The new leftist NPP government will remain with the IMF programme without proposing drastic changes that could undermine it, demonstrating a refreshing sense of pragmatism and maturity on the part of its leadership. However, the stakes remain high.
In late November 2024, the IMF reached a staff-level agreement with Sri Lanka for the third review of its Extended Fund Facility (EFF) programme, signalling a continued commitment to economic reforms under a newly elected administration.
The agreement, which awaits IMF Executive Board approval, will give Sri Lanka access to $333 million, bolstering efforts to stabilize the economy and advance structural reforms.
President Anura Kumara Dissanayake has emphasized the need for a new economic strategy, acknowledging the limitations of the current framework to address deep-seated challenges.
In a recent policy address, the President stated that while the IMF-supported programme provides a foundation for crisis management, the country must explore broader reforms to navigate what he termed as a structural collapse.
IMF Senior Mission Chief Peter Breuer noted that adjustments to the programme remain possible within its existing guardrails, allowing the government to align priorities, such as easing tax burdens and increasing subsidies, which will be known in the delayed 2025 budget, now expected in February, which the IMF will closely review to ensure consistency with programme objectives.
Despite challenges, Sri Lanka has made significant progress, including an average economic expansion of 4% over the past year, improved public finances, and inflation stabilization. Foreign reserves have also risen to $6.4 billion. However, concerns linger over unmet social spending targets and delayed structural benchmarks, partly attributed to the recent election cycle.
Debt restructuring remains a critical component, with the government reaching agreements in principle with bondholders and moving towards bilateral accords. These efforts, coupled with potential revenue gains from the proposed liberalization of vehicle imports, aim to achieve a projected government revenue of 15.1% of GDP in 2025 and a 2.3% primary surplus.
As Sri Lanka works to finalize debt restructuring by year-end, the IMF stresses the importance of maintaining fiscal discipline, avoiding new tax exemptions, and safeguarding social safety nets to ensure inclusive growth. With the new administration signalling both continuity and recalibration of reform strategies, the coming months will test its ability to balance immediate recovery needs with long-term economic stability.
As Sri Lanka continues its economic recovery, questions about balancing fiscal discipline with growth and welfare persist. The new administration faces a dual challenge: addressing long-standing inefficiencies while fulfilling its promise to eradicate corruption and transform political culture. It must confront difficult decisions around reforming state-owned enterprises and institutions, which have long strained public finances.
The recently proposed Public Financial Management (PFM) Bill exemplifies the tension between fiscal reform and socio-economic priorities. Gazetted in May 2024, the bill aims to enhance transparency and accountability, introducing measures such as improved budget analysis and capping discretionary spending. However, a rigid cap on primary expenditure at 13% of GDP has sparked debate, with critics arguing that such constraints could stifle growth and welfare.
Verité Research has highlighted the risks of this expenditure rule, noting that it decouples spending limits from revenue generation. International comparisons suggest that rigid caps on expenditure, like the one proposed, are rare, with only 10 out of 106 countries in the IMF fiscal rules database employing such measures. Advanced economies, by contrast, spend an average of 43% of GDP on primary expenditures, supporting growth and welfare, Verité says.
Historically, Sri Lanka’s primary expenditure has ranged between 20-30% of GDP, significantly higher than the proposed cap. The current public sector and welfare spending—estimated at 8-10% of GDP—is already lean compared to global norms. Limiting expenditure at such low levels risks crowding out vital capital investments, further undermining growth prospects. The IMF has cautioned against relying on ad hoc cuts to capital spending, emphasizing their detrimental impact on long-term development, Verité Research says.
An alternative, it argues, would be to adopt a budget or primary balance rule that ties expenditure to revenue. This approach would maintain fiscal discipline while allowing room for critical public investments and welfare spending, fostering economic resilience and social equity.
The new administration intends to raise income tax thresholds and reduce rates, further complicating matters. While aimed at easing burdens on citizens, this move risks eroding the tax base and undermining revenue collection, a persistent weakness in Sri Lanka’s fiscal framework. Strengthening tax compliance and broadening the revenue base remains crucial to sustainable public financing and reducing corruption risks.
The new government’s fiscal strategy is a gamble, testing the limits of economic pragmatism and political will, although only the budget for 2025 will present a clearer picture.
Balancing the urgent need for recovery with the imperative for inclusive growth requires careful calibration. Whether the administration can align fiscal prudence with equitable development will ultimately define Sri Lanka’s path to long-term stability and prosperity.
Elsewhere, this magazine explores how increasing indirect taxes like VAT can be harmful. Sri Lanka cannot access international capital markets until 2027 because it defaulted. It is up to individuals to contribute a fair share based on their income.
Sri Lanka is close to completing its debt restructuring under the IMF programme, aiming for debt sustainability. The overall efforts have obtained over $17.5 billion (40.4% of total external debt) of debt service relief during the IMF programme period: $2.4 billion from EXIM Bank of China, $2.9 billion from the OCC (Official Credit Committee, and $2.5 billion from the China Development Bank, and $9.5 billion from the ISB holders.
Debt restructuring is a critical step towards fixing the economy, which is much more challenging. One misstep too many from hereon, and Sri Lanka could be facing another default. After all, debt-to-GDP will remain over 100% even after the restructuring. According to Fitch, the debt-to-GDP ratio will remain high, declining only gradually to 103% by 2028 from 116% in 2022, even with successful debt restructuring.
We remain with the problem that caused the excessive borrowing in the first place. Government revenue (Rs3.8 trillion estimate for 2024) is inadequate to service public sector wages and pensions (Rs1.1 trillion), subsidies and transfers (Rs1.2 trillion), and loan servicing (Rs2.6 trillion), while state-owned enterprises compound the fiscal problems with Rs744.6 billion in losses in 2022 alone. In 2022, personal income tax accounted for just 3% of total tax revenue, below the 16% average for the Asia Pacific region, 17% in Africa and 24% in the OECD. Sri Lanka’s total tax revenue-to-GDP ratio was 7.4% in 2022, below the Asia and Pacific average of 19.3%, Africa’s 15.8% and the OECD’s 34%.
Tax avoidance is a problem. Cutting rates and increasing the income tax threshold could be a problem. Gotabhaya Rajapaksa began his presidency with sweeping tax cuts.
The IMF Governance Diagnostics also highlights problems with the tax administrator, the Inland Revenue Department. It remains encumbered by inefficiencies that perpetuate rent-seeking vulnerabilities and undermine the principles of self-assessment. Excessive manual cross-checking, unnecessary data submission, and a lack of streamlined digital processes create opportunities for corruption while burdening taxpayers. Although online filing exists for corporate income tax and large taxpayers, the cumbersome interface reflects outdated design principles rather than user-centric innovation, hampering the system’s potential to reduce human interaction and improve efficiency.
Fragmented management of tax exemptions further compounds the issue. Miscommunication between the Inland Revenue Department (IRD), the Ministry of Finance, and the Board of Investment has resulted in a lack of clarity and accountability in tracking and recording tax expenditures. The absence of reliable data sharing between government agencies undermines fiscal analysis and policy formulation crucial for meeting the revenue targets outlined in the IMF Extended Fund Facility agreement.
Addressing these systemic issues requires robust oversight and accountability for the IRD. Calls for reforms, including a Tax Ombudsperson and a Taxpayer Charter, reflect growing private sector frustration. These measures, alongside stricter enforcement against tax evasion and rent-seeking, could bolster public trust and improve revenue administration. However, reforms must include structural changes, such as enhancing state enterprise productivity and ensuring efficient public sector management.
The stakes are high. Sharmini Cooray, a former IMF official, told a recent forum organized by the Advocata Institute, a think tank, that Sri Lanka needs to raise tax revenue from 9.2% of GDP now to 14% of GDP by 2028 to cover loan interest after restructuring, with 45% allocated to debt servicing.
For now, it appears the NPP and IMF are aligned with the broader fiscal reforms needed to stabilize the economy. But that only means NPP has hard choices to make.
IMF and Bondholder Group Urge Investors to Take Debt Restructure Offer
Sri Lanka has made gains in stabilizing the economy and addressing the external debt burden, with two recent developments sending encouraging signals: the IMF Managing Director and the Steering Committee of the Ad Hoc Group of Sri Lanka Bondholders, both asking bondholders to take up the debt restructuring offer to resolve Sri Lanka’s debt crisis quickly.
In November 2024, the International Monetary Fund (IMF) Managing Director Kristalina Georgieva commended the country’s ongoing economic reform programme supported by a $3 billion Extended Fund Facility (EFF). Georgieva said the programme has yielded promising outcomes since it began in March 2023, including controlled inflation, signs of economic recovery, and improved foreign reserves.
The IMF’s latest assessment follows a staff-level agreement with Sri Lankan authorities on the third review of the EFF programme. According to Georgieva, key milestones this year have included the agreement with the Official Creditors Committee (OCC) and a restructuring deal with the China EXIM Bank, both integral to restoring the country’s debt sustainability.
The IMF expressed optimism about Sri Lanka’s commitment to implementing its reform agenda, describing the progress as a vital foundation for achieving sustained economic growth. However, Georgieva underscored the importance of expediting the debt restructuring process, calling for high participation from creditors to ensure the programme’s success.
Adding to the momentum, the Steering Committee of the Ad Hoc Group of Sri Lanka Bondholders announced its formal support for the country’s proposed debt restructuring terms on the same day. The Steering Committee, representing around 40% of Sri Lanka’s outstanding sovereign bonds, has been a central player in the two-and-a-half-year negotiations following Sri Lanka’s sovereign default in 2022. The restructuring proposal, which also has the backing of the Local Consortium of Sri Lanka (LCSL), covers over 50% of the country’s $12.55 billion in sovereign bonds.
The restructuring framework introduces innovative financial instruments to align creditor interests with Sri Lanka’s long-term goals. Among these are Macro-Linked Bonds (MLBs), which tie payouts to the country’s economic performance, and Governance-Linked Bonds (GLBs), which link returns to specific governance benchmarks and incentivize meaningful reforms and accountability while ensuring fair treatment of creditors. The Steering Committee emphasized that the terms meet IMF debt sustainability targets and foster collaboration between Sri Lanka’s authorities and international investors.
The IMF’s endorsement of these restructuring terms reinforces confidence in the country’s path to recovery. The agreement provides Sri Lanka significant debt service relief, creating fiscal space to prioritize critical domestic needs such as healthcare, education, and infrastructure. The debt restructuring could restore investor trust, improve access to global financial markets, and support economic growth. Provided debt restructuring is coupled with reforms.
However, challenges remain. The success of the debt restructuring hinges on widespread participation from bondholders, a process the Steering Committee has strongly encouraged. Domestically, reforms may involve austerity measures that could strain public support, particularly among vulnerable populations. Navigating these complexities will require careful management and continued international assistance.
The IMF has reiterated its commitment to supporting Sri Lanka through this transition, viewing the country’s efforts as pivotal in achieving long-term fiscal stability.
These developments mark a turning point for Sri Lanka as it seeks to emerge from its financial crisis. The combined support of the IMF, bondholders, and other international stakeholders provides a foundation for the country to rebuild its economy and restore stability.
While Fitch Ratings recognized Sri Lanka’s debt restructuring agreements as positive milestones, it cautioned that debt-to-GDP will remain elevated, projected to fall from 116% in 2022 to 103% by 2028. Fitch highlighted improved revenue collection—up 43% year-over-year in 2024 due to tax reforms—but stressed that fiscal sustainability depends on structural reforms and effective governance.
External challenges persist, with Sri Lanka locked out of international capital markets until 2028. Foreign reserves rose to $6 billion in 2024 but may slow as external debt repayments resume.
With over $17.5 billion in debt service relief secured through coordinated efforts with the IMF, bondholders, and official creditors, Sri Lanka is not closer to achieving debt sustainability. That could take many years. However, the progress with debt restructuring marks the beginning of a recovery journey that hinges on effective reforms, strong governance, and policy stability to ensure lasting economic resilience. An environment not seen since independence.