The Sri Lanka Development Update (SLDU) has two main aims. First, it reports on key developments over the past 12 months in Sri Lanka’s economy, places these in longer term and global contexts, and updates the outlook for Sri Lanka’s economy. Second, the SLDU provides a more in-depth examination of selected economic and policy issues. It is intended for a wide audience, including policymakers, business leaders, financial market participants, think tanks, non-governmental organizations and the community of analysts and professionals interested in Sri Lanka’s evolving economy.
Thilina Kaluthotage
Click here to download the latest Sri Lanka Development Update (April 2024).
RECENT ECONOMIC DEVELOPMENTS
The economy contracted by 2.3 percent in 2023, despite growth in third and fourth quarters (1.6 and 4.5 percent, respectively) following six quarters of contraction. This was driven by shrinking construction and mining, financial and IT services, and textile manufacturing, amid weak demand, tight private credit, and shortages of inputs, and was partly offset by growth in transport, accommodation, food, and beverage services, resulting from a rebound in tourism. Inflation remained benign, after declining to single-digit levels in July 2023, supported by currency appreciation and improved supply. However, with the recent spike in food prices and pass-through of fuel and utility prices, headline inflation as measured by the Colombo Consumer Price Index increased to 5.9 percent in February 2024. Labor force participation declined (from 49.8 to 48.8 percent between 2022 and third quarter of 2023), especially in urban areas. Households have adopted risky coping strategies to deal with lower incomes and price pressures, including using savings, taking on more debt, and limiting their diets. Food insecurity rose during the second-half of 2023, with 24 percent of households being food insecure.
After almost two years of monetary tightening, the central bank cut policy rates by 650 basis points between June and November 2023. Combined with improvements in liquidity, this resulted in a sharp decline in the government’s cost of domestic borrowing. While growth rates remain negative, private sector credit has been recovering monthly since June 2023.
In 2023, the current account recorded a surplus for the first time since 1977, as remittances and tourism rebounded sharply, and imports remained subdued. The continued external debt service suspension, inflows from development partners, large purchases of foreign exchange, and postponed repayments on existing credit lines have helped build usable official reserves to about 2 months of imports (US$3.1 billion by end-February 2024, compared to US$500 million in December 2022). The Rupee appreciated by 10.8 percent against the US Dollar in 2023.
Despite the primary balance registering a surplus—due to a significant increase in revenue and the repayment of an on-lent amount by an State-Owned Enterprise (SOE), a sharp rise in interest payments is estimated to have contributed to a high overall fiscal deficit in 2023. Interest payments absorbed approximately three-fourths of revenue collected.
CHALLENGES
In 2022, Sri Lanka plunged into a severe economic crisis, as longstanding structural weaknesses were exacerbated by exogenous shocks and policy mistakes. After losing access to international financial markets in 2020, official reserves dropped precipitously, and the forex liquidity constraint led to severe shortages of essential goods. The country announced an external debt service suspension in April 2022, pending debt restructuring. The economy contracted by 9.5 percent in total during 2022 and 2023, and public and publicly guaranteed debt ballooned to 119.2 percent of Gross Domestic Product (GDP) in 2022 amid high inflation (46.4 percent, annual average in 2022) and a sharp currency depreciation (81.2 percent, 2022). Food insecurity and malnutrition increased, poverty doubled, and inequality widened. Approximately 60 percent of households experienced a decline in income due to reduced work hours or job losses. The implementation of recent structural reforms, including cost-reflective utility pricing and new revenue measures, helped macroeconomic stability but strained household budgets. Domestic debt restructuring was completed in September 2023, while negotiations with external creditors are progressing. In March 2024, a Staff Level Agreement was reached between the authorities and International Monetary Fund staff on the second review of the Extended Fund Facility program. Key reforms focusing on debt, fiscal management, trade, investment, and SOEs continue to advance.
OUTLOOK
Growth prospects depend on progress with debt restructuring and the continued implementation of structural reforms. The primarily revenue-based fiscal adjustment is, however, likely to further reduce disposable incomes, weaken demand, and weigh down growth in the short-term. The modest recovery will be insufficient to reverse welfare losses experienced during the crisis, and poverty is estimated to remain above 22 percent until 2026.
Inflation is likely to rise moderately in the near-term, due to new revenue measures and the waning of favorable base effects, and remain benign in the medium-term as demand continues to be subdued. Further increases could reverse the marginal poverty reduction (1.1 percentage points) expected in 2024.
The current account is projected to remain in surplus, with subdued import growth and gradual recovery in tourism and remittances. Although the primary deficit is expected to decline further, the overall fiscal balance will remain high in 2024 due to the large interest bill. Debt restructuring and continued fiscal consolidation are projected to reduce the overall fiscal balance in the medium term.
While recent macroeconomic performance has been better than expected, downside risks remain high, given a narrow path to recovery and limited buffers. These risks include a protracted or insufficiently deep debt restructuring, reform fatigue or reversal following the elections, and a weaker recovery linked to scarring effects from the crisis. With declining household expenditure on health and education, concerns over the impact on future human capital remain high. Financial sector risks need to be carefully monitored as elevated nonperforming loans and significant exposure to the sovereign continue to hinder financial sector stability and impede credit intermediation. On the upside, a strong and sustained implementation of the structural reform program, could boost confidence and attract fresh capital inflows.
Last Updated: Apr 02, 2024
Sri Lanka’s economy is on the road to recovery, but sustained efforts to mitigate the impact of the economic crisis on the poor and vulnerable are critical, alongside a continuation of the path of robust and credible structural reforms. This involves a two-pronged strategy: first, to maintain reforms that contribute to macroeconomic stability and second, to accelerate reforms to stimulate private investment and capital inflows, which are crucial for economic growth and poverty reduction.
PAST ISSUES
- October 2023: Mobilizing Tax Revenue for a Better Future
- April 2023: Time to Reset
- October 2022: Protecting the Poor and Vulnerable in Time of a Crisis
- April 2021: The Economic and Poverty Impact of COVID-19
CONTACTS
Richard Walker
Senior Country Economist | rwalker3@worldbank.org
Buddhi Feelixge
External Affairs Officer | bfeelixge@worldbankgroup.org