By Uditha Jayasinghe
COLOMBO, May 27 (Reuters) - Sri Lanka's surprise 100 basis-point interest rate hike risks tipping into over-tightening just as a fragile, IMF-backed recovery takes hold, signalling a shift by policymakers back to crisis-prevention mode as external pressures mount, analysts said.
The Central Bank of Sri Lanka's Tuesday policy rate hike - the first in more than three years - to 8.75% from 7.75% comes as authorities scramble to contain pressure on foreign exchange reserves, while
preventing fiscal slippage under a $2.9 billion IMF programme that includes strict targets on primary surpluses, inflation and reserve accumulation.
The island nation's currency reserves are now down to $6.7 billion - enough to cover about 3.8 months' worth of import costs - from $7 billion at the end of March.
The policy pivot has been driven by soaring energy costs in the wake of the Iran war, which has lifted the import bill for the fuel-dependent economy, reviving risks of currency weakness and widening deficits.
But the authorities are walking a fine line: tighten too aggressively and risk stalling credit, investment and growth; move too slowly and risk renewed pressure on the rupee, reserves and inflation — the vulnerabilities that triggered the island’s 2022 balance-of-payments crisis.
Colombo has responded this time with a mix of monetary tightening and administrative curbs, including a 40% increase in fuel prices, higher import duties on vehicles, rationing and energy-saving measures such as mid-week public holidays, in an effort to compress demand and use less foreign currency.
While the steps could help safeguard hard-earned gains in macroeconomic stability and keep the IMF programme on track, analysts say the scale of Tuesday's rate hike risks undermining growth by choking off credit and investment.
"We feel it’s a bit of an overreaction. In our estimates we were looking at about a 25 to 50 basis-point hike," said Dimantha Mathew, head of research at First Capital. He has cut his 2026 economic growth forecast to 2.5%-3% from a previous 3%-4%.
Other analysts have also pared their forecasts, with Colombo-based equity research firm CAL lowering its growth view by 100 basis points to around 3% and Citi trimming its projection by 40 basis points to 3.8%, reflecting the growing risk that aggressive tightening could stall the recovery.
The IMF has not commented on Sri Lanka's rate hike, but its executive board meets later on Wednesday to decide on giving the country $700 million in two tranches to help shore up its reserves.
OIL SHOCK COMPLICATES RECOVERY
Sri Lanka's economy had only just begun to stabilise, with central bank chief Nandalal Weerasinghe estimating growth of about 5% in the first half as easing inflation and a revival in tourism underpinned the IMF-backed recovery. But annual inflation jumped from 2.2% in March to 5.4% last month, and Weerasinghe said it was likely to remain above the official target of 5% for a while.
The bank's abrupt tightening signals that the authorities are prioritising price stability and external buffers over sustaining momentum, wary of a repeat of past boom-bust cycles.
The latest oil shock has complicated that trade-off.
Higher fuel costs are already beginning to weigh on tourism, a key source of foreign exchange, while strong domestic demand, reflected in double-digit credit growth, risks fuelling imports and widening both the current account and fiscal deficits.
"There will be a moderating of growth, but stemming revenue loss from tourism, reducing currency pressure and containing inflation is more important," said Shehan Cooray, head of research at HNB Stockbrokers, underscoring the central bank’s shift towards pre-emptive tightening.
Rising fuel costs have revived the internal pressure for subsidies, with parliament approving 57 billion Sri Lankan rupees ($176 million) for three months, but extending that further could strain its fiscal targets under the IMF programme.
Any slippage on subsidy reforms risks eroding hard-won gains in public finances and could delay further disbursements from the fund.
"I think this hike is continuing the recovery path by taking a stabilisation measure," said Sanjeewa Fernando, chief economist at Asia Securities.
(Reporting by Uditha Jayasinghe; Editing by Hugh Lawson)
