CBSL seen holding fire on rates ahead of 2026 Budget, shaky external sector

• Monetary Policy announcement on Wed. (24)
• Liquidity positive but economic growth sluggish, says First Capital Research
• External sector volatile, with projected outflows from swap settlements 

First Capital Research (FCR) said Sri Lanka’s fragile external balances, with reserves rising only slightly to $ 6.2 billion in August from $ 6.1 billion in July and with projected outflows of $ 513 million in August and $ 611 million over the next three months, are likely to keep the Central Bank of Sri Lanka (CBSL) cautious at its Policy Review on Wednesday (24), ahead of the 2026 Budget in November.

FCR placed a 50% probability on rates being left unchanged, while assigning a 40% chance of a 25 basis point (bps) cut and a 10% chance of a 50 bps cut. It gave an 80% probability to the Statutory Reserve Ratio (SRR) remaining unchanged, with a 20% chance of a 100 bps hike.

“Reserves are expected to strengthen gradually through US dollar purchases, supported by higher tourism earnings during the peak season and an anticipated rise in worker remittances towards year-end,” FCR said in its September 2025 Pre-Policy Analysis ‘Monetary Patience Ahead of Fiscal Clarity.’ 

It said the expected International Monetary Fund (IMF)-Extended Fund Facility (EFF) sixth tranche disbursement in December will also add support. Moreover, the pent-up demand from vehicle imports is also expected to ease in the coming months, positively impacting the Balance of Payments (BOP) position.

“However, these gains are tempered by projected foreign exchange (FX) outflows of $ 513 million in August and $ 611 million over the next three months, mainly due to settlement of currency swaps,” FCR said, highlighting one argument as to why policy rates may not be eased.

The case for keeping rates steady is supported by strong credit momentum. Private sector borrowings rose by Rs. 201.5 billion in July, pushing total credit above Rs. 9.5 trillion for the first seven months of the year. 

Domestic bank lending to the private sector increased to Rs. 192.7 billion in July, up 20.7% year-on-year (YoY), compared with a slower 17.9% growth in June. 

The CBSL’s Willingness to Lend Index rose for the ninth consecutive quarter in the second quarter of 2025, while the Credit Supply Survey suggests this momentum will continue into Q3 2025, underpinned by ample liquidity, recovery in activity, and a pick-up in construction. 

FCR argues that under such conditions, further easing may not be required.

Another factor is the Average Weighted Call Money Rate (AWCMR), which has consistently remained above the policy rate despite liquidity gains. In July, the Overnight Policy Rate (OPR) was steady at 7.75%, while the AWCMR averaged 7.86%, about 11 bps higher. 

A lower OPR could boost credit demand, strain liquidity, and push the AWCMR higher, undermining policy transmission.

FCR points out that those arguing for a rate cut point to signs of slowing growth. GDP expanded 4.9% in the second quarter, but this pace is expected to moderate as public capital expenditure remains weak—only 20% of the Rs. 1.3 trillion allocation had been utilised by mid-year, while higher taxes and inflation weigh on consumption. 

Household spending and Government investment are likely to stay subdued, while external headwinds such as US tariffs and slowing global trade add to the drag.

Liquidity conditions, however, give the CBSL room to manoeuvre. After falling to Rs. 50 billion in April, liquidity has recovered to between Rs. 125 billion and Rs. 175 billion, supported by $ 1.3 billion in FX purchases during the first eight months of 2025. 

FCR expects liquidity to strengthen further towards Rs. 200 billion as pent-up demand for vehicle imports fades.

Inflation also remains well below the CBSL’s medium-term target. Consumer prices turned positive in August, rising 1.2% YoY after 11 months of deflation, though prices fell 0.4% month-on-month. 

FCR expects inflation to average -0.9% in 2025 and 2.8% in 2026, short of the 5% target, suggesting space for monetary support to lift demand.

Global conditions may further tilt the balance. Fitch projects world growth at 2.4% in 2025, down from a 2.9% forecast in June, with stagflation risks in the US leading the Federal Reserve to cut rates in September to 4.00%-4.25%. 

More Fed cuts are expected this year, while other central banks are also easing. In this context, FCR noted that the CBSL may weigh global trends and consider aligning with peers to offset external headwinds.