Barely three years after battling its worst financial collapse in decades, Sri Lanka is once again confronting economic turbulence, this time triggered by soaring global energy prices and instability in West Asia.
In a surprise move on Tuesday (May 26), the Central Bank of Sri Lanka (CBSL) raised its key policy rate by a massive 100 basis points, the sharpest increase since the peak of the island nation’s 2022-23 economic crisis. The benchmark overnight policy rate now stands at 8.75%, up from 7.75%.
The decision stunned markets and economists, many of whom had expected only a minor rate increase. But the central bank’s aggressive action shows growing fears that the Iran-Israel conflict and rising fuel costs could derail Sri Lanka’s fragile recovery.
Why Sri Lanka suddenly raised interest rates
The CBSL said the sharp hike was necessary to tackle rising inflation and stabilise the rapidly weakening Sri Lankan rupee.
According to Reuters, Governor P Nandalal Weerasinghe said the central bank would continue taking steps to curb demand-side pressures and protect price stability as global uncertainties intensify.
The crisis in West Asia has hit Sri Lanka particularly hard because the country depends almost entirely on imported fuel. The latest energy shock has already forced a nearly 40% increase in fuel prices, fuel rationing in some areas and public holidays on Wednesdays to reduce energy consumption.
On Tuesday, petrol prices in the island nation ranged between Rs 410 and Rs 470 per litre, while diesel retailed at Rs 390–460 per litre.
Inflation, which had fallen sharply after the 2022 crisis, is now rising again. Annual inflation climbed from 2.2% in March to 5.4% last month, while the rupee has weakened nearly 8.7% since March.
From financial collapse to fragile recovery
Sri Lanka’s latest troubles come after the country suffered a devastating financial meltdown in 2022, when severe foreign exchange shortages triggered fuel shortages, power cuts, inflation spikes and widespread public protests that eventually forced then-president Gotabaya Rajapaksa to flee the country.
The island nation defaulted on its debt for the first time in history and relied heavily on international assistance to stabilise the economy.
India played a crucial role during that period, emerging as Sri Lanka’s biggest immediate lifeline. New Delhi extended nearly $4 billion in assistance through credit lines, currency support and fuel supplies at a time when Colombo was struggling to pay for essential imports.
India also supplied fuel, food, medicines and fertilisers, helping Sri Lanka avoid a complete economic collapse during the peak of the crisis. The support also strengthened India’s strategic and diplomatic influence in the region as China’s role came under scrutiny during the debt crisis.
Sri Lanka later secured a $2.9 billion bailout package from the International Monetary Fund (IMF), which remains central to its recovery efforts.
Energy shock threatens growth again
Despite signs of recovery over the past year, the fresh surge in oil prices is now threatening to slow Sri Lanka’s economic momentum once again.
Analysts say the central bank’s latest move signals a clear shift in focus, from boosting growth to defending the currency and controlling inflation.
“This 100 basis-point rate hike suggests the CBSL is shifting gears from supporting growth to defending price stability,” Reuters reported Udeeshan Jonas, strategy head at Colombo-based research firm CAL as saying. Following the hike, Jonas lowered Sri Lanka’s 2026 growth forecast from 4.2% to 3%.
However, the central bank continues to project economic growth within the lower end of its earlier 4-5% target range.
Foreign reserves under pressure again
The latest crisis has once again exposed Sri Lanka’s vulnerability to global fuel markets. The country’s foreign exchange reserves dropped 3.8% to $6.7 billion in April after spending nearly $1.5 billion on fuel imports during the first four months of the year.
Fuel import costs alone reportedly surged 77% in March.
According to Reuters, prolonged tensions in West Asia could worsen pressure on Sri Lanka’s reserves, increase import costs and trigger renewed currency instability. Sri Lanka is not alone in facing the fallout of the Iran-Israel conflict.
Several emerging economies dependent on imported energy are struggling with rising crude oil prices, supply chain disruptions, currency depreciation and capital outflows.
India too has faced pressure on the rupee and rising import costs due to higher crude prices, prompting the Reserve Bank of India to intervene in currency markets.
However, for Sri Lanka, the risks are far greater because the country is still recovering from a historic economic collapse and remains heavily dependent on external financial support.
With the IMF board set to decide on releasing another $700 million tranche under Sri Lanka’s bailout programme, the island nation’s recovery now appears increasingly tied to how long the geopolitical crisis in West Asia continues.