Sri Lanka

Sri Lanka’s economic growth path has been somewhat volatile, but the country has exhibited robust long-term averages: +5% in the 2000s and +5.3% in the 2010s. 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 +3.5% in 2021. Then GDP plunged even more by around -8% in 2022 due to structural imbalances and financing risks that were not tackled in a timely manner. In 2023, the country will continue to face economic challenges and we forecast real GDP to decline by around -4%. Our tentative forecast for 2024 is for a modest recovery.

In May 2022, Sri Lanka defaulted on its sovereign debt for the first time in its history due to a series of adverse events: a loss in fiscal revenues in 2019 due to terrorist attacks impairing tourism and the global Covid-19 crisis in 2020-2021, as well as poor economic policies in 2021, notably a ban on imported chemical fertilizers – in an attempt to halt an ongoing decline in foreign exchange (FX) reserves – which led to a rise in agricultural producer prices (+35% in two months) and dramatically low harvests. As FX reserves had fallen to less than USD2bn in early 2022, and without access to international financial markets since sovereign credit rating downgrades in 2020, the Sri Lankan government eventually had no other choice than to call for a restructuring of its debt in May 2022. In March 2023, the IMF approved a 48-month USD2.9bn Extended Fund Facility to help the country get back on track, but Sri Lanka will remain in default until 2024 at least.

Monetary policy was tightened between mid-2021 and early 2023 in response to surging inflation, which hit a peak of over 70% y/y in September 2022 and averaged about 50% over the year, causing a cost-of-living crisis. However, the benchmark policy interest rate was only raised by 1,100bps to 15.50% in March 2023, leaving the real interest rate deep in negative territory due to the high inflation. Since then, as inflation eased to around 12% in mid-2023, the Central Bank of Sri Lanka has begun lowering the policy rate, which should allow domestic debt restructuring to roll out more easily for the country.

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 property rights, judicial effectiveness, government integrity, labor freedom, investment and financial freedom. Better scores are only achieved for tax freedom and trade freedom. Moreover, the World Bank Institute’s annual Worldwide Governance Indicators surveys indicate weaknesses concerning the regulatory framework, the rule of law and measures to combat corruption. Our proprietary Environmental Sustainability Index puts Sri Lanka at rank 96 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 renewable electricity output, the recycling rate and the general vulnerability to climate change.

The political situation in Sri Lanka has dramatically evolved since 2022. In March 2022, worn down by an erratic handling of the economic crisis that led to high inflation, as well as power and oil shortages, the Sri Lankan population began demonstrating massively against then President Gotabaya Rajapaksa and his brother and Prime Minister Mahinda Rajapaksa. Eventually the Rajapaksas had to step down and flee the country. Since then, Ranil Wickremesinghe – who is a party leader and former minister – has led the country as President, with a slim parliamentary majority that impairs the stability of his government. With the next presidential and parliamentary elections planned for 2024 and 2025, respectively, the President remains weak and is significantly trailing his main opponent, Anura Kumara Dissanayake, in opinion polls. Considering that President Wickremesinghe’s opponents have already expressed antipathy towards the IMF deal in place, a change in government could be a risk to the program and  loan agreement in its current form.