SRI LANKA'S INTEREST-RATE TRAP

The Sri Lankan economy is grappling with a paradoxical combination of punishing interest rates, sustained disinflationary forces, and continuing debt problems

- Arjun Jayadev, Ahilan Kadirgamar, J.W. Mason

The Central Bank of Sri Lanka has inexplicably maintained high interest rates in a deflationary environment, which increases debt-service costs and suppresses economic activity. It must change course now, because austerity in the name of fiscal sustainability is self-defeating if it destroys the conditions for growth.

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. 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 recognised 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%.