* Cbank eases lending rate for first time since April 2015
* Economic growth slumped to 16-year low of 3.1 pct last year
* Cbank chief sees 2018 growth rebounding to below 5 pct
* Fall in private sector credit growth "substantial" - finmin sec
* Woes over political instability remains amid confidence vote (Adds cenbank chief comments)
By Shihar Aneez and Ranga Sirilal
COLOMBO, April 4 (Reuters) - Sri Lanka's central bank unexpectedly cut its key lending rate by 25 basis points on Wednesday, as policy makers sought to revitalise an economy growing at its weakest pace in 16 years and facing heightened political uncertainty.
The move, some analysts say, keeps the door open for further easings, as investors worry about political instability after the ruling coalition lost a local government election in February, and communal clashes earlier last month in the central highlands following attacks on Muslims by nationalist Sinhalese crowds.,
Citing favourable inflation and lacklustre growth, the central bank cut the standing lending facility rate (SLFR) by 25 basis points to 8.50 percent - the first cut in three years - and maintained the standing deposit facility rate (SDFR) at 7.25 percent. The market, however, had widely expected both rates to be kept steady.
The economy grew 3.1 percent in 2017, the slowest since a recession in 2001 and well below the 4.5 percent pace of 2016.
"This decision is also expected to dampen the volatility observed in interest rates in the domestic market during the recent past," the central bank said in a statement.
The IMF last month urged the central bank to stand ready to tighten if signs of demand-side inflation pressures or accelerating credit growth resurface.
However, R.H.S. Samaratunga, Treasury Secretary and a member of the monetary board, said credit growth has fallen substantially and is well below the government's expectation.
"How can growth take place when the credit growth has slowed to such level?," he told Reuters.
Credit growth slipped to 14.6 percent year-on-year in February, well off a near four-year high of 28.5 percent hit in July 2016.
Central Bank Governor Indrajit Coomaraswamy said the monetary board has moved away from a tightening bias, and picked this year's economic growth to be slightly below 5 percent.
He said the inflation would remain in the bottom half of the 4-6 percent band through the rest of this year.
Wednesday's rate cut also comes ahead of a no confidence motion against Prime Minister Ranil Wickremesinghe due later on Wednesday, with the opposition accusing him of failing to address an alleged bond scam involved the former central bank chief.
Since the February election setback for the unity government, the central bank governor has warned of risk to growth from political instability.
"Prolonged political instability will have a significant impact on the growth," Coomaraswamy told reporters.
The previous rate hikes, aimed at curbing high inflation and fending off pressure on the fragile rupee, along with tight fiscal measures to meet conditions by the International Monetary Fund (IMF) for a $1.5 billion loan have sapped economic growth.
The rupee hit record high last month as investors worried about policy paralysis in the wake of the election results. It slipped to a record-low of 156.20 on March 16, and was trading at 155.60/75 at 0349 GMT.
"While further monetary policy loosening looks likely against a backdrop of weak growth and easing inflation, aggressive rate cuts are not on the cards," said Krystal Tan, Asia economist at Capital Economics.
"Sri Lanka’s high level of foreign currency debt makes the economy vulnerable to sudden falls in the currency."
(Reporting by Shihar Aneez and Ranga Sirilal Editing by Shri Navaratnam)