Sri Lanka needs a growth plan to avoid another crisis

By Dirk Willem te Velde & Ganeshan Wignaraja

Sri Lanka’s experience offers valuable lessons for middle-income countries grappling with post-Covid debt distress. While the economy is showing signs of stabilisation in mid-January 2025—bolstered by positive growth, low inflation, a boom in tourism and a bullish stock market—the challenges ahead are far from over.

Sri Lanka’s experience offers valuable lessons for middle-income countries grappling with post-Covid debt distress. While the economy is showing signs of stabilisation in mid-January 2025—bolstered by positive growth, low inflation, a boom in tourism and a bullish stock market—the challenges ahead are far from over. Sri Lanka finds itself on the precipice of both opportunity and risk, and it is crucial that the new National Peoples Power (NPP) government charts a new path towards inclusive and transformative growth that ensures debt sustainability, avoids future crises and delivers for all Sri Lankans.

To address this critical need, ODI Global has initiated a study group with eminent Sri Lankan economic thinkers to develop a new growth plan for the country. This exercise builds on our co-edited essay series, Sri Lanka: from debt default to transformative growth, which presents 27 pragmatic policy proposals drawing on insights by leading Sri Lankan and international experts.

This topic is a priority because the NPP government, led by President Anura Kumara Dissanayake, entered office in late 2024 at a pivotal moment. Sri Lanka is emerging from its worst post-independence economic crisis (2022-2023) which was triggered by a default on external debt obligations in April 2022. The default represents a development setback for Sri Lanka which was often cited as a ‘basic needs’ success story as early as the 1970s despite being a poor country.

The causes of this crisis are complex and widely debated. Key factors include a long history of fiscal and current account deficits, acute economic mismanagement during 2019-2022 (locally known as “homegrown solutions”), commercial borrowing from China’s policy banks for a plethora of low-return infrastructure projects (e.g., Hambantota Port and Mattala Airport in Southern Sri Lanka), and external shocks like the fallout from the Easter Bomb attacks in 2019, the Covid-19 pandemic and the Russia-Ukraine crisis. President Dissanayake and the NPP campaigned on a platform of compassionate and corruption-free governance.

Remarkable economic stabilisation, but risks remain

Sri Lanka’s recent economic outlook offers reasons for cautious optimism. Thanks to prudent monetary and financial stability policies by the Central Bank of Sri Lanka, a $3 billion four-year IMF programme and $4 billion of Indian financial assistance, the economy appears to have stabilised after severe macroeconomic turbulence. A $17.5 billion debt restructuring deal with private bondholders and China has provided much-needed breathing room, and a resurgence in tourism has boosted foreign exchange reserves. To his credit, President Dissanayake has committed to the IMF programme and the debt restructuring process but with increased social spending to reduce high poverty, both agreed to by his predecessor.

In this environment, the new government has inherited a stabilising economy. The latest World Bank growth forecasts point to growth at 4.4% in 2024 though slowing slightly to 3.5% in 2025. However, the road ahead is still fraught with uncertainty. The best way to overcome this uncertainty is to have a robust growth plan that addresses potential risks.

While the economic outlook is positive, there are looming risks that the new government must tackle head-on. Public debt levels are projected to remain high (over 100% of GDP in 2028 after the end of the current IMF programme) with notable debt servicing needs despite the restructuring deal with private and official creditors, and there is a risk of significant wage demands from public sector trade unions concerned about the cost of living.

Another pressing concern is the outflow of skilled professionals. In 2024 alone, an estimated 300,016 individuals, including IT, banking, marketing and medical professionals, migrated seeking better opportunities abroad. This brain drain poses a serious challenge for both business and governance, as the country faces a growing gap in the talent pool needed to propel growth.

Rather than putting barriers to outward migration, creating an environment that encourages skilled professionals to stay is crucial. This requires a growth plan that incentivises the use of their skills, provides competitive salaries and benefits and fosters a stable and promising economic future.

Key ingredients and policies of a growth plan

A successful growth plan requires considering what are likely high-growth sectors and supporting them. There are several candidates in the country’s evolving comparative advantage, such as niche manufacturing (high-value textiles, auto parts, boat building and electronic components), ICT and the digital economy, and tourism.

Tourism, in particular, presents a quick win for a new government. It has long been a critical sector for Sri Lanka and continues to show a strong post-crisis recovery. With over 2 million tourists visiting Sri Lanka in 2024, a 38% increase over 2023, tourism offers significant potential to boost foreign exchange reserves and spur growth. However, the government must do more to ensure that tourism is sustainable and benefits communities beyond Colombo. Better marketing of Sri Lanka as a multi-cultural destination, coupled with targeted development of less-visited regions such as the North and East of the country, and support for small businesses linked to tourism activities, such as small hotels, restaurants and wellness products, are essential and will help create a more balanced and decentralised tourism industry. Furthermore, addressing the recent wave of gang-related violence is also vital to ensure the safety and security of tourists.

A growth plan needs to further consider which domestic and international policies may support sectoral growth. Fiscal sustainability remains one of the most contentious issues facing the new government. To date, there has been very little attention to the growth and development impacts of fiscal multipliers in Sri Lanka (i.e. active targeted fiscal policies that support growth rather than just saying fiscal prudence). This is an important area for research and policy action. While revenues have increased, rationalising government spending remains a priority, largely due to the state’s expansive role in the economy.

While ruling out privatisation, the government plans to improve the management of state-owned enterprises (SOEs). However, reconsidering the privatisation or restructuring of some of the larger loss-making SOEs like Sri Lankan Airlines and the Ceylon Petroleum Corporation may be necessary as their continued drain on public funds threatens long-term fiscal stability. With the support of international financial institutions, the government should pursue a strategy that right-sizes the state, encourages private-sector growth and ensures fiscal health in the coming years.

Appropriate monetary and financial policies are also crucial ingredients of a growth plan. The Central Bank Act of 2023 provides a framework for flexible inflation targeting and Central Bank independence, enabling the bank to refuse monetary financing and encourage better fiscal discipline. However, alongside this, the financial sector must be organised and incentivised to support high-growth sectors and small businesses. Further research is needed, drawing on global good practices, to determine whether the existing banking and non-bank financial system is sufficient or if a new development finance institution is required. Implementing global good practices on methodologies for regular stress testing of banks is also crucial to determine whether banks have sufficient capital to withstand negative economic shocks.

Sri Lanka’s international economic policies are equally important. The inauguration of President Trump and his promise of tariff-raising policies could affect the geopolitics of the Indo-Pacific. Strengthening economic ties with neighbouring India is vital to ensure Sri Lanka benefits from investments, technology transfer, market access and collaborations from this fast-growing nation. President Dissanayake’s recent visit to India offers a promising foundation for stronger bilateral relations. The focus should now be on making concrete progress in areas such as B-B links in high-growth sectors, cross-border energy projects, an Indian private sector port investment in the West Container terminal of Colombo Port, a digital ID scheme and the deeper bilateral free trade agreement under negotiation.

Japan’s relationship with smaller ASEAN countries, which has fostered regional industrial development and cooperation, may offer a valuable ‘flying geese type’ model for such efforts. This has led to, among other things, the increase of global supply chains and jobs in Southeast Asia and a framework for regional trade and monetary cooperation. Sri Lanka’s strategic geographical location, its deep water ports, skilled labour and arguably less red tape regulations are some of its comparative advantages for improved trade and investment ties with India.

Building capacity for implementing growth policy

We have known the importance of some policies for some time. However, the challenge lies in the implementation due to weak state capacity and political incentives. One constraint is the lack of good oversight, as the new government has a parliament with little experience. Of the 225 MPs, about 150 are untested first-time representatives, mostly from the NPP, which raises concerns about the legislative and technical capacity needed to enact the economic reforms Sri Lanka so desperately needs. In addition, the government must prioritise better public sector service delivery, retain key talent within the state sector and create policies that encourage the development of expertise in governance and public administration. Improved state planning for undertaking market-oriented public policies, digitisation of public services, training MPs in the legislative process and understanding the complexities of economic reforms are also crucial. Establishing a top-quality public policy school to train civil servants and MPs would be a valuable addition to Sri Lanka’s university system.

Sri Lanka stands at a crossroads, and the world is watching. While the new Sri Lankan government has made a reasonable start, the economic challenges ahead are significant. Developing a comprehensive, inclusive and transformative growth plan that addresses immediate risks and seizes long-term opportunities is essential. This plan should identify sectors that are going to drive transformative growth in the future; which domestic macroeconomic policies are supportive of these sectors, and effective trade and investment policies. It must also prioritise building state capacity for how these economic transformation policies are going to be effectively implemented. Navigating these choppy waters will require pragmatic leadership, bold policy decisions, a clear vision for Sri Lanka’s future prosperity and donor support.

*Professor Dirk Willem te Velde is a Principal Research Fellow and Director of ODI’s International Economic Development Group. He is the Director of Supporting Investment and Trade in Africa and Supporting Economic Transformation programmes.

*Dr Ganeshan Wignaraja also holds positions as Professorial Fellow in Economics and Trade at Gateway House: The Indian Council on Global Relations in Mumbai and as a Non-Resident Senior Fellow at the Institute of South Asian Studies of the National University of Singapore.