Sri Lanka

Economic recovery hampered by Cyclone Ditwah

The effects of the balance of payments crisis and sovereign external default of 2022 continued into 2023, before the economy began to recover in 2024. The recovery continued in 2025, driven by foreign tourism and a rebound in private consumption, stimulated by rising wages and expatriate remittances, strong credit growth and deflation. However, the arrival of Cyclone Ditwah on 28 November 2025, followed by torrential rains, caused significant damage. The World Bank estimates the direct physical damage to be equivalent to 4% of 2024 GDP. Infrastructure – roads, bridges, railways and water networks – accounted for the largest share of the damage, estimated at USD 1.735 billion, followed by housing (USD 985 million) and agriculture (USD 814 million).

The destruction certainly caused a dip in activity at the turn of 2025 and 2026. However, activity is expected to rebound quickly. Construction is likely to show the fastest growth rate due to strong demand for reconstruction. Nevertheless, services (59% of GDP in 2024) will remain the main driver of activity in 2026, with the revival of tourism in particular. Before the cyclone, international arrivals had exceeded 2018 levels – the high point before the Easter 2019 attacks and the pandemic – and are expected to resume the growth path, supported by the destination's strong price competitiveness. Transport, which was only slightly affected by the cyclone, will continue to contribute to growth, particularly maritime transhipment, driven by robust demand and increased port capacity in Colombo and Hambantota. Driven by clothing manufacturing (the leading export item), industry (27% of GDP) should also return to recovery once the infrastructure has been repaired. In addition, the gradual recovery of agriculture (8% of GDP), which was severely affected by the cyclone, will play a key role as it accounts for nearly 30% of jobs – making it instrumental to consumption – while tea remains the second-largest export product. Last, the more predictable macroeconomic framework established by the IMF programme is boosting investor confidence. In this regard, the reform of the energy sector should attract new FDI in solar, wind and storage projects, supported by the World Bank's USD 150 million programme (June 2025).

After eleven months of deflation, inflation returned to positive territory in August 2025, driven by rising food prices and increases in several administered tariffs. To bring inflation closer to its 5% target, the central bank eased its monetary policy, lowering its key interest rate by 25 basis points to 7.75% in May 2025. This contributed to a sharp acceleration in private sector credit, which rose by 19.6% year-on-year in July 2025. Despite the temporary impact of the cyclone – disruptions to supply chains causing shortages of certain food products – inflation is expected to remain below target in 2026. The easing of global commodity prices and the stabilisation of the rupee are expected to outweigh the recovery in demand and new tariff adjustments (particularly on electricity). Further cuts in the key interest rate can therefore be expected in 2026.

Budget consolidation halted by the cyclone

In terms of the budget, the government has honoured the commitments made under the programme agreed with the IMF in March 2023. This programme provides for a package of USD 2.9 billion, to be disbursed in instalments until 2027. It serves as an anchor for the consolidation path, which is mainly based on revenue. Rather than further tax increases, the focus in 2026 will be on broadening the tax base and improving collection. The authorities plan to lower the tax threshold for VAT and social security contributions, while stepping up the digitisation of payment terminals. On the expenditure side, only a small portion of the financing for post-cyclone reconstruction will be covered by emergency aid from international partners. This represents around 0.5% of GDP, while the damage is estimated at nearly 4% of GDP. The target agreed with the IMF to stabilise total expenditure at around 20% of GDP in 2026 will not be met and the deficit will widen.

Sri Lanka took a decisive step towards resolving its debt crisis at the end of December 2024 by signing an agreement to restructure approximately 98% of the nominal value of its international bonds. Almost all Eurobonds were exchanged for new, more sustainable instruments (extended maturities, grace periods, lower interest rates). At the same time, bilateral agreements were signed with official creditors, including those from the Paris Club – notably Japan, India and France – as well as with China. The external public debt ratio is now on a downward trajectory. Sri Lanka has been granted a grace period until 2027. Last, despite the additional cyclone-related expenditure, the debt burden is not expected to increase as the authorities will draw on cash reserves.

The current account balance is expected to turn negative in 2026, penalised by the slump in tourism following the cyclone and the widening trade deficit. Between January and November 2025, the merchandise trade deficit widened by 32% year-on-year, with imports – driven by purchases of vehicles and consumer goods – growing faster than exports. However, exports, dominated by clothing, tea and rubber, recovered as the input shortages inherited from the 2022 crisis gradually dissipated. Exports will bear the brunt of destruction wreaked by the cyclone. Customs duties imposed by the US (30% from August 2025), even if comparable to or lower than those of neighbouring competitors, are putting additional pressure on the clothing industry. The primary income deficit narrowed by 18% over the period January-November 2025 and will continue to do so in 2026, thanks in particular to lower debt interest payments. Remittances from the diaspora – mainly from the Middle East – increased by 22% to reach 8.1% of GDP in 2025 and will continue to grow in 2026. However, this will not be enough to keep the current account in positive territory. Nevertheless, emergency financing from partners, IMF disbursements and increased exchange rate flexibility should enable the continued replenishment of foreign exchange reserves (equivalent to 3.4 months of imports in November 2025).

New left-wing government faces high expectations for change after the 2022 crisis

The election in September 2024 of President Aruna Kumara Dissanayake, followed by the landslide victory of his left-wing National People's Power (NPP) coalition in the general election, brought an end to seven decades of rule by traditional parties. The coalition is led by the presidential party, the Marxist-inspired People's Liberation Front, which has not prevented the President from committing to the IMF programme. The government enjoys popular support, fuelled by high expectations for change, particularly in the fight against corruption and state reform. During its first year, the government reduced many political privileges and prosecuted several figures from the former regime, thus consolidating its image of breaking with the past. However, the growing gap between promises and the slow pace of reforms is already being highlighted by the local media, especially as the structural challenges are immense. The main risk to political stability is economic: poverty remains high, and improvements in living conditions are slow to materialise. The government's handling of Cyclone Ditwah has reinforced this feeling, with some opponents criticising the government for its inexperience and inefficiency. In the local elections in May 2025, the NPP won only 43% of the vote – a decline from its presidential and parliamentary victories.

Heavily dependent on international aid, the country must balance its relations with the major powers, particularly India and China, while keeping other creditors happy. India, the main financial supporter during the 2022-23 crisis that provided nearly USD 4 billion in emergency aid, occupies a central place following the signing in 2025 of a five-year military cooperation agreement. At the same time, the country aims to preserve its relations with China, which the first creditor to agree to a debt restructuring agreement in October 2023. Beijing remains a key partner: it has financed and built numerous major infrastructure projects and is likely to remain very much involved.

Last updated: January 2026