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Overview

Country context

Outlook

Sri Lanka is facing an unprecedented economic crisis. Depletion of forex reserves, lead to Sri Lanka’s first sovereign default and the worst economic crisis since independence.

According to the latest South Asia Economic Focus and the Sri Lanka Development Update, Sri Lanka’s real GDP is expected to fall by 9.2 percent in 2022 and a further 4.2 percent in 2023.

The fluid political situation and heightened fiscal, external and financial sector imbalances pose significant uncertainty for Sri Lanka’s economic outlook. The growth outlook is subject to high uncertainty and will depend on the progress in fiscal consolidation, debt restructuring, and growth enhancing structural reforms. Despite tightened monetary policy, inflation will likely stay elevated. The fiscal deficit is expected to gradually fall over the medium-term due to consolidation efforts. The current account deficit is expected to decline due to import compression. Additional resources will be needed in 2023 and beyond to close the external financing gap. Poverty is projected to remain above 25 percent in the next few years.

Key downside risks include a slow debt restructuring process, limited external financing support, and a prolonged recovery from the scarring effects of the crisis. Fiscal consolidation needs to be accompanied by tighter monetary policy to contain inflationary pressures. Significant debt restructuring is essential to restore a sustainable debt level. The financial sector has to be managed carefully given high exposures to the public sector. The necessary macroeconomic adjustments may initially adversely affect growth and poverty, but will correct the macroeconomic imbalances, help regain access to international financial markets, and build the foundation for sustainable growth. Mitigating the impacts on the poor and vulnerable remain critical during the adjustment. Reductions in poverty will require an expansion of employment in industry and services and a recovery in the real value of incomes. On the upside, a credible reform program supported by financing from international partners could enhance confidence and attract fresh capital inflows.

Background

Sri Lanka’s economy was already showing signs of weakness before the COVID-19 pandemic. Growth and poverty reduction had slowed down in the last five years. A restrictive trade regime, weak investment climate, episodes of loose monetary policy and an administered exchange rate had contributed to external imbalances. Sustained fiscal disparities, driven primarily by low revenue collections, combined with tax cuts in 2019, has contributed to high fiscal deficits, large gross financing needs, and a rapid growth in unsustainable debt .

Sri Lanka lost access to international financial markets in 2020, after credit rating downgrades. Without market access, Sri Lanka continued to service its external debt and pay for imports using official reserves and loans from the banking sector. Official reserves dropped from US$7.6 billion in 2019 to less than US$400 million (excluding a currency swap equivalent to US$1.5 billion with China) in June 2022. Net foreign assets in the banking system also fell to US$ -5.9 billion in June 2022. This severe forex liquidity constraint has been felt across the economy, particularly from the second quarter of 2022, with shortages of fuel, medicines, cooking gas, and inputs needed for economic activity. Amid depleted reserves, Sri Lanka announced an external debt service suspension in April, 2022 and later appointed legal and financial advisors to support debt restructuring.

Amid mass public protests, a new president was appointed in July, 2022. However, political tensions remain elevated with the continued economic crisis.

Recent developments

The economy contracted by 4.8 percent year-on-year in the first half of 2022. All key sectors contracted, amid shortages of inputs and supply chain disruptions. High frequency indicators such as the purchasing managers’ indices indicate a continued stress beyond the first six months.

Year-on-year inflation reached an unprecedented 64.3 percent in August 2022, due largely to high food inflation of 93.7 percent. This reflects the impact of rising global commodity prices, monetization of the fiscal deficit and currency depreciation. The ban on chemical fertilizers in 2021 and related impact on crop yields has also affected domestic food supplies, agriculture earnings and food security. Between January and July 2022, the central bank raised policy rates by a cumulative 950 basis points to curb inflation.

Poverty is expected to have increased in 2022 due to the contraction in the economy. Poorer households are hardest hit owing to food inflation, job losses, limited fertilizer supply and drop in remittances. While social assistance provides some relief, it is inadequate in the face of substantial losses in real income. The goods trade deficit declined by 18.6 percent year-on-year in the first half of 2022 as exports, particularly textiles, grew faster than imports, which were largely financed by Indian financial support of approximately US$3.8 billion. With declining remittances and limited tourism receipts, the current account deficit is expected to have widened in this period. Sri Lanka’s central bank floated the Sri Lankan Rupee (LKR) in March and returned to a managed float in May after the currency depreciated by about 78 percent since the floating. Despite mandatory repatriation and conversion rules, it has been challenging to bring export earnings and remittances to Sri Lanka through formal channels due to low market confidence.

Although expenditures increased in the first four months of 2022 on account of additional support provided to social protection beneficiaries, public servants and pensioners, several revenue measures, such as a one-off tax imposed on large corporates, helped reduce the primary deficit. The overall deficit was financed primarily by the central bank and remained broadly unchanged, pertaining to the rising interest bill. To raise more revenue, the government increased the Value Added Tax rate from 8 to 15 percent and proposed additional tax measures in May, and through the Interim Budget in August.

Last Updated: Oct 06, 2022

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Households use electricity generated by village hydro and biomass projects

LENDING

Sri Lanka: Commitments by Fiscal Year (in millions of dollars)*

*Amounts include IBRD and IDA commitments
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Country Office Contacts

Colombo
6th Floor, Hilton Colombo
2, Chittampalam A. Gardiner Mawatha
Colombo 2, Sri Lanka
+94-11 5561300
Washington
1818 H Street NW Washington, DC 20433
+1 202-473-8955