Credit rebound enters rate reality check

 Credit-to-GDP remains below pre-crisis levels despite strong lending recovery

 Lower fuel and vehicle imports, resilient remittances seen restoring current account surplus

 Strong fiscal position and resilient growth provide buffer against tighter monetary conditions

Sri Lanka’s credit recovery is facing its first major test as higher interest rates begin to filter through the economy, with KPMG warning that future lending momentum will determine whether the post-crisis expansion can sustain its pace even as external balances are set to improve.

In its July 2026 Sri Lanka Macroeconomic Outlook, the professional services firm said forthcoming credit data will be a key indicator of the economy’s underlying strength after the Central Bank’s 100 basis point policy rate increase in May, noting that private sector credit-to-GDP remains below pre-crisis levels despite the sharp recovery in lending over the past year. 

The assessment points to a transition in Sri Lanka’s recovery from one supported by abundant liquidity and lower interest rates to one where sustained private sector borrowing will increasingly determine the pace of economic activity.

The economy expanded by 5.1% in the first quarter, supported by benign inflation, lower interest rates during the period and ample liquidity, while all three major sectors recorded positive growth. Industry grew 7.2%, Services expanded 3.4% and Agriculture increased 1.1%, underscoring the broad-based nature of the recovery despite lingering external headwinds. 

Private sector credit, widely regarded as a leading indicator of future economic activity, increased by Rs. 485.4 billion during the first quarter, 24% above the level recorded a year earlier. Lending accelerated further in May, rising 79.1% year-on-year, with KPMG suggesting borrowers may have advanced financing decisions ahead of the Central Bank’s rate increase on 26 May. 

However, the report said the recent pace of credit expansion also heightened the risk of second-round inflation after higher global energy prices triggered by the Middle East conflict fed through to domestic fuel and energy prices.

That prompted the Central Bank to raise the Overnight Policy Rate to 8.75%, its first increase in 38 months, to contain inflation expectations, moderate demand and support exchange rate stability. The policy shift has already tightened domestic financial conditions, with Treasury bill yields moving higher and overnight liquidity declining to Rs. 82.6 billion in June from Rs. 333.7 billion in February, indicating effective monetary policy transmission. 

KPMG expects the tighter monetary environment to moderate private sector credit growth in the coming quarters, while reducing pressure on imports and helping rebalance the external sector. The report also noted that lending rates have already begun adjusting upwards following the May policy action. 

The current account slipped back into deficit during the first quarter as higher fuel and vehicle imports and slower growth in tourism earnings offset resilient remittance inflows. Fuel and vehicle imports rose to $ 1.8 billion from $ 1.2 billion in the corresponding period last year, while workers’ remittances increased 26.5% year-on-year to $ 2.3 billion, continuing to provide an important buffer to external balances. 

Looking ahead, KPMG expects lower crude oil prices, tighter financial conditions and the unwinding of earlier front-loaded imports to moderate fuel and vehicle imports. Together with resilient remittances and continued, albeit moderating, tourism earnings, these developments are expected to support a return to a current account surplus in June, although renewed geopolitical tensions remain the principal risk to that outlook. 

The report said the recovery continues to be underpinned by improving public finances. Tax revenue increased 36.4% year-on-year during the first quarter, supported by the resumption of vehicle import-related taxes, which accounted for nearly one-fifth of total collections, and stronger indirect tax revenue amid improving nominal economic activity. 

Despite a 16.3% increase in recurrent expenditure excluding interest payments, stronger revenue enabled the Government to record a primary surplus equivalent to 7.7% of GDP and an overall fiscal surplus of Rs. 116.4 billion in the first quarter. KPMG noted that subsequent Treasury data showed fiscal consolidation continuing into the second quarter, with the overall budget balance improving to a surplus of Rs. 197.3 billion during January to May from a deficit of Rs. 236.6 billion a year earlier. 

Beyond the macroeconomic indicators, KPMG said underlying economic activity has remained resilient. Manufacturing and construction purchasing managers’ indices both returned to expansionary territory in May, while cement production increased 21.5% year-on-year during the first five months, suggesting domestic investment activity has remained firm despite rising geopolitical uncertainty.