Sri Lanka's central bank delivered a significant surprise to markets by raising its policy rate by 100 basis points to 8.75% from 7.75%, marking the largest increase in four years. According to reports from Reuters, this move came as policymakers scrambled to stem inflation and support a currency under pressure from soaring energy prices driven by the Middle East conflict. The Central Bank of Sri Lanka (CBSL) attributed the hike to higher inflation and a depreciating rupee due to the U.S.-Israeli war with Iran. As per Reuters, this was the biggest increase since a similar hike during the depths of the financial crisis in March 2023, with the central bank last having changed rates in May 2025 when it reduced them by 25 basis points to boost growth. At a post-policy press conference, Governor P. Nandalal Weerasinghe said the CBSL's expectation is for economic growth and inflation to maintain a "reasonable" pace, noting that "this hike will help stabilise exchange rates and inflation."
The decision significantly exceeded market expectations, with seven out of twelve economists and analysts polled by Reuters forecasting only a 25 basis-point or slightly higher change to the rate. As reported by Reuters, this divergence highlights the severity of the current economic pressures facing the nation. The central bank's statement noted that similar to regional peer currencies, the Sri Lanka rupee experienced notable depreciation pressures in recent weeks, with the currency tumbling 8.7% since early March, though conditions have since eased to some extent. According to Reuters, the central bank expects the deepening impact on foreign reserves from the conflict to be a key factor in the decision. Capital Economics' senior Asia economist Gareth Leather noted that "today's sharp increase in interest rates in Sri Lanka highlights the country's vulnerability to the crisis in the Middle East, and is unlikely to be the last unless the crisis subsides soon."
Annual inflation has jumped dramatically from 2.2% in March to 5.4% last month, though this remains well below the 70% peak during the 2022 crisis. According to Reuters, headline inflation is likely to remain above the target of 5% in the period ahead before easing and stabilizing around it. The CBSL expects supply-side pressures from the Iran conflict, specifically oil price volatility and subsequent rupee pressure, to have a prolonged impact on domestic inflation rather than being transitory. As per Reuters, Udeeshan Jonas from CAL strategy head noted that "this 100bps rate hike suggests the CBSL is shifting gears from supporting growth to defending price stability." The country, which is fully reliant on imported fuel, has been battered by the Iran war-driven energy shock that has forced a 40% fuel price hike, rationing, and even public holidays on Wednesdays.
The rate hike has prompted significant downward revisions to growth forecasts, with Udeeshan Jonas from CAL strategy head cutting his 2026 growth forecast to 3.0% from 4.2% following the move. As reported by Reuters, the central bank and finance ministry had previously projected growth of between 4% and 5% in January. Jonas explained to Reuters that "this 100bps rate hike suggests the CBSL is shifting gears from supporting growth to defending price stability." Governor Weerasinghe said Sri Lanka could still grow at the "lower band of the 4%-5%" projection. The country's stock market was down 0.8% after the policy announcement, while the currency hugged tight ranges to fetch 322 rupees per dollar. Economic growth in the South Asian nation, only just recovering from a devastating 2022 financial crisis that left businesses and households deeply scarred, is expected to take a hit from the turmoil in the Middle East.
Sri Lanka's foreign reserves decreased 3.8% to $6.7 billion in April after spending $1.5 billion on fuel imports in the first four months of the year, with the fuel bill surging 77% in March alone. According to Reuters, the country is backed by a $2.9 billion programme from the International Monetary Fund and is clawing its way out of the 2022 upheaval caused by a severe dollar shortfall. The IMF Executive Board will meet on Wednesday to decide whether Sri Lanka will receive $700 million under its programme, which would help to top up its reserves. Emerging economies are bearing the brunt of the Iran war as soaring energy prices, supply disruptions, and capital outflows threaten to trigger stagflation, with India also grappling with a sharp decline in the rupee.
