 100 basis points to around 3%, while Citi lowered its projection by 40 basis points to 3.8%, reflecting concerns that aggressive monetary tightening may derail recovery momentum.
The International Monetary Fund has not issued a public comment on the rate increase. The IMF’s executive board is scheduled to meet later on Wednesday to consider disbursing $700 million in two tranches to bolster Sri Lanka’s reserves as part of the broader $2.9 billion programme.
Oil shock complicates policy trade-offs
The recent energy-price shock has complicated policymakers’ choices. Central bank chief Nandalal Weerasinghe estimated growth of about 5% in the first half, supported by easing inflation and a rebound in tourism that underpins the IMF-led recovery. Yet annual inflation rose from 2.2% in March to 5.4% last month, and Weerasinghe said inflation is likely to remain above the official 5% target for some time.
Rising fuel costs are already starting to weigh on tourism, a key source of foreign exchange, while strong domestic demand has been reflected in double-digit credit growth - conditions that risk feeding higher imports and widening both the current account and fiscal deficits. Shehan Cooray, head of research at HNB Stockbrokers, noted the trade-off facing policymakers: "There will be a moderating of growth, but stemming revenue loss from tourism, reducing currency pressure and containing inflation is more important." His comments underline the central bank’s tilt toward pre-emptive tightening to guard external buffers and price stability.
Domestic political and fiscal pressures have also resurfaced. Rising fuel costs have renewed calls to subsidise households and businesses; parliament recently approved 57 billion Sri Lankan rupees ($176 million) in subsidies for three months. Officials warn that extending such support beyond the current window could jeopardise the fiscal targets embedded in the IMF programme.
Any backtracking on subsidy reforms risks eroding hard-won improvements in public finances and could delay further fund disbursements conditioned on meeting programme targets. "I think this hike is continuing the recovery path by taking a stabilisation measure," said Sanjeewa Fernando, chief economist at Asia Securities, framing the rate move as a defensive step to preserve the recovery rather than to stimulate activity.
Policy tightrope
The central bank and government are navigating a narrow path. Tighten policy too sharply and the economy may face a squeeze in credit flows, lower investment and slower growth. Move too cautiously, and Sri Lanka risks renewed currency weakness, dwindling reserves and accelerating inflation - the same vulnerabilities that culminated in the 2022 balance-of-payments crisis.
For now, authorities have chosen to prioritise external stability and price control measures, combining monetary tightening with administrative curbs aimed at reducing foreign-exchange demand. How that balance affects lending, investment and the recovery trajectory will depend on both the persistence of the oil shock and whether fiscal support measures remain temporary, factors highlighted repeatedly by analysts and policymakers.
With the IMF decision on a $700 million tranche pending, and inflation above the official target while growth prospects are being revised downward by prominent forecasters, Sri Lanka’s policymakers remain on alert. The policy shift signals a return to crisis-prevention mode as external pressures mount, leaving officials to manage the trade-offs between stabilising the economy and sustaining the fragile rebound.