The Central Bank of Sri Lanka (CBSL) made headlines on May 21, 2025, with its decision to cut the policy rate by 25 basis points, bringing it to 7.75% (Double-Edged Sword). This move, the first rate cut in six months, has sparked a heated debate among economists, policymakers, and industry stakeholders. While the CBSL aims to stimulate economic growth and support Sri Lanka’s ongoing recovery, Bloomberg economist Ankur Shukla has raised concerns about the potential risks of this decision, labeling it as “undue.” In this analysis, we dive deep into the implications of the rate cut, its potential to overheat the economy, and the delicate balance Sri Lanka must strike to safeguard its dollar reserves amid global uncertainties.
The Rate Cut: A Strategic Move to Boost Growth
The CBSL’s decision to lower the policy rate to 7.75% comes after a six-month pause in monetary easing, signaling a shift towards a more accommodative stance. The central bank’s primary objective appears to be stimulating aggregate demand and supporting economic recovery in a country still healing from the scars of its 2022 economic crisis. At that time, Sri Lanka faced a devastating collapse, with foreign exchange reserves plummeting, inflation soaring, and the nation defaulting on its external debt. Fast forward to 2025, and the economy has shown signs of stabilization, largely due to support from the International Monetary Fund (IMF), a rebound in tourism, and rising remittances.
The rate cut aligns with the CBSL’s inflation-targeting framework, which aims to maintain inflation at around 5% by mid-2025. By reducing borrowing costs, the central bank hopes to encourage credit growth, particularly in the private sector, which has been a key driver of economic activity. Data from the CBSL indicates that credit growth to the private sector is on the rise, fueled by lower lending rates. Additionally, the tourism sector has seen a significant rebound, with increased arrivals contributing to foreign exchange inflows. Investor confidence has also improved, thanks to fiscal targets set by the IMF and recent government announcements on tax reliefs and wage increases for public sector employees.
However, as Ankur Shukla points out in his Bloomberg Economics analysis, this move might push the economy into “positive territory,” leading to an output gap that could fuel inflationary pressures. The output gap—the difference between the economy’s actual and potential output—is currently negative, but Shukla warns that the rate cut could close this gap faster than anticipated, potentially overheating the economy.
Risks on the Horizon: Overheating and Reserve Pressures
One of the most critical concerns raised by Shukla is the potential strain on Sri Lanka’s dollar reserves. As of 2024, the country’s foreign exchange reserves had risen to $9.3 billion, a significant improvement from the $6.3 billion recorded in 2023, thanks to IMF disbursements. However, this buffer remains fragile, especially as Sri Lanka prepares to resume debt repayments in 2025(Double-Edged Sword). The country’s external debt stood at $55 billion in 2023, equivalent to 65% of its GDP, making reserve management a top priority.
The rate cut could exacerbate this vulnerability by spurring imports and increasing demand for foreign currency. Sri Lanka’s economy is heavily reliant on imports, particularly for fuel and capital-intensive goods like machinery and pharmaceuticals. A surge in import demand, coupled with the need to service external debt, could deplete reserves rapidly. Shukla notes that a positive output gap, driven by the rate cut, might lead to “sub-neutral real rates,” fueling excessive demand for imports by early 2026. This, in turn, could put pressure on the Sri Lankan rupee, which has already faced depreciation challenges in recent years.
Adding to these concerns are global headwinds, particularly the impact of U.S. tariff policies under President Trump. In April 2025, Trump imposed a 44% tariff on Sri Lankan goods, a move that threatens the country’s export sector. Sri Lanka’s exports, primarily labor-intensive products like apparel and tea, are a key source of foreign exchange, with total exports valued at $14.9 billion in 2023. These tariffs could dampen export earnings at a time when the country can ill afford to lose foreign currency inflows(Double-Edged Sword). While tourism and remittances are expected to provide some relief—remittances reached $569.7 million in December 2023, up 19.7% year-on-year—these may not be sufficient to offset the combined pressures of rising imports and declining exports.
Inflation Dynamics: A Delicate Balancing Act
Inflation is another critical factor in this equation. The CBSL is targeting an inflation rate of 5% by mid-2025, and current projections suggest that inflation could reach 18.3% in the second half of 2025 if the economy overheats. Shukla argues that the central bank may have underestimated its inflation projections, as factors such as rising energy prices and global supply chain disruptions could push inflation higher(Double-Edged Sword). For context, U.S. consumer prices in December 2024 rose slightly more than expected due to higher energy costs, a trend that could have a ripple effect on import-dependent economies like Sri Lanka.
Prior to the rate cut, inflation was relatively subdued, with the CBSL reporting deflationary trends in late 2024. However, Shukla warns that the rate cut could reverse this trend by boosting aggregate demand too quickly. The 12-month forward-looking real rate, currently around 4.75%, is expected to dip below the neutral level of around 3% by 1Q26, potentially driving inflation higher(Double-Edged Sword). This poses a challenge for the CBSL, which may need to reverse course and tighten monetary policy sooner than anticipated.
The Counterargument: Why the Rate Cut Might Work
Despite these risks, some industry observers argue that the rate cut is a necessary step to sustain Sri Lanka’s economic recovery. As noted by Amali from BizColombo on X, rate cuts are not permanent and can be rolled back if the CBSL detects signs of overheating. The Monetary Board appears to be prioritizing growth in the short term, with the flexibility to adjust policy as needed. Moreover, a modest 25-basis-point cut is unlikely to cause significant overheating, as Miracle Island pointed out on X. Instead, it could create a positive trend by encouraging investment and consumption without pushing the economy into unsustainable territory.
Additionally, the CBSL is banking on continued growth in tourism and remittances to bolster reserves(Double-Edged Sword). The relaxation of outward remittance restrictions in July 2023 has already contributed to higher inflows, and the government’s focus on tourism promotion is yielding results. If these sectors perform as expected, they could provide a buffer against the risks highlighted by Shukla.
Looking Ahead: What’s Next for Sri Lanka?
Shukla predicts that the CBSL will hold the policy rate at 7.75% through December 2025, a cautious approach that reflects the central bank’s awareness of the risks involved. However, the road ahead remains uncertain. Sri Lanka must navigate a complex web of domestic and global challenges, from managing inflation and reserves to mitigating the impact of U.S. tariffs. The government’s advisory committee, appointed by President Anura Kumara Dissanayake, will play a crucial role in assessing the tariff impact and devising strategies to protect the export sector.
For now, the rate cut represents a calculated risk—one that could either propel Sri Lanka towards a stronger recovery or push it into a new set of economic challenges. As Edwards Deming famously said, “Without data, you’re just another person with an opinion(Double-Edged Sword).” The CBS: true test of the CBSL’s decision will lie in the data that emerges over the coming months, particularly on inflation, reserve levels, and economic growth.
