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. An agreement on the restructuring of 98% of the face value of Sri Lanka’s outstanding sovereign debt was reached with the country’s new government in December 2024 and the fifth review of the EFF in October 2025 was approved by the IMF. 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.

Looking ahead, Sri Lanka’s financing risk will depend heavily on its ability to meet debt-restructuring goals. The country officially exited default at the end of 2024 and is likely to regain access to international capital markets in 2026-2027, as the IMF program comes to an end and international agencies improve Sri Lanka’s credit rating. The general government budget deficit will only narrow gradually in the coming years and gross public debt is also expected to slowly decrease to around 90% of GDP in 2027, though it will remain slightly elevated compared with c.80% in 2019. Sri Lanka’s external finances will remain fragile, reflected in current account deficits in the coming years and a high level of external debt (estimated at around 70% of GDP). FX reserves have remained stable at USD6.1bn but that covers just around three months of imports (clearly below the favorable ratio of four months). Over the long term, to tackle these structural imbalances, an export diversification away from the high dependence on the textile & clothing and tourism sectors will be required, among other actions.

Sri Lanka’s business environment is considered below average in our assessment of 185 economies. The Heritage Foundation’s Index of Economic Freedom survey 2025 assigns Sri Lanka rank 148 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 110 out of 210 economies, reflecting relative strengths in CO2 emissions per GDP and water stress but weaknesses in the recycling rate energy use per GDP and the general vulnerability to climate change.

The political situation has undergone significant changes over the past years 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 2024 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 continuing to implement reforms falling under the IMF program. The main risk to political stability is likely from the economy as Dissanayake’s popularity could be affected if living standards do not improve.