Referenced Article:

Title: “Revolution Outside: Sri Lanka’s Policy Slumber”

Published on: 18 July 2025

Source: Daily FT

Author: Daily FT Contributor

The Bond Trap: Sri Lanka's Growth Aspirations and the Interest Rate Challenge 

Summary of the Article 

The economic problems of  Sri Lanka stem from basic flaws in its trade and industrial policies. The country struggles to build competitive export-based industries because it maintains excessive trade barriers and outdated regulatory frameworks. The increase in global interest rates makes Sri Lanka more vulnerable to debt problems because its external debt consists mainly of International Sovereign Bonds (ISBs), which increases the risks of rollover and currency mismatch. 

The IMF requires two conditions for reserve growth and monetary restraint which stem from the Liquidity Preference Theory (LPT) and Loanable Funds Theory (LFT). The worldwide interest rate increases create higher expenses for issuing new bonds which reduces the amount of available credit. The Sri Lankan government needs to create a structured industrial plan immediately to achieve stability and increase exports while minimizing financial risks and interest rate pressures. 

Liquidity preference influences central bank reserve targets. 

Sri Lanka's monetary policy issues demonstrate the Liquidity Preference Theory (LPT), indicating that interest rates are influenced by the supply and demand for money. The Central Bank of Sri Lanka (CBSL) faces pressure to increase its reserves for the IMF program to $15–16 billion, but unusable currency swaps with China prevent it from meeting IMF standards, limiting the usable money supply (Ms). Due to the liquidity effect, attempts to expand the money supply by printing more bonds or buying more bonds may initially result in lower interest rates. However, interest rates might eventually increase again because of inflation, growing incomes, and rupee devaluation. Variations are uncertain and influenced by internal and external factors.

Source: Unstop – Liquidity Preference Theory

Loanable Funds Theory – Rising Interest Rates 

The economic challenges in Sri Lanka demonstrate the Loanable Funds Theory (LFT) by showing how interest rates respond to changes in loanable funds demand and supply. The government's plan to issue $1 billion in International Sovereign Bonds (ISBs) each year has boosted loanable funds demand which shifts the demand curve to the right and increases equilibrium interest rates. The supply of loanable funds remains limited because investors lack confidence while institutions remain weak and policies remain inconsistent and domestic savings and FDI remain insufficient. The mismatch between growing demand and limited supply of loanable funds drives interest rates higher which makes debt servicing more difficult because the government has borrowed excessively in a weak financial system.

 

Source: Lumen Learning – The Market for Loanable Funds

Global rates impact Sri Lanka's economy significantly. 

Sri Lanka's interest rate environment is influenced by domestic policies and international trends, particularly as global rates stabilise between 4%-5%, indicating the conclusion of low borrowing costs. This situation presents considerable dangers for Sri Lanka, which is heavily dependent on foreign-currency loans via ISBs, resulting in a currency imbalance, as it receives income in rupees while settling debts in dollars. Increasing global rates elevate refinancing expenses and amplify susceptibility to interest rate fluctuations and investor unpredictability. This situation exemplifies the “original sin,” where developing countries borrow in foreign currencies without strong export capabilities to manage repayments effectively.

The Cycle of Growth, Debt, and Interest Rates 

Sri Lanka’s economic challenges cannot be solved by the Central Bank’s careful management of interest rates alone. The country struggles with earning enough foreign revenue to pay off its debt in lack of industrial development and export expansion. Borrowing costs rise as a result of investors demanding higher returns due to stagnation's impact on government debt and fiscal credibility. Low industrial activity leads to slower growth, more debt, and higher interest rates. Monetary policy alone won't address these problems. Long-term reforms targeted at increasing exports and productivity are essential.

Conclusion

Sri Lanka’s economic challenges reflect the critical role of interest rates in stability. The increasing demand for funds from government borrowing and the limited supply are pushing up interest rates. IMF constraints and low reserves hinder effective money supply management. Merely understanding concepts such as loanable funds and liquidity preference is not enough; tangible reforms are essential. The country faces deeper problems such as stagnant exports, underdeveloped industries and weak institutions, rising borrowing costs and risks. To move forward, Sri Lanka must improve productivity, strengthen industries and increase foreign earnings. Without decisive action, high interest rates and a prolonged economic recovery will persist, which will require significant reform rather than just policy reassurances.

✍  Written by: P.G.C.Hansana

📆 Published on: July 26, 2025