Budgets in Sri Lanka have never lacked ambition for social welfare spending for a number of reasons. First, no government wishes to waste the platform and media circus that follows the announcement of a fiscal plan. Since detailed outturns don’t attract much public interest, undeliverable undertakings can be made with impunity.
Even when the spotlight shines on them, poor budget outturns are dismissively explained as due to rising crude oil prices, bad weather, or other externalities.
Without realistic assumptions, optimistic government revenue targets are missed year after year. That assumptions are a cornerstone of budget making is somehow lost. When public finances are creaky, budgeted capital expenditure is slashed as a priority. That a new school building isn’t built is a bureaucratic detail, unlike having unpaid teachers, a political liability.
However, 2022’s economic crisis and the sovereign debt default transformed Sri Lanka’s economic governance.
Sri Lanka’s economic crisis could not have been more poorly timed for its people. The new growth model the country needs has to be built on the emerging ruins of global institutions and rules intended to foster international trade and investment.
The first part of the story outlines the macroeconomic successes, followed by the challenges to building a new growth model.
A major cause of recurring macroeconomic instability—at least the domestically driven kind—has been government fiscal mismanagement. A rules-based framework enforced by the Public Finance Management law now anchors policy to the government budget’s primary balance (the budget deficit excluding interest costs). The current target is a 2.3% of GDP primary surplus.
In addition to mandating the core principle that the primary balance must stay in surplus, the Public Finance Management law also brings transparency, accountability, and medium-term fiscal sustainability to economic management. This is the first of five governance milestones that have delivered macroeconomic stability.
President Ranil Wickramasinghe negotiated an IMF programme in conjunction with restructuring the public debt (a 4-year Extended Fund Facility approved by the IMF in March 2023). By keeping the EFF reforms on course, the government has achieved economic stability compared to 2022. The policy continuity in the last three years across two political cycles is unusual for Sri Lanka.
The second is the Central Bank Act, which introduced autonomy as well as accountability for the operations of the Central Bank. Once the inflation target is set by the finance minister in consultation with the Bank’s governor, the act grants instrument autonomy for the Central Bank to achieve it.
The new central bank act addresses the two key sources of instability in terms of monetary policy. One is deficit financing. The fiscal dominance in monetary policy was reflected through large amounts of deficit financing from time to time. That is no longer possible. The Central Bank is not allowed to lend to the government except in exceptional circumstances.
Second, financial repression has ended. In the past, interest rates have been held low artificially to generate cheap money for the government and to create artificial growth.
Both major sources of economic instability—deficit financing and financial repression—are no longer viable. Interest rates are now set under a flexible, data-driven inflation-targeting regime that is forward-looking and blocks any return to artificially administered rates.
The third milestone is the Public Debt Management Act. Public debt management is highly fragmented. The external resources department at the finance ministry manages bilateral and multilateral debt. The treasury operations department, at the same ministry, looks after syndicated loans and commercial debt from banks, and the Central Bank manages the ISBs (international sovereign bonds).
From the beginning of 2026, debt management will be unified into one entity, the Public Debt Management Office, creating the conditions for a harmonised debt management strategy that takes into account rollover risks while optimising the debt portfolio.
The fourth economic governance milestone is cost-reflective pricing for state-owned enterprises. Cost-reflective pricing also strengthens state bank balance sheets, as losses incurred by public enterprises like CPC and CEB were parked on the balance sheets of these banks.
Untargeted subsidies – which SOE losses were – distort resource allocation, undermine the government’s fiscal position, and erode the balance sheets of state banks. Cost-reflective pricing has cleaned up the government’s own balance sheet and those of state banks. Instead of using SOEs, social protection is now delivered through targeted cash transfers more efficiently.
Corruption and poor governance act as an implicit tax on development; they increase the cost and raise the margin needed for a project to achieve a hurdle rate of return. In turn, it depresses development across the board. With its implementation, Sri Lanka now has a significantly improved anti-corruption framework, with the Anti-Corruption Act being the fifth overhaul to economic management.
The combined effect of these is that Sri Lanka will sidestep repeating cycles of macro instability and serial IMF programmes.
Government revenue increased by 29% by August 2025, while spending grew by a more moderate 7%. Capital expenditure declined by 24%. EFF targets of tax revenues equal to 13.9% of GDP and a primary surplus of 2.3% in 2025 will likely be surpassed. One estimate by Bloomberg News suggests an outturn of 15.2% and 4.5% for government revenue and the primary surplus. EFF’s targets for 2026 are 14.2% and 2.3% for revenue and the primary deficit. Overperformance relative to 2026 EFF tar- gets, however, isn’t directly comparable as GDP will change in 2026.
Families were devastated by the economic crisis of 2022 when living standards fell and poverty rates doubled. The number of families who are vulnerable to poverty, or one economic shock away from falling into poverty, rose.
Good governance and competent economic stewardship since the presidency changed in 2022, didn’t reset living standards to 2018 levels for these families. In the five years since 2018, Sri Lanka has dipped in and out of recession. By 2022, its economy had shrunk by around 10% from 2018 levels.
Its economic growth of 3% to 4.5% annually and inflation, which the central bank expects will be 5% in 2026, will fail to transform the lives of people.
If Sri Lanka has laid a foundation of economic governance as a first step, then to meet the aspirations of all its people, the country will have to be put on a faster growth path. Former central bank deputy governor W A Wijewardena suggests, to transform lives of people, Sri Lanka will need 7-8% economic growth. So, how can Sri Lanka change its growth model?
In a recent speech, former central bank governor Indrajit Coomaraswamy argues for several structural reforms and fixes to the model to transition the stability to sustained growth. He attributes low growth as a primary reason why governments resort to unsustainable macroeconomic policies to create ‘sugar highs’ by pumping in excess aggregate demand into the system, and suggests only a competitive outward-oriented economy will return sustainably high growth. This is Sri Lanka’s biggest opportunity, and will require factor market structural reforms.
By the cold war’s end what economic isolation did to countries was obvious, and a consensus emerged that it was easier for economies to grow through integration than self-isolation. Three trends drove glo- balisation in the 1990s; the trade negotiations that saw the evolution of the General Agreement on Tariffs and Trade (GATT) into the WTO in 1995, the second was liberalisation of capital flows and the third, was the outsized business opportunities that emerged with mainstreaming of the internet.
Those three things that drove globalization lifted millions of people out of poverty, particularly in India and China but also other parts of the global south.
“When public finances are creaky, budgeted capital expenditure is slashed as a priority. That a new school building isn’t built is a bureaucratic detail, unlike having unpaid teachers, a political liability.”
However, Sri Lanka did not have any benefits from that process of globalisation and the boost it gave to international trading because, in the 1990s, it began to reverse the liberalisation, fearing the loss of sovereignty. It built only a negligible presence in global supply chains at a time when supply chains were the most dynamic component of the international trading system. Sri Lanka failed to make any headway with any of these three global shifts that accelerated three decades ago. Reforms to integrate Sri Lanka into global supply chains are the second opportunity.
Correcting the anti-export bias is the third area of reform. Before the fears of globalisation’s eroding sovereignty emerged, Sri Lanka’s exports of goods and services peaked at about 39% of GDP in the year 2000. Since then, the economy has become more closed and less competitive and by 2024, the level of foreign trade has halved to the equivalent of 19% of GDP. For an economy of 23 million people with a per capita income of a little over $4,000, it is impossible to drive sustained growth of 7% or over without opening up to the rest of the world.
The various geopolitical tensions in the multilateral trading system and its fragmentation leading to a multipolar world, is the fourth challenge. How countries responded was to have more and more plurilateral or regional and bilateral trade agreements.
Countries like Vietnam, which have over 20 bilateral trade agreements, and plurilateral agreements like RCEP and the successor arrangement to TPP are well integrated into trade. Because globalisation was being rolled back, this was the way countries increased their access to markets: through bilateral and regional arrangements.
In the last decade Sri Lanka has entered two trade agreements, with Singapore and Thailand, but neither of which has been implemented. It demon-strates the island’s lack of an agenda to increase market access, to diversify the products and also to diversify markets.
Although the shifts in global trade with the Trump tariffs have not yet had much impact on global living standards, they constitute a giant and alarming risk. The US is Sri Lanka’s largest trading partner. Responding to deglobalisation-for want of a better term—is now a priority.
Sri Lanka’s tariff structure is highly distorted by various interest group oriented ad hoc measures over the years. Removing para-tariffs which serve to exclude Sri Lanka from crossborder supply chains is a key reform. While globalization may be in reverse, with obstacles multiplying as the rules fray, a strategic trade strategy reset will serve to maintain access and diversify the export portfolio.
The major cause of repeating cycles of macroeconomic stress and why political leadership violated basic principles of economics has been the conundrum of low growth. Sri Lanka now processes a paradigm which addresses that. While the IMF has helped smooth the way through the financing needs and lent credibility to debt restructuring, it has importantly backed a policy and reform package for growth and competitiveness. The government that was elected after the EFF was finalised has enthusiastically stuck with the reforms. Sri Lanka is beginning to understand consistently in sensible economic governance.