Sri Lanka slashes rates to jumpstart economic recovery

Interest rate surprise: Sri Lanka's central bank surprised markets by slashing interest rates by 50 basis points on Tuesday, indicating a willingness to further ease monetary policy to stimulate economic growth amidst the country's severe financial crisis.

The Central Bank of Sri Lanka (CBSL) reduced the Standing Deposit Facility Rate to 8.50 per cent and the Standing Lending Facility Rate to 9.50 per cent, contrary to the expectations of most economists and analysts. CBSL Governor P. Nandalal Weerasinghe stated that if inflation remains stable between 4 per cent and 5 per cent, there's room for additional rate cuts.

Monetary conditions remain tight

Weerasinghe highlighted that despite the recent reduction, monetary conditions remain tight. Projections indicate inflation will hover between 4 per cent to 5 per cent over the next 12 to 18 months.

This move follows a series of interest rate cuts totalling 700 basis points since last year, as Sri Lanka endeavours to recover from its worst economic crisis since gaining independence in 1948.

The decision appears to be aimed at bolstering demand and fostering growth, particularly amidst recent developments such as the reduction in electricity tariffs and currency appreciation, according to Thilina Panduwawala, head of research at Frontier Research.

While inflation spiked to 5.9 per cent in February due to a sales tax increase, the central bank believes the rate cut will help maintain inflation around the targeted level of 5 per cent over the medium term.

The central bank stressed the importance of further decreases in market interest rates to support subdued demand conditions, notwithstanding the lower-than-expected impact of recent tax policy changes on inflation.

Sri Lanka's negotiations

Despite the positive sentiment from the IMF staff agreement, the rate cut is unlikely to majorly influence ongoing debt restructuring talks. Sri Lanka is set to negotiate with private bondholders to restructure $12 billion of debt defaulted on in May 2022, after its foreign reserves plummeted, leading to difficulties in essential imports.

The recent staff-level agreement with the IMF signals progress, but completion of the debt restructuring is necessary before the next IMF review. Sri Lanka's economy contracted by 2.3 per cent in 2023 but showed growth of 4.5 per cent in the fourth quarter, indicating signs of recovery expected to continue in the coming quarters, according to CBSL.

(With Reuters Inputs)