Sri Lanka’s economy is finally steadying. Growth has returned, inflation has eased, and the rupee has held firm. GDP expanded 4.8% year-on-year in the first half of 2025, led by a rebound in consumption and tourism. Inflation fell to low single digits, while foreign reserves climbed to nearly $6 billion. Debt restructuring and the country’s first primary sur plus in years (2.2% of GDP) have restored confidence, though largely through fiscal tightening.
Yet both the World Bank’s “Better Spending for All” and the Institute of Policy Studies (IPS) “State of the Economy 2025” reports reach the same conclusion: Sri Lanka’s recovery remains shallow. The rebound has been cyclical rather than structural; driven by consumption and short term investment instead of productivity or reform. IPS economists Dushni Weerakoon and Nisha Arunatilake observe, output may return to pre-crisis levels by 2026, but that alone will not rebuild what was lost.
The Need for Strong Governance and Structural Reforms
The turnaround has been achieved through a combination of strict fiscal consolidation, monetary restraint, and external support under the IMF programme. Debt restructuring reduced short-term pressure, and tighter spending controls produced the first primary surplus in years. These measures have restored confidence among investors and
creditors, but at a cost.
The country’s fiscal breathing room today comes largely from deferred debt, not diminished debt. Commercial loan repayments have been postponed until 2028, with the repayment window now extended to 2043. In effect, Sri Lanka has paused the repayment of the borrowed money itself, but continues to pay the “rent” on it through interest. Those interest costs still consume about 65% of government revenue, leaving little room for investment in growth or welfare.
This temporary relief has helped stabilise markets and reserves, but it has not changed the underlying structure of the economy. With 82% of total government spending tied up in wages, welfare, and debt service, only a fraction remains for development projects. Capital expenditure, once 4.1% of GDP in 2017, has fallen to around 3.4%, slowing infrastructure renewal. Further, since its independence, Sri Lanka has entered 16 IMF programmes and completed only 9. Over the past 12 years, the nation has met its key fiscal goals in only 2 of those years. This history makes the risk clear. Sri Lanka’s recent gains are real but reversible.
As IPS economist Dr. Dushni Weerakoon cautioned, “breaking down debt and borrowing does not automatically equate to sustainable public finances.” Sri Lanka has balanced its books. But without structural reforms, the next phase of payments could reopen the very vulnerabilities this stability was meant to close.
Consumption, Not Productivity
Sri Lanka’s recent growth reflects an industrial rebound and steady gains in services, according to the World Bank. Industrial output rose 7.9%, supported by higher textile and apparel production ahead of tariff deadlines. Cement use increased 10.1%, signalling a modest recovery in building activity, though still below pre-crisis levels. Services grew 3.3%, led by financial and tourism-related services, such as accommodation and transport. These gains mark a reopening of activity, not a rise in productivity.
On the demand side, private consumption and investment have powered the rebound. Household spending grew 7.7% year-on-year in Q1 of 2025, accounting for nearly 90% of GDP growth. Private credit expanded 19.6% by July as lending rates eased to around 10%. As a result, spending has risen, but imports are growing faster than exports. The removal of vehicle import restrictions, for instance, led to a 13-fold rise to $506 million by July, surpassing the cumulative total of the previous 5 years.
Hence, the trade deficit widened 22.5% to $3.9 billion, even as tourism earned $2 billion and remittances rose 19% to $5.1 billion, supporting reserves. Yet these gains are cyclical. The World Bank warns growth could slow to 3.1% without reform. As Dr. Weerakoon notes, “The momentum of a cyclical recovery will start to ease unless we provide productivity and efficiency gains through reform.”
“Breaking down debt and borrowing does not automatically equate to sustainable public finances.”
– Dr. Dushni Weerakoon, Executive Director of the Institute of Policy Studies of Sri Lanka
Sri Lanka’s Public Workforce Far Exceeds Regional and Global Averages
The country’s first primary surplus in years and a 36% reduction in the fiscal deficit signal tighter control over public finances. Yet this balance has been achieved through restraint rather than reform. Nearly 65% of government revenue now goes to interest payments, leaving little room for investment or service delivery. Real public wages have fallen 33% since 2020, pensions by 26%, and capital budgets remain underspent. Stability, in short, has been bought through compression rather than efficiency.
This rigidity runs deep within the state itself. Around 15% of the national workforce is employed by the public sector, and Sri Lanka maintains 3x more armed forces personnel per capita than comparable middle-income economies. The size and structure of the public payroll leave little fiscal space to invest in productivity-linked pay, technology, or service modernisation.
Allowances make up 30–60% of take-home pay in many public professions, distorting incentives and complicating
payroll management. Administrative systems remain largely paper-based and decentralised, with processes dating back to 1985. The absence of reliable workforce data makes it difficult to plan staffing or reallocate personnel efficiently.
To address these weaknesses, the Public Sector Wage Bill Report recommends establishing a National Pay Commission, modernising payroll systems, and gradually downsizing through attrition. The goal is to redirect spending toward essential services: education, health, and administration, where improved pay and management can raise productivity. These reforms are critical to make fiscal stability sustainable; without them, wage compression and stagnant public employment will continue to deepen inequality and weaken household resilience.
Stability Has Yet to Ease the Strain on Households
While macroeconomic stability has returned, daily life for many Sri Lankans tells a different story. Poverty is estimated at 22.4% in 2025, down from 24.9% in 2024, yet still roughly double the 2019 level, according to the World Bank. Nearly 10% of Sri Lankans live just above the poverty line, and 17% of children under five are underweight, with stunting rates still rising.
Food insecurity and malnutrition persist, particularly among low-income families, as higher living costs continue to erode real incomes. Earnings remain below pre-2022 levels, and purchasing power has yet to recover. Inflation, though subdued, turned positive again in August 2025 at 1.2% year-on-year, driven by higher food and energy prices. Poorer households spend 3x more of their budgets on food, leaving little for savings or essential services.
These household struggles reflect deeper structural weaknesses in the labour market. Participation and earnings remain low, limiting how much families benefit from recovery. Overall participation stood at 49.7% in early 2025, with female participation around 32%, both below pre-crisis levels. Urban centres have recovered faster than rural areas, while districts dependent on farming and small industries face weaker demand and limited credit access.
Weak fiscal flexibility has also starved public institutions of the resources needed to deliver better outcomes. According to Dr. Arunatilake, only 70.7% of schools have science laboratories, and digital readiness across institutions remains uneven. Digital literacy stands at just 35%, and only one in five employees regularly use computers. In the health sector, equipment shortages and weak data systems continue to limit service delivery. Social protection programmes have expanded since the crisis, but benefits remain modest and fragmented, offering short-term relief rather than lasting recovery.
“Nearly 10% of Sri Lankans live just above the poverty line, and 17% of children under five are underweight, with stunting rates still rising.”
Capital Spending Stalls Despite Economic Recovery
These institutional shortcomings have also weakened Sri Lanka’s ability to invest and build. Capital expenditure has fallen from 4.1% of GDP between 2017 and 2022 to 3.4% in 2023, and by mid-2025 only 27% of the year’s planned development spending had been executed. Large public projects now take an average of 5.8 years to complete, while maintenance spending stands at just 0.2% of GDP, well below the international benchmark of 0.7–1.8%. The World Bank estimates that reprioritizing about 0.4% of GDP from slow-moving projects and adding 0.6% to complete near-finished ones could lift efficiency without widening the deficit.
The issue is not scarcity of funds but weak planning, fragmented execution, and annual budget rules that disrupt long-term delivery. The impact is visible across the economy. Infrastructure renewal has slowed, with roads, schools, and hospitals deteriorating faster than they can be repaired. Delays and cost overruns are common, eroding productivity and investor confidence. Private investment has not stepped in to fill the gap: foreign direct investment remains close to 1% of GDP, among the lowest in comparable economies, as firms hesitate amid policy uncertainty and slow project approvals.
At the root of this weakness are institutional rigidities. Over-centralised decision-making, inconsistent regulations, and limited accountability have left the public sector unable to spend effectively or partner confidently with the private sector. Fiscal discipline has restored order, but without institutional reform it cannot create growth.
The World Bank and IPS both point to the same remedy: structural reform. Strengthening project appraisal, enabling multi-year budgeting, and prioritizing maintenance over new construction would improve public investment efficiency. Simplifying approvals and stabilising land and tax policies would unlock private confidence.
With fiscal space tight and administrative reform slow to advance, the IPS identified digitalisation as a path to modernise institutions, improve service delivery, and raise efficiency across sectors. Dr. Arunatilake notes that the opportunity lies in “practical, low-cost systems that improve performance across sectors.”
According to IPS analysis, digitalisation can drive reform in three key areas: improving coordination and accountability in public services, cutting trade costs, and expanding access to education and employment. Some initiatives are already taking shape. The government’s new Ministry of Digital Economy aims to expand the digital sector’s share of GDP from 4.5% to 12% by 2030. A National Single Window for trade, could reduce clearance times from two days to 15 minutes and cut trade costs by 70%. Digitizing land records would help farmers meet EU deforestation regulations, protecting over $100 million in export earnings. Similar systems in health, education, and social protection could reduce administrative waste while improving service quality.
Dr. Weerakoon describes digitalisation as “a feasible and politically neutral reform path that can deliver early, visible productivity gains.” These reforms are affordable and build on existing systems. Yet technology alone will not suffice. Real progress depends on human capital. Digital adoption must be paired with stronger skills training, better connectivity, and inclusive access to public services. Dr. Arunatilake, adds, “Digitalisation is not only about technology; it’s about creating opportunities for people to participate in and benefit from growth.”
“Digitalisation is not only about technology; it’s about creating opportunities for people to participate in and benefit from growth.”
– Dr. Nisha Arunatilake, Director of Research at the Institute of Policy Studies of Sri Lanka
Sri Lanka’s crisis is over, but its recovery is unfinished. The recent rebound rests on discipline and deferral. Fiscal tightening and debt restructuring have reduced pressure, but not created room for growth. With 65% of revenue absorbed by interest payments and investment spending still low, the country’s recovery remains shallow. Real wages are below pre-crisis levels, poverty remains elevated, and productivity growth is weak.
Sri Lanka’s future now hinges on whether stability can lead to reform. The foundations are in place: stronger revenue collection, lower inflation, and renewed market confidence. But these must be used to rebuild the state’s capacity: to invest, execute, and deliver. Structural reforms in public finance, labour, and digitalisation will determine whether stability becomes strength or fades into another cycle of failed IMF programmes.