The move signals a change of course to fuel a rebound in the economy as the island recovers from its worst ever financial crisis.

Economic mismanagement, coupled with the effects of the COVID-19 pandemic, left Sri Lanka severely short of dollars for essential imports at the beginning of last year, tipping the island nation into its worst financial crisis in seven decades.

Severe shortages of food, medicine and fuel led to street protests that forced then-President Gotabaya Rajapaksa to flee the country and resign.

A new government took the reins in July and negotiated a $2.9bn bailout from the International Monetary Fund (IMF) in March. This was the 17th IMF bailout for Sri Lanka and the third since the country’s decades-long civil war ended in 2009.

Inflation, which hit a record high of about 70 percent in September, is coming down, government revenues are looking up and pressure on the country’s balance of payments is easing.

The government aims to complete talks to restructure its bilateral debt with other countries by September.

“This can possibly be seen as an end to the crisis,” said Sanjeewa Fernando, a senior vice president at Asia Securities in Colombo.

The Central Bank of Sri Lanka (CBSL) cut its standing deposit facility rate and standing lending facility rate by 250 basis points – to 13 percent and 14 percent, respectively, from 15.5 percent and 16.5 percent. The central bank said the big rate cut would “help steer the economy towards a rebound phase”.

Governor P Nandalal Weerasinghe said the economy “was getting back to normalcy”.

“Coming out of the crisis is gradual,” he told reporters. “Cannot say yesterday, day before or tomorrow. It is a gradual recovery process.”

While inflation has come down, it remains steep so most analysts had expected the bank to keep rates steady. The rates are now at their lowest level since March 2022, the start of the crisis.

The surprise decision was welcomed by markets, with the rupee rising to 288 against the dollar, its highest since April 2022 and the benchmark Colombo Stock Exchange index closing up 1.59 percent, lifting away from five-month lows.

The rate cut comes after the key Colombo Consumer Price Index rose 25.2 percent on year in May compared with 35.3 percent in April, reducing some stress on the crisis-hit economy.

The index peaked at an annual 69.8 percent surge in September last year. The national inflation rate was at 33.6 percent in April, easing from 73.7 percent in September.

Shifting gears

Analysts said with the CBSL having successfully dealt with runaway inflation, it was turning its attention to growth.

The central bank raised rates by a record 950 basis points last year to tame inflation and by 100bps on March 3 this year.

The IMF expects gross domestic product to contract by 3 percent this year after a 7.8 percent contraction last year. The CBSL has forecast a 2 percent contraction in 2023 and Weerasinghe said the bank expects the economy to grow from the third quarter onward, after a small contraction in the second quarter.

“Hopefully banks will gradually expand their loan books and credit will start flowing into businesses and with that, the economy will start to recover,” Weerasinghe said.

Inflation is expected to moderate further, with Fernando at Asia Securities predicting a figure of 5 percent by year end.

The IMF has set Sri Lanka an inflation target of 15.2 percent for this year but the CBSL is eyeing a more ambitious target of single-digit inflation by September which was clearly within reach, Weerasinghe said.

“Headline inflation is forecast to reach single-digit levels in early Q3-2023, and stabilise around mid-single digit levels over the medium term,” the bank said.

It said faster deceleration of inflation and the lower probability of demand pressure during the economic rebound “creates space for a gradual policy relaxation in the period ahead”.