By: Staff Writer
September 22, Colombo (LNW): Sri Lanka’s external sector remains under strain as the Central Bank of Sri Lanka (CBSL) cautiously holds fire on interest rates in the run-up to the 2026 Budget. Despite subdued inflation and recent signs of growth, policymakers face the difficult task of balancing domestic stability with external vulnerabilities that continue to weigh heavily on the economy.
Consumer prices, which had been in deflation for nearly a year, finally turned positive in August 2025, rising 1.2% year-on-year. However, prices still slipped 0.4% month-on-month, underscoring fragile demand conditions. Fitch Consensus Research (FCR) expects inflation to average -0.9% in 2025 before edging up to 2.8% in 2026 well short of CBSL’s medium-term target of 5%.
In principle, this creates room for monetary easing to boost consumption and investment. Yet, the central bank has so far avoided rate cuts, mindful of the risks to external stability and the rupee.
Globally, the tide is turning toward looser monetary policy. The U.S. Federal Reserve, facing stagflation risks, lowered its benchmark rate to 4.00–4.25% in September, with further cuts expected. Other central banks are following suit, raising expectations that Sri Lanka might eventually align with global easing to avoid falling out of step. For now, however, CBSL’s restraint highlights the structural weaknesses in the country’s external accounts.
Sri Lanka’s external income picture tells a mixed story. Merchandise exports fell slightly in the first eight months of 2025, slipping to $8.7 billion from $9.1 billion a year earlier, as weaker global demand weighed on textiles and apparel the country’s leading export.
Tourism has been the bright spot, generating $2.6 billion between January and August 2025, up from $2.1 billion in the same period last year, while remittances also improved to $5.2 billion from $4.9 billion. Together, these inflows have helped ease some pressure, but they remain insufficient against the country’s heavy debt servicing needs and import bills.
Foreign reserves recovered to $6.1 billion by August 2025, compared with just $3.7 billion a year ago, boosted by IMF-backed inflows, debt restructuring agreements, and tighter import controls. Yet, these buffers remain fragile. Net government debt is projected at a daunting 101% of GDP this year, with interest payments alone swallowing 51% of government revenue three times the median for peer economies.
Global rating agencies have acknowledged Sri Lanka’s tentative progress by lifting it out of default. Fitch Ratings upgraded the sovereign to ‘CCC+’, S&P Global Ratings raised it to ‘CCC+/C’, and Moody’s shifted its grade to Caa1. These moves mark an important milestone, but the agencies continue to classify Sri Lanka within speculative grade, citing persistent fiscal fragility, governance concerns, and political risks. Investor confidence, they warned, will depend on whether the government can sustain IMF-backed fiscal and structural reforms in the years ahead.
Meanwhile, the economy has shown encouraging momentum, with GDP expanding by 4.9% in the second quarter of 2025 after two years of contraction. But sustaining this recovery requires more than tourism and remittances; the country needs to broaden its export base, improve competitiveness, and attract stable foreign investment.
As the government prepares the 2026 Budget, the CBSL’s cautious stance underlines the difficult trade-off it faces: stimulate growth through lower interest rates or prioritize external stability by maintaining discipline. For now, with external revenues still shaky and debt pressures mounting, stability appears to be winning out over stimulus.
