Rebuilding after the storms

Sri Lanka’s economic growth path has been volatile. The country had in the past exhibited robust long-term averages (+5% in the 2000s and +5.3% in the 2010s), before entering a more difficult phase in recent years. Since 2020, the country’s economic health has been suffering from exogenous shocks and endogenous weaknesses. The Covid-19 pandemic caused a contraction of real GDP by -4.6% in 2020, followed by a moderate recovery of +4.2% in 2021. Then GDP plunged even more by around -7.4% in 2022 due to structural imbalances and financing risks that were not tackled in a timely manner, followed by another contraction by -2.3% in 2023. A recovery has taken place since (growth in 2024 likely exceeding +5%) and is likely to continue into 2025 (around +4%) and 2026 (+3.5%), thanks to improving real income growth supporting consumption and the recovering manufacturing sector lifting investment. Externally, exports should be supported by the rebound in tourism and relatively conducive global demand for goods. As such, future growth prospects are generally on the right track, but are unlikely to return to pre-pandemic and pre-crisis levels, reflecting permanent economic scarring.

Sri Lanka defaulted on its sovereign debt for the first time in its history in May 2022 due to a series of adverse events: terrorist attacks in 2019 impairing tourism, the Covid-19 crisis in 2020-2021 and poor economic policies in 2021 that led to a drastic fall in foreign exchange (FX) reserves. In March 2023, the IMF approved a 48-month USD2.9bn Extended Fund Facility (EFF), to help the country get back on track. A first review of the EFF in December 2023 was approved by the IMF and an agreement on the restructuring of 98% of the face value of Sri Lanka’s outstanding sovereign debt was found with the country’s new government in December 2024. Sri Lanka will thus likely continue to try and improve its fiscal framework, by increasing revenue and implementing governance and anti-corruption reforms. The government may seek to deliver left-leaning domestic policies, but the risk of another liquidity crunch is likely low.

Monetary policy was tightened significantly between 2021-2023 (+1100bps in total), in response to surging inflation (around 50% in 2022 and around 17% in 2023). Since then, inflation has eased (around 2.5% in 2024) and should stabilize at a manageable level in the coming few years. The Central Bank of Sri Lanka (CBSL) thus began to ease the monetary policy in 2023, cutting policy rates by -750bps until the end of 2024 and allowing domestic debt restructuring to roll out more easily for the country. Monetary easing should continue in 2025.

Sri Lanka’s business environment is considered below average in our assessment of 185 economies. The Heritage Foundation’s Index of Economic Freedom survey 2023 assigns Sri Lanka rank 136 out of 184 economies, reflecting weaknesses with regards to fiscal health, investment freedom, financial freedom, government integrity and judicial effectiveness. Comparatively better scores are only achieved for tax burden and government spending. Moreover, the World Bank Institute’s annual Worldwide Governance Indicators surveys indicate weaknesses concerning the regulatory framework, measures to combat corruption and the rule of law. Our proprietary Environmental Sustainability Index puts Sri Lanka at rank 45 out of 210 economies, reflecting strengths in energy use and CO2 emissions per GDP, as well as water stress. However, there are still weaknesses in the recycling rate, the general vulnerability to climate change and renewable electricity output.

The political situation has undergone significant changes following widespread dissatisfaction with the established political parties. Anura Dissanayake, of Janatha Vimukthi Peramuna (JVP), was elected president in September 2024, representing the first victory by a third-party candidate. The parliamentary snap election in November aligned the legislature with the president, with the National People’s Power (an alliance led by JVP) winning 159 seats, up from their prior election results of three, and obtaining a more than two-thirds majority. The election represents a broad shift in the political climate in the country, improving stability. Going forward, we expect the government to focus on its left-leaning domestic platform, while also attempting to discuss with the IMF about debt restructuring. The main risk to political stability is likely from the economy as Dissanayake’s popularity could be affected if living standards do not improve.