Sri Lanka's Interest-Rate trap

Sri Lanka is experiencing its worst economic crisis since gaining independence in 1948. After defaulting on its external debt in 2022, the government was forced to impose severe austerity measures in exchange for a loan from the International Monetary Fund. As a result, the poverty rate remains alarmingly high, reaching 24.5% in 2024, up from 11.3% in 2019, while real per capita GDP is not expected to return to its 2018 level until 2026. The country is losing a generation to malnutrition, high youth unemployment, and educational losses as school-dropout rates climb.

- By ARJUN JAYADEVA, AHILAN KADIRGAMAR AND J.W. Mason

The Sri Lankan economy is grappling with a paradoxical combination of punishing interest rates, sustained disinflationary forces, and continuing debt problems. The Central Bank of Sri Lanka’s August 2025 Monetary Policy Report recognized the extent of disinflation, with the headline inflation rate falling below policymakers’ 5% target for three consecutive quarters. The most recent data suggest that inflation moved from negative territory in the first two quarters of this year to slightly above zero in the third quarter, yet the benchmark interest rate remains at 7.75%.

When output falls short of potential, or inflation is below target, the central bank should lower interest rates. Given below-target inflation and an employment-to-population ratio that has fallen by a full four percentage points since 2017 (a sure sign of an economy not fulfilling its potential), maintaining double-digit real (inflation-adjusted) rates is fiscal self-harm, not prudence.

In addition to the textbook argument, there is a more pragmatic case for lower interest rates in Sri Lanka: debt sustainability. The debt-to-GDP ratio depends not only on current expenditure and revenue, but also on economic growth and interest on debt accumulated in the past. The larger the ratio is, the stronger the effect of these latter factors. With a debt-to-GDP ratio close to 100%, Sri Lanka’s debt sustainability is highly sensitive to increases in interest rates: a few percentage points can be the difference between a stable ratio and one that is crushing.