In a sign of confidence that the worst of Sri Lanka's financial crisis is over, its central bank surprised markets by cutting interest rates for the first time in three years on Thursday, signalling a change of course to fuel a rebound in the economy.

The South Asian island republic plunged into crisis last year as its foreign exchange reserves ran out, food and energy prices spiralled and protesting mobs forced the ouster of the country's president.

A new government took the reins in July, and negotiated a $2.9 billion bailout from the International Monetary Fund (IMF) in March. Inflation, which hit a record high of around 70% in September, is coming down, government revenues are looking up and pressure on the country's balance of payments is easing.

The government aims to complete talks to restructure its bilateral debt with other countries by September.

"This can possibly be seen as an end to the crisis," said Sanjeewa Fernando, a senior vice president at Asia Securities in Colombo.

The Central Bank of Sri Lanka (CBSL) cut its standing deposit facility rate and standing lending facility rate by 250 basis points - to 13% and 14%, respectively, from 15.5% and 16.5%. The central bank said the big rate cut would "help steer the economy towards a rebound phase."

Governor P. Nandalal Weerasinghe said the economy "was getting back to normalcy".

"Coming out of the crisis is gradual," he told reporters. "Cannot say yesterday, day before or tomorrow. It is a gradual recovery process,"

While inflation has come down, it remains steep so most analysts had expected the bank to keep rates steady. They are now at their lowest level since March 2022, the start of the crisis.

The surprise decision was welcomed by markets, with the rupee rising to its highest since April 2022 at 288 to the dollar and the benchmark Colombo Stock Exchange index gaining 1.5% to lift away from five-month lows.

The rate cut comes after the key Colombo Consumer Price Index rose 25.2% on year in May compared with 35.3% in April, reducing some stress on the crisis-hit economy.

The index peaked at a annual 69.8% surge in September last year. The national inflation rate was at 33.6% in April, easing from 73.7% in September.



Analysts said with the CBSL having successfully dealt with the runaway inflation, it was turning its attention to growth.

The central bank raised rates by a record 950 basis points last year to tame inflation and by 100 bps on March 3 this year.

The IMF expects GDP to contract 3% this year after a 7.8% contraction last year. The CBSL said it expects domestic economic activity to rebound gradually from late 2023.

"Hopefully banks will gradually expand their loan books and credit will start flowing into businesses and with that the economy will start to recover," Weerasinghe said.

Inflation is expected to moderate further, with Fernando at Asia Securities predicting a figure of 5% by year end.

The IMF has set Sri Lanka an inflation target of 15.2% for this year but the CBSL is eyeing a more ambitious target of single digit inflation by September.

"Headline inflation is forecast to reach single digit levels in early Q3-2023, and stabilise around mid-single digit levels over the medium term," the bank said.

It said faster deceleration of inflation and the lower probability of demand pressure during the economic rebound "creates space for a gradual policy relaxation in the period ahead".

( Editing by Shri Navaratnam and Raju Gopalakrishnan)