Sri Lanka raised interest rates to the highest level in two decades on Thursday (Jul 7), saying it had to head off runaway inflation to avoid even deeper pain for an economy that is already in crisis and is shrinking.

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The Sri Lankan central bank increased its standing lending facility rate by 100 basis points to 15.50 per cent while the standing deposit facility rate was similarly raised to 14.50 per cent, the highest since August 2001.

Inflation touched a year-on-year record of 54.6 per cent in June, and central bank Governor P Nandalal Weerasinghe said it could go as high as 70 per cent, prompting the central bank to raise rates to address the rise in prices.

"We will work to manage inflation as much as possible but other measures such as cash transfers will also be needed to give relief to the poor," he told reporters.

Interest rate rises, however, would further dampen economic growth in the island nation.

The country is struggling to pay for food, medicine and fuel, with foreign exchange reserves at a record low. The economy contracted by an annual 1.6 per cent in the first quarter and is forecast to have shrunk more in the second.

Sri Lanka is pushing for a possible US$3 billion extended financing programme from the International Monetary Fund (IMF) which would help it unlock other bridge financing options to pay for essential imports.