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 recognized 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%.

When output falls short of potential, or inflation is below target, the central bank should lower interest rates. Given below-target inflation and an employment-to-population ratio that has fallen by a full four percentage points since 2017 ( a sure sign of an economy not fulfilling its potential ), maintaining double-digit real ( inflation-adjusted ) rates is fiscal self-harm, not prudence.

In addition to the textbook argument, there is a more pragmatic case for lower interest rates in Sri Lanka: debt sustainability. The debt-to-GDP ratio depends not only on current expenditure and revenue, but also on economic growth and interest on debt accumulated in the past. The larger the ratio is, the stronger the effect of these latter factors. With a debt-to-GDP ratio close to 100%, Sri Lanka’s debt sustainability is highly sensitive to increases in interest rates: a few percentage points can be the difference between a stable ratio and one that is crushing.

Moreover, heavily indebted countries have long known that the GDP denominator matters just as much as the debt numerator. For example, after receiving multiple bailouts and adopting austerity measures between 2010 and 2015, Greece reduced its total debt by €15 billion ( US$17.4 billion ) – nearly 5% of GDP – but its debt ratio rose by 30 percentage points because GDP fell at a much faster pace.

Sri Lanka risks suffering the same fate. High interest rates in a deflationary environment increase debt-service costs while suppressing economic activity – the worst of both worlds. Austerity in the name of fiscal sustainability is self-defeating if it destroys the conditions for growth.

Keeping rates high also does little to tame prices, because food accounts for around 35.1% of the average household consumption basket in Sri Lanka, and these prices depend more on global conditions and supply shocks than on domestic demand.

A more realistic goal for Sri Lanka would be to stabilize the balance of payments and avoid swings in capital flows. But if the central bank’s focus is indeed on the external balance, its public statements do a poor job of communicating this.

In August, the central bank projected a current account surplus in 2025, meaning the country is accumulating rather than losing foreign exchange. Gross official reserves climbed to more than US$6 billion in the first half of the year, despite debt-service outflows. After a large devaluation in early 2022, the rupee has been stable. In short, there is no evidence of a possible financing crisis that could justify sky-high domestic interest rates. The surplus liquidity in money markets suggests that conditions are ripe for monetary easing.

Policymakers cite “heightened worldwide economic uncertainty” as a reason for caution. But this makes no sense: the interest-rate level, not the change in rates over time, is what matters. An interest rate of 7.75% is no less discouraging for investment just because rates were higher a year ago.

High interest rates and rising foreign reserves signal Sri Lanka’s willingness to place the interests of outside actors ahead of the country’s own people and businesses. But if ultra-tight monetary policy triggers a renewed crisis and another default, even foreign creditors will lose.

Instead of stabilizing inflation or the external balance, high interest rates are delaying the economy’s recovery and straining public finances. But it’s not too late for the central bank to change course. After several years of flat or falling output, the Sri Lankan economy grew by 4.9% in the second quarter of 2025, implying that renewed growth is possible with the right monetary-policy stance.

Economies escape debt traps through growth, not endless austerity. Sri Lanka is no exception. With below-target inflation, stable external accounts and growth still tentative, maintaining a rate of 7.75% is indefensible. Policymakers should begin easing monetary conditions as soon as possible, while keeping an eye on capital flight.

Arjun Jayadev is a professor of economics and the director of the Center for the Study of the Indian Economy at Azim Premji University, Ahilan Kadirgamar is a senior lecturer at the University of Jaffna and J.W. Mason is an associate professor of economics at John Jay College, City University of New York.

Copyright: Project Syndicate